Consumer Compliance Outlook
Right of Rescission in Times of Foreclosure
Reports of rising numbers of foreclosures continue to dominate the evening news. A joint report from the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) issued in March 2010 stated that for the institutions they supervise, mortgages classified as seriously delinquent (in bankruptcy or 60 or more days past due) increased 13.8 percent during the fourth quarter of 2009.1 Serious delinquencies for prime mortgages, which make up two-thirds of the mortgages in the institutions’ portfolios, showed a 75 percent increase from a year ago. The report further states that nearly 40 percent of residential mortgage loans for institutions supervised by the OCC and OTS that went through loan modification programs became seriously delinquent only 12 months after the modification. In this economic environment, the number of foreclosures is not likely to decline any time soon.
It is therefore important that lenders pay close attention to the rescission provisions of Regulation Z, the implementing regulation for the Truth in Lending Act (TILA). Rescission provides consumers with the right to rescind certain credit transactions secured by their principal dwelling for up to three business days after consummation. However, if creditors fail to provide borrowers with the notice of the right of rescission or the material TILA disclosures, the rescission period is extended to three years. Attorneys representing borrowers in foreclosure will typically scrutinize the notice and TILA disclosures for any violations that would extend the rescission period to three years.
Transactions Subject to the Right of Rescission
In general, the right of rescission applies to both open-end (§226.15) and closed-end (§226.23) consumer credit transactions secured by the consumer’s principal dwelling. However, certain transactions are exempt. For open-end credit, §226.15(f) exempts a “residential mortgage transaction” (a loan to purchase or construct a principal dwelling) and a credit plan in which a state agency is a creditor. For closed-end credit, §226.23(f) exempts the following transactions: (1) a residential mortgage transaction; (2) a refinancing by the same creditor for a previous extension of credit already secured by the consumer’s principal dwelling; (3) a transaction in which a state agency is a creditor; (4) an advance, other than the initial advance, in a series of advances; and (5) a renewal of optional insurance premiums not considered a refinancing under §226.20(a)(5).
These exemptions can create ambiguities. For example, if a borrower offers her current residence as collateral to finance the construction or purchase of another property to be used as a principal residence in the near future, is the loan subject to rescission? The Official Staff Commentary (OSC) to Regulation Z addresses this issue in comment 226.23(a)(1)-4 for closed-end credit and comment 226.15(a)(1)-6 for open-end credit: Transactions such as bridge loans are subject to the right of rescission. The right of rescission also applies when the bridge loan is secured by both the current residence and the new property to be used as a principal residence. The consumer’s current principal dwelling triggers rescission rights in this circumstance because the bridge loan is secured by the current dwelling and is not for the purpose of purchasing that dwelling. But if the consumer’s construction loan for a new principal dwelling is secured only by the new dwelling, the loan would qualify as a residential mortgage transaction that is exempt from rescission.2
Another complex situation is whether the residential mortgage transaction exemption applies when a consumer obtains an open-end credit line and uses a portion of the line for a down payment to purchase a dwelling securing the remainder of the line. In this circumstance, comment 226.15(f)-1 clarifies that only the portion of the line used for the down payment is exempt from the right of rescission.
For refinancing of closed-end credit, the right of rescission applies under comment 226.23(f)-4 if a new creditor is involved or if a new advance is made by the existing creditor. A new advance does not include the cost of the refinancing, such as attorney’s fees, title examination, and insurance fees, if bona fide and reasonable. It also does not include any finance charges paid or payable with the new loan.
Congress included the right of rescission in the TILA legislation to protect homeowners from the practices of unscrupulous home improvement contractors who obtain liens on their customers’ houses, often without their customers’ knowledge. Representative John Sullivan stated that TILA’s rescission requirements would “strike at home improvement racketeers who trick homeowners, particularly the poor, into signing contracts at exorbitant rates, which turn out to be liens on the family residences.”3
To protect homeowners from such abuses, Regulation Z requires lenders to provide, in addition to the TILA disclosure statement, two copies of the notice of the right to rescind to each consumer who has an ownership interest in the property. One copy is for the consumer to send to the lender to rescind the loan during the three-business-day period, and the other copy is for the consumer to keep for his or her records, since it contains important information about the consumer’s rights and responsibilities. However, if the notice is delivered in electronic format in accordance with the Electronic Signatures in Global and National Commerce Act (the E-Sign Act), only one copy has to be provided to each consumer.4 The notice must disclose the retention or acquisition of a security interest in the consumer’s principal dwelling, the consumer’s right to rescind, the procedure for the consumer to exercise the right, the effect of exercising the right of rescission, and the date the rescission period ends.
If the lender fails to provide a properly completed rescission notice or if the creditor fails to deliver any of the material disclosures, the consumer’s right to rescind is extended for a period of three years.5 For example, the United States Court of Appeals for the Seventh Circuit held in Handy v. Anchor Mortgage Corporation, 464 F.3d 760 (7th Cir. 2006), that the rescission period was extended from three business days to three years because the creditor provided the borrower with two different model rescission notice forms: H-8 (the general form) and H-9 (refinancing with original creditor). Form H-8 was appropriate for the transaction. The court held that providing two forms, one of which was incorrect for the transaction, violated TILA’s “clear and conspicuous” requirements. Similarly, in Harris v. OSI Financial Services, Inc., 595 F.Supp.2d 885 (N.D. Ill. 2009), the court extended the rescission period to three years because the creditor used model form H-8 when it should have used form H-9.6
Lenders are prohibited from disbursing the funds (other than in escrow), performing services for the consumer, or delivering materials to the consumer until the three-business-day rescission period has ended, and the lender has reasonable assurance that the consumer has not rescinded the transaction. Failure to comply with the three-business-day waiting period requirement can have serious consequences. For example, in Rand Corporation v. Yer Song Moua, 559 F.3d 842 (8th Cir. 2009), the Eighth Circuit held that a creditor who required borrowers to sign a statement at loan closing acknowledging receipt of the rescission notice and falsely stating that the three-day rescission period had passed and that the borrowers had not rescinded the transaction violated TILA and extended the rescission period from three business days to three years. The court cited numerous other decisions that reached the same conclusion.
All consumers with an ownership interest in the property that will be encumbered by the creditor’s security interest must receive a rescission notice, even if they are not applying for credit. Only one consumer’s exercise of the rescission right is necessary to rescind the loan. Therefore, lenders must be certain that each consumer with an ownership interest has agreed not to rescind by the end of the rescission period. The only time lenders are permitted to disburse the funds prior to the end of the rescission period is when the consumer requests the funds based on a bona fide personal financial emergency.7
The three-business-day rescission period begins following the date of consummation, delivery of two notices of the right to rescind to each consumer, or delivery of all material disclosures, whichever occurs last. For the purpose of the right of rescission, business day includes all calendar days except Sundays and legal public holidays. Lenders must disclose the last day for the consumer to rescind the loan by applying this correct definition of business day. In Cornerstone Mortgage, Inc. v. Ponzar, 254 S.W.3d 221 (Mo.App. E.D. 2008), the creditor’s rescission notice erroneously stated that the last day for the borrowers to exercise their right of rescission was January 15, 2006. The correct date was January 17, 2006, but the creditor failed to exclude Sunday and a legal holiday when calculating three business days. As a result, the court held that the rescission period was extended to three years. A related problem occurs when the creditor fails to disclose the deadline for exercising the right of rescission in the rescission notice. In Johnson v. Chase Manhattan Bank USA, N.A., 2007 WL 2033833 (E.D.Pa. July 11, 2007), the court extended the rescission period to three years because the creditor left a blank in the deadline area of the rescission notice: “If you cancel by mail or telegram, you must send the notice no later than midnight of [left blank] (or midnight of the third business day following the latest of the three events listed above).”
It is important to understand the definition of “consummation” for the purpose of calculating the three-business-day rescission period. Section 226.2(a)(13) defines “consummation” as “the time that a consumer becomes contractually obligated on a credit transaction.” Comment 226.2(a)(13)-1 clarifies that this determination must be made by reference to applicable state law. For example, in Murphy v. Empire of America, FSA, 746 F.2d 931, 934 (2d Cir. 1984), the Second Circuit concluded, based on New York law, that consummation occurred once the borrowers accepted the lender’s commitment offer.
The meaning of “consummation” is also important for determining whether a consumer can exercise the right of rescission. The Fourth Circuit recently had to determine whether loan applicants could exercise the right of rescission for an unconsummated credit transaction. In Weintraub v. Quicken Loans, Inc., 594 F.3d 270 (4th Cir. 2010), applicants who had been approved for a loan attempted to rescind it prior to closing to obtain a refund of their deposit because the rate increased. The court rejected their rescission request because it found that rescission applies only to consummated credit transactions, and the loan was never consummated. The Weintraub case is discussed in greater detail in “On the Docket.”
Material Disclosures for the Purpose of Rescission
The three-business-day rescission clock commences following the date of consummation, delivery of two notices of the right to rescind, or delivery of all the material disclosures, whichever occurs last. Material disclosures are defined in footnote 36 of §226.15(a)(3) for open-end credit and in footnote 48 of §226.23(a)(3) for closed-end credit. For open-end transactions, the material disclosures are:
- the method of determining the finance charge and the balance upon which a finance charge will be imposed;
- the annual percentage rate (APR);
- the amount or method of determining the amount of any membership or participation fee that could be charged;
- the length of the draw period and any repayment period;
- an explanation of how the minimum payment is calculated;
- the timing of the payments; and
- if payment of only the minimum periodic payment may not repay any of the principal or may repay less than the outstanding balance, a statement of this fact as well as that a balloon payment may result.
For closed-end transactions, the material disclosures are:
- the APR;
- the finance charge;
- the amount financed;
- the total of payments;
- the payment schedule;
- the high-cost loan disclosures in §226.32(c) and restrictions in §226.32(d); and
- the restrictions on prepayment penalties for higher priced mortgage loans in §226.35(b)(2)
Creditors should be especially careful with disclosures for the APR, the finance charge, and the payment schedule because violations of these disclosures most frequently trigger the three-year rescission period. Section 226.23(g) provides a tolerance for errors in disclosures affected by the finance charge, including the amount financed and the APR. These disclosures are considered accurate if the disclosed finance charge is understated by no more than 0.5 percent of the face amount of the note or $100, whichever is greater, or if it is overstated by any amount. For a refinance with a new creditor, the disclosures are considered accurate if the finance charge is understated by no more than 1 percent of the face amount of the note or $100, whichever is greater. A special rule applies when the consumer’s principal dwelling securing a consumer credit transaction is in foreclosure. The disclosed finance charge is accurate if it is understated by no more than $35 or if it is overstated. Thus, the margin of error in foreclosure proceedings is lower.
The regulation does not provide any accuracy tolerances for the payment schedule disclosures. Therefore, any error involving this material disclosure can trigger a three-year rescission period. For example, in Hamm v. Ameriquest Mortgage Company, 506 F.3d 525 (7th Cir. 2007), the Seventh Circuit held that a creditor’s disclosure statement that identified the payment amount and the number of payments (360) but failed to state that payments were due monthly violated TILA. As a result, the consumer was granted three years to exercise the right to rescind.
Exercising Rescission Rights
Once the borrower exercises the right of rescission, any security interest the creditor obtained is void, regardless of its status and whether it was recorded or perfected. The borrower cannot be required to pay any amount to the lender or a third party in connection with the credit transaction. Any amounts already paid, including broker fees, application and commitment fees, or fees for a title search or an appraisal, must be refunded. Within 20 calendar days after receipt of the notice of rescission, the lender must take action to terminate the security interest and return any money in connection with the transaction. When the lender has complied with these requirements, the borrower must tender the money or property to the lender.8 If the lender fails to take possession of the money or property within 20 calendar days after the borrower’s tender, the borrower may keep it without further obligation. However, these procedures may be modified by court order.
Statute of Limitation for Rescission
In cases where the right of rescission is extended to three years, the question has arisen whether courts can extend the three-year period. The United States Supreme Court addressed this issue in Beach v. Ocwen Federal Bank, 523 U.S. 410 (1998), where the court held that the borrower’s right of rescission expires three years after the date of consummation of the transaction or upon the sale of the property, whichever occurs first, even if the lender failed to provide all material disclosures or notice of the right of rescission. The court based this conclusion on the express language in §125(f) of TILA (15 U.S.C. §1635(f)): “An obligor’s right of rescission shall expire three years after the date of consummation of the transaction or upon the sale of the property, whichever occurs first, notwithstanding the fact that the information and forms required under this section or any other disclosures required under this part have not been delivered to the obligor.”9 This limitation on extending the three-year period also applies to mortgages in foreclosure under §125(i)(1) of TILA (15 U.S.C. §1635(i)(1)).
Another important limitation on the right of rescission concerns lawsuits seeking class-action certification for violations of the right of rescission. A number of courts have recently held that the right of rescission cannot be adjudicated in a class-action lawsuit because rescission raises individual issues that are not appropriate for class-wide determination. See Andrews v. Chevy Chase Bank, 545 F.3d 570 (7th Cir. 2008), McKenna v. First Horizon Home Loan Corp., 475 F.3d 418 (1st Cir. 2007), and LaLiberte v. Pacific Mercantile Bank, 53 Cal. Rptr.3d 745 (Cal. Ct. App. 2007).
In addition, institutions purchasing loans are subject to the right of rescission. Under §131(c) of TILA, (15 U.S.C. §1641(c)), any consumer who has the right to rescind a transaction may rescind against any assignee. See, for example, Shepeard v. Quality Siding & Window Factory, Inc., 730 F.Supp. 1295 (D.Del. 1990) (allowing consumers to exercise rescission against an assignee).
The current mortgage crisis has made compliance with the requirements of the right of rescission under TILA more important than ever. Creditors must ensure compliance with Regulation Z technical rules related to rescission. At a minimum, lenders must establish clear and detailed procedures and provide sufficient training to their staff to ensure day-to-day compliance with these provisions. One mistake can result in a three-year rescission period and lost fees and interest over that period. Specific issues and questions should be raised with the consumer compliance contact at your Reserve Bank or with your primary regulator.