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January 30, 2013

California Supreme Court Rules: Borrowers Can Introduce Evidence re Oral Promises Allegedly Made by Lender to Invalidate Agreements Based on Lender Fraud

by Starfield & Smith

On January 14, 2013, in Riverisland Cold Storage v. Fresno-Madera Production Credit Assn., 2013 Cal. Lexis 253 (2013) (“Riverisland”), the California Supreme Court overturned Bank of America etc. Assn. v. Pendergrass,4 Cal.2d 258 (1935) (“Pendergrass”) which, for nearly 80 years, has limited borrowers’ ability to challenge contracts based on alleged oral promises made by a lender that contradict the terms of the loan documents. This change in California law will make it harder for California lenders to quickly dispose of such borrower allegations by demurrer or summary judgment, and is likely to result in increased litigation costs – and longer times to complete liquidation – for California lenders.

In Riverisland, the borrowers alleged that the lender’s vice president had met with them two weeks before a loan modification agreement was signed, and that he represented to them that the lender would extend the loan for two years in exchange for two pieces of additional real property collateral. The borrowers further alleged that when they signed the agreement, which they did not read (although they initialed the pages setting forth the legal descriptions), the lender’s vice president assured them that the term of the agreement was two years, and that the two additional pieces of real property were the only additional collateral being taken. In fact, however, the written agreement provided for only three months of forbearance by the lender, and identified eight additional pieces of real property collateral. The borrowers subsequently failed to make payments as agreed, and the lender recorded a notice of default. After the borrowers repaid the loan and the foreclosure proceedings were dismissed, the borrowers filed an action against the lender seeking damages for fraud and negligent misrepresentation. Causes of action included reformation of the restructuring agreement and rescission.

Under California law, the parol evidence rule (set forth in California Code of Civil Procedure §1856) prohibits the introduction of outside evidence, such as oral statements or earlier writings, to contradict the terms of a final written agreement. The parol evidence rule is subject to exceptions, however, and allows for evidence challenging the validity of an agreement, or evidence to establish fraud. The decision in the Pendergrass case limited the parol evidence rule’s fraud exception, requiring that the evidence offered to show fraud relates to fraud in procuring the written agreement and not a promise that was different from the terms of the agreement.

In Riverisland, the lender filed a motion for summary judgment, seeking to have the case dismissed based upon the Pendergrass rule. The California Supreme Court overruled Pendergrass, finding it to be inconsistent with California law, an “aberration,” and a potential shield for fraud. 2013 Cal. LEXIS 253, 25-27. Consequently, borrowers will be able to offer additional evidence, such as oral statements allegedly made by a representative of the lender as to the terms of loan documents, to support allegations of lender fraud.

What are the ramifications for lenders? Quite simply, lenders may be unable to quickly dispose of claims of oral promises differing from the terms of written loan documents through demurrer or summary judgment. Such claims will most likely result in time-consuming and costly litigation, with most cases brought by borrowers expected to include allegations of fraud, and more cases expected to go to trial.

What actions might a lender take to protect itself? While the facts of Riverisland indicate that the initialing of loan documents will likely not be sufficient to support a lender’s defense that borrowers had knowledge of the contents of loan documents, there are a number of protective measures that lenders can take to protect themselves from allegations of fraud.

• Some experts have recommended the inclusion of arbitration or judicial reference clauses in loan documents which, if enforced, would allow the lender to have the dispute heard by an arbitrator or judge rather than a jury that might have more sympathy for a borrower.

• Experts have also recommended that loan documents be provided to the borrower in advance of closing to allow the borrower time to read the documents, possibly coupled with an acknowledgment that the borrower has been encouraged, and has been provided an opportunity, to have the documents reviewed by its own legal counsel.

• A lender might require the borrower to re-execute a commitment letter at closing, confirming the pertinent terms of the loan.

• A lender might obtain an affidavit, to be signed under penalty of perjury, which is read to the parties and signed by them prior to the execution of loan documents, to specifically disclaim reliance upon oral representations and warranties made by the lender.

• Lenders should ensure that their personnel, including outside brokers and agents, are aware of the state of the law on this issue. All employees and agents who interact with borrowers and other loan parties must understand that misrepresentations to these parties may result in a court determining that the borrower and other loan parties are not bound by the terms of the loan documents. Terms and conditions of a loan or loan documents should never be misrepresented to any borrower party.

Solutions will vary for each lender and each loan. Please feel free to contact Amy at (215) 542-7070 for additional assistance in addressing this issue.