National City Bank v. Hill et al

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UNITED STATES BANKRUPTCY COURT
NORTHERN DISTRICT OF CALIFORNIA
In re 	No. 07-41137 TT
Chapter 7
CECELIA ANN HILL, etc. and
NORMAN HENRY HILL,
Debtors.
___________________________/
NATIONAL CITY BANK, 	A.P. No. 07-4106 AT
Plaintiff,
vs.
CECELIA ANN HILL, etc. and
NORMAN HENRY HILL,,
Defendants.
___________________________/
MEMORANDUM OF DECISION
In this adversary proceeding, plaintiff National City Bank (the
“Bank”), a foreclosed out former junior deed of trust holder, seeks
to except its approximately $250,000 claim from the above-captioned
debtors’ (the “Debtors”) chapter 7 discharge 	pursuant to 11 U.S.C.
§ 523(a)(2)(B). 	For the reasons stated below, the Court will enter
judgment in favor of the Debtors.
Signed: May 23, 2008
________________________________________
LESLIE TCHAIKOVSKY
U.S. Bankruptcy Judge
________________________________________
Entered on Docket
May 28, 2008
GLORIA L. FRANKLIN, CLERK
U.S BANKRUPTCY COURT
NORTHERN DISTRICT OF CALIFORNIA
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SUMMARY OF FACTS
This 	adversary 	proceeding 	is 	a 	poster 	child 	for 	some 	of 	the
practices that have led to the current crisis in our housing market.
The 	Debtors 	bought 	their 	home 	in 	El 	Sobrante, 	California 	(the
“House”) nearly 20 years ago for $220,000. 	They filed for chapter 7
bankruptcy in April 2007. 	After purchasing the House, as the value
of 	the 	House 	increased, 	the 	Debtors 	refinanced 	the 	original 	first
deed of trust to obtain additional cash. 	They also obtained a junior
deed of trust, which they refinanced several times. 	At the time they
filed 	their 	bankruptcy 	petition, 	the 	Debtors 	scheduled 	the 	debt
secured by the House as totaling approximately $683,000.
The Debtors’ income was modest. 	Mr. Hill was a parts manager at
Auto 	Wholesaling, 	earning 	an 	annual 	salary 	of 	up 	to 	$39,000,
depending on overtime. 	Mrs. Hill was self-employed, using a dba of
C 	Ann 	H 	Distributing, 	distributing 	free 	periodicals 	for 	various
companies. 	Her 	income 	also 	fluctuated, 	depending 	on 	how 	many
companies 	were 	employing 	her 	for 	this 	purpose. 	According 	to 	the
Debtors’ 	Statement 	of 	Financial 	Affairs, 	filed 	in 	their 	bankruptcy
case, 	in 	2006, 	Mrs. 	Hill’s 	annual 	gross 	income 	was 	between 	$25,000
and $26,000. 	It appears doubtful that the Debtors’ combined annual
gross income was ever greater than $65,000.
In 	April 	2006, 	Mrs. 	Hill 	contacted 	a 	mortgage 	broker, 	Winston
Ellerbeck (“Ellerback”), seeking to refinance the Debtors’ existing
second deed of trust debt. 	Ellerback, who testified at trial, stated
that 	he 	had 	acted 	as 	the 	Debtors’ 	loan 	broker 	on 	five 	prior
occasions. 	At 	that 	time, 	the 	second 	deed 	of 	trust 	was 	held 	by
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1 Mrs. Hill denied having told Ellerback that her and her
husband’s incomes were in the amounts set forth on the loan
application. 	She and her husband both testified that they had not
read the loan application before signing it and that moreover they
had never read a loan application in their lives. The Bank
presented evidence that called into question the credibility of
this testimony. 	In April 2006, together with the loan application,
Ellerback sent the Debtors an estimated closing statement for their
signatures. 	He had inadvertently checked a box on the second page
of the document in a section dealing with pre-payment penalties.
Mrs. Hill called Ellerback and told him about the error. 	He told
her to cross it out and initial the change. 	She did so.
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someone other than the Bank. 	The debt secured by the second deed of
trust 	had 	a 	balance 	of 	approximately 	$100,000. 	The 	Debtors 	sought
and obtained from Bank an equity line of credit for $200,000, thereby
obtaining approximately $60,000 in cash after paying the cost of the
refinance and other consumer obligations. 	They used the cash to pay
off their consumer debt and to “fix up” the House.
In 	the 	loan 	application 	submitted 	to 	obtain 	this 	loan 	(the
“April 	Loan 	Application”), 	Mr. 	Hill’s 	monthly 	income 	was 	listed 	as
$8,176 	(i.e., 	$98,112 	on 	an 	annual 	basis) 	and 	Mrs. 	Hill’s 	annual
income was listed as $3,967 (i.e., $47,604 on an annual basis) for a
combined annual income of approximately $12,143 (i.e., $145,716 on an
annual 	basis). 	Ellerback 	stated 	that 	he 	obtained 	this 	income
information 	from 	Mrs. 	Hill 	over 	the 	phone, 	inputted 	it 	into 	the
application form, and sent the application to the Debtors for their
signature. 1
In 	October 	2006, 	the 	Debtors 	were 	in 	need 	of 	more 	cash. 	The
Bank 	permitted 	them 	to 	increase 	their 	equity 	line 	of 	credit 	to
$250,000. 	This time, instead of contacting Ellerback to handle the
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transaction, 	Mrs. 	Hill 	dealt 	with 	the 	Bank 	directly. 	On 	this 	loan
application (the “October Loan Application”), Mr. Hill’s income was
listed 	as 	$5,600 	per 	month 	(i.e., 	$67,200 	on 	an 	annual 	basis) 	and
Mrs. Hill’s income was listed as $10,300 per month (i.e., $123,600 on
an annual basis) for a total of $15,900 (i.e., $190,800 on an annual
basis). 	Again, 	Mrs. 	Hill 	denied 	having 	provided 	this 	income
information to the Bank.
The Bank did not call as a witness the individual who took the
information for the loan application from Mrs. Hill. 	The only Bank
employee 	who 	testified 	was 	Dick 	Eubanks 	(“Eubanks”), 	the 	District
Manager for one of the Bank’s subsidiaries. 	He testified that he did
not 	know 	if 	the 	individual 	in 	question 	was 	still 	employed 	by 	the
Bank. 	However, he noted that both this loan and the loan obtained by
the 	Debtors 	in 	April 	2006 	were 	“stated 	income” 	loans 	which 	did 	not
require 	verification 	of 	income. 	Eubanks 	testified 	that 	the 	loans
were generated for the purposes of sale and that certain guidelines
(the “Guidelines”) had to be followed to render them acceptable for
that 	purpose. 	He 	testified 	that 	the 	Bank 	followed 	the 	Guidelines.
A copy of the Guidelines was introduced into evidence.
The Guidelines stated that, for a borrower who was employed, the
only requirement was verification of employment, not verification of
income. 	However, 	the 	Guidelines 	stated 	that 	a 	third 	party 	vendor
would evaluate the reasonableness of the stated income based on job
type, 	tenure, 	and 	geographical 	location 	among 	other 	things. 	No
evidence 	was 	presented 	that 	a 	third 	party 	vendor 	ever 	evaluated
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26 	2 The Guidelines require a maximum debt to income ratio of
.45, and a maximum loan to value ratio of .899.
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whether it was reasonable for an automobile parts manager in the San
Francisco Bay Area to earn $98,112 on an annual basis.
According 	to 	the 	Guidelines, 	for 	a 	borrower 	who 	was 	self-
employed, the Bank could choose one of three types of verification:
(1) a copy of the borrower’s business license, (2) a copy of the most
recent month’s bank statement reflecting liquidity at least equal to
one-tenth 	of 	the 	borrower’s 	annual 	income, 	or 	(3) 	a 	CPA 	letter
verifying 	the 	existence 	and 	ownership 	of 	the 	business. 	The 	Bank
chose 	the 	third 	option 	with 	respect 	to 	Mrs. 	Hill. 	With 	respect 	to
this 	option, 	the 	Guidelines 	stated 	that: 	“[i]nternal
procedures...[would] 	be 	performed 	to 	verify 	the 	legitimacy 	of 	the
letter.” 	A copy of a letter verifying the existence and ownership of
Mrs. 	Hill’s 	business 	was 	introduced 	into 	evidence. 	The 	letter 	was
written on the letterhead of a CPA, but was signed by someone other
than 	the 	CPA 	whose 	name 	was 	on 	the 	letterhead. 	Evidence 	was 	also
introduced that the Bank had verified the existence of the CPA on the
letterhead. 	However, 	no 	evidence 	was 	presented 	that 	the 	Bank 	had
verified 	the 	identity 	or 	credentials 	of 	the 	person 	who 	signed 	the
letter.
The only other requirements established by the Guidelines with
respect 	to 	the 	April 	2006 	loan 	were 	that 	the 	collateral 	be 	the
borrower’s 	primary 	residence, 	the 	loan 	not 	exceed 	$350,000, 	the
borrower’s FICA score be sufficiently high, and the loan to value and
debt 	to 	income 	ratios 	satisfy 	certain 	criteria. 2 	The 	value 	of 	the
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3 Section 523(a)(2)(B) reads in relevant part:
A discharge under section 727 . . . of this title does not
discharge an individual debtor from any debt . . . for money,
property, services, or an extension, renewal, or refinancing
of credit, to the extent obtained by . . . use of a statement
in writing—
(i) that is materially false;
(ii) respecting the debtor’s . . . financial condition;
(iii) on which the creditor to whom the debtor is liable for
such money, property, services, or credit reasonably relied;
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House was determined through the Bank’s underwriting process. 	It was
unclear whether the Bank performed the appraisal itself or obtained
a 	third 	party 	vendor 	to 	do 	so. 	In 	April 	2006, 	the 	House 	had 	been
appraised at $785,000. 	In October 2006, the House was appraised at
$856,000. 	Shortly 	after 	the 	Debtors 	filed 	for 	bankruptcy 	in 	April
2007, 	the 	first 	deed 	of 	trust 	holder 	purchased 	the 	House 	at 	its
foreclosure sale pursuant to a credit bid based on a secured debt of
approximately $450,000, no one having submitted an overbid.
DISCUSSION
A. 	APPLICABLE LAW
A creditor seeking to establish a debt as nondischargeable
under § 523(a)(2)(B) must demonstrate that: (1) The debtor made a
written representation of respecting the debtor’s financial
condition; (2) the representation was material; (3) the debtor knew
at the time the representation was made that it was false; (4) the
representation was made with the intent to deceive the creditor;
(5) the creditor relied on the representation; (6) the reliance was
reasonable; and (7) the damage suffered by the creditor proximately
resulted from the representation. 3 	In re Candland, 90 F.3d 1466,
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and
(iv) that the debtor caused to be made or published with
intent to deceive.
11 U.S.C. § 523(a)(2)(B). 	The Ninth Circuit reorganized these
factors into a seven-factor analysis. In re Siriani, 967 F.2d 302,
304 (9 th Cir. 1992).
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1470 (9th Cir. 1996). 	The creditor must prove each element by a
preponderance of the evidence. 	Grogan v. Gardner, 498 U.S. 279,
291 (1991).
A statement is materially false if it is substantially
inaccurate and affects the creditor’s decision making process. See
Candland, 90 F.3d at 1470 (9th Cir. 1996). 	Significant
misrepresentations of financial condition are generally considered
material. Id.
A debtor’s intent to deceive for nondischargeability purposes
under § 523(a)(2)(B) requires either a finding that the debtor
actually knew the statement was false, or can be inferred from the
totality of the circumstances, including the debtor’s reckless
disregard for the truth. In re Gertsch, 237 B.R. 160, 167-68
(Bankr. 9th Cir. 1999). 	Where the debtor knows the purpose of
documents and that they contained statements of the debtor’s
financial condition, the debtor’s failure to question the accuracy
of the documents constitutes reckless disregard for the truth of
the statements, and justifies a finding of fraudulent intent under
§ 523(a)(2)(B). 	In re Oh, 278 B.R. 844, 858-60 (Bankr. C.D. Cal.
2002).
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Whether the creditor reasonably relied on the materially false
statement under § 523(a)(2)(B) is measured objectively by the
degree of care exercised by a reasonably cautious person in the
same transaction under similar circumstances. 	See Gertsch, 237
B.R. at 170; (citing In re Cohn, 54 F.3d 1108, 1117 (3d Cir.
1995)). 	Absent other factors, a creditor’s reliance on a statement
of financial condition is reasonable if it followed its normal
business practices. 	See id. 	Other factors that may be affect
whether the creditor’s reliance on its own standard lending
practices is reasonable include the standards of the creditor’s
industry in evaluating creditworthiness, and the existence of any
“red flags” that would alert the reasonably prudent lender of the
possibility that the information was inaccurate. 	Cohn, 54 F.3d at
1117.
When there is evidence of materially false statements made by
the debtor, only minimal investigation is required by the creditor
to have reasonably relied on the debtor’s representation. 	In re
Gosney, 205 B.R. 418, 420 (9th Cir. B.A.P. 1996) (citing Candland,
90 F.3d 1466, and In re Lansford, 822 F.2d 902, 904 (9th Cir.
1987)).
B. 	DECISION
As set forth above, the Ninth Circuit has identified seven
elements to a claim under § 523(a)(2)(B). 	The creditor seeking to
except its debt from the debtor’s discharge must prove each of
these elements by a preponderance of the evidence.
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4 The Debtors testified that they did not read the October
Loan Application before signing it and submitting it to the Bank.
Even if this were true, by signing the Application and submitting
it to the Bank, they effectively made the representation to the
Bank. 	Their testimony, if believed, would pertain solely to the
next two elements of the Bank’s claim: i.e., knowledge of falsity
and intent to deceive.
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The first two elements of the Bank’s claim were not in
dispute: 	i.e., that the Debtors made a false representation to the
Bank in writing concerning their financial condition and that the
misrepresentation was material. 	The Debtors admitted that they
submitted the October Loan Application and that the figures listed
for their incomes were significantly overstated. 	Those
representations concerned their financial condition and were false.
Thus, the first element of the Bank’s claim is established. 	If
their true incomes had been disclosed, the Debtors would not have
qualified for the loan. 	Their debt to income ratio would have
exceeded the maximum permitted by the Guidelines. 	Thus, the false
representation was material, thereby establishing the second
element of the Bank’s claim. 4
The Court concludes that the Bank met its burden of proof with
respect to the second and third elements of its claim: i.e., that
the Debtors knew that the representation was false at the time it
was made and that they made the representation with the intent to
deceive the Bank. 	The Debtors testified that they did not supply
the false figures regarding their income and did not read the
October Loan Application before they signed it. 	As a result, they
contended, the Bank failed to establish either their knowledge or
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5 The Court also found it likely that Mrs. Hill avoided using
Ellerback to obtain the October 2006 loan for fear that he would
have questioned her concerning the changes in their income figures
as compared to six months earlier.
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the falsity of the representation or their intent to deceive the
Bank. 	The Court did not find their testimony credible.
In large part, this conclusion is drawn from the evidence
presented with respect to the April 2006 loan. 	The April Loan
Application also contained false figures with respect to the
Debtors’ income. 	The Debtors also testified that they did not
supply this income information and did not read the April Loan
Application before they submitted it to the Bank.
Their testimony was contradicted by their loan broker.
Ellerback testified that Mrs. Hill provided him with the income
information. 	He also testified that, before signing and submitting
the April Loan Application, Mrs. Hill caught a mistake he had made
in one of the loan documents and called it to his attention. 	The
Court found Ellerback to be a more credible witness than Mrs. Hill.
The Debtors’ lack of credibility concerning the April 2006 loan
transaction undermines the credibility of their testimony
concerning the October 2006 loan transaction. 5
Moreover, the Hills, while not highly educated, were not
unsophisticated. 	They had obtained numerous home and car loans and
were familiar with the loan application process. 	They knew they
were responsible for supplying accurate information to a lender
concerning their financial condition when obtaining a loan. 	Even
if the Court were persuaded that they had signed and submitted the
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26 6 Given the Court’s conclusion with respect to this element,
it need not address the seventh element of the Bank’s claim,
proximate cause.
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October Loan Application without verifying its accuracy, their
reckless disregard would have been sufficient to satisfy the third
and fourth elements of the Bank’s claim. 	See Oh, 278 B.R. at 858-
60 (Bankr. C.D. Cal. 2002).
However, the Bank’s suit fails due to its failure to prove the
sixth element of its claim: i.e., the reasonableness of its
reliance. 6 	As stated above, the reasonableness of a creditor’s
reliance is judged by an objective standard. 	In general, a
lender’s reliance is reasonable if it followed its normal business
practices. 	However, this may not be enough if those practices
deviate from industry standards or if the creditor ignored a “red
flag.” 	See Cohn, 54 F.3d at 1117. 	Here, it is highly questionable
whether the industry standards–-as those standards are reflected by
the Guidelines–-were objectively reasonable. 	However, even if they
were, the Bank clearly deviated to some extent from those
standards. 	In addition, the Bank ignored a “red flag” that should
have called for more investigation concerning the accuracy of the
income figures.
As noted above, the Guidelines required an evaluation of the
reasonableness of the salary listed by an employed borrower based
on job type and geographical area, among other things. 	No evidence
was provided by the Bank that this evaluation was done.
Additionally, with respect to a self-employed individual, the
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Guidelines required a letter from a CPA verifying the existence and
ownership of the business. 	While the letter relied upon by the
Bank verifying the existence and ownership of Mrs. Hill’s business
was on the letterhead of a CPA, whose existence was itself
independently verified by the Bank, the letter was not signed by
the CPA. 	The person signing the letter did not identify himself as
a CPA and may not even have been an employee of the CPA on whose
letterhead the letter was written.
More important, the Bank ignored the “red flag” established by
the variation in the incomes set forth on the April Loan
Application as compared to the incomes set forth on the October
Loan Application. 	The Bank employee handling the loan transaction
in October 2006 knew that the Bank had made a loan to the Debtors
just six months earlier and that they were now attempting to
increase the amount of the loan. 	The employee necessarily had at
her disposal the file with respect to the earlier loan. 	Not only
were the total income figures on the October 2006 Loan Application
substantially higher than the figures on the October 2006 Loan
Application, the income figures for the spouses were switched. 	The
total annual income listed for the Debtors on the April 2006 Loan
Application was $145,716. 	On the October Loan Application, it was
$190,000. 	On the April Loan Application, Mr. Hill’s annual income
was listed as $98,112 and Mrs. Hill’s as $47,604. 	On the October
Loan Application, Mr. Hill’s annual income was listed as $67,200
and Mrs. Hill’s as $123,600.
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Based on the foregoing, the Court concludes that either the
Bank did not rely on the Debtors representations concerning their
income or that its reliance was not reasonable based on an
objective standard. 	In fact, the minimal verification required by
an “income stated” loan, as established by the Guidelines, suggests
that this type of loan is essentially an “asset based” loan. 	In
other words, the Court surmises that the Bank made the loan
principally in reliance on the value of the collateral: i.e., the
House. 	If so, the Bank obtained the appraisal upon which it
principally relied in making the loan. 	Subsequent events strongly
suggest that the appraisal was inflated. 	However, under these
circumstances, the Debtors cannot be blamed for the Bank’s loss,
and the Bank’s claim should be discharged.
CONCLUSION
While the Court finds and concludes that the Debtors made a
material false representation concerning their financial condition
to the Bank in October 2006, with knowledge of its falsity and the
intent to deceive the Bank, the Court finds and concludes that the
Bank’s nondischargeability claim under § 523(a)(2)(B) must fail.
The Bank failed to prove that it reasonably relied on the Debtors’
false representation concerning their income, as set forth in the
October Loan Application. 	As a result, the Bank’s claim has been
discharged. 	Judgment will be ordered accordingly.
END OF DOCUMENT
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COURT SERVICE LIST
Joshua Scheer
Scheer Law Group
155 N Redwood Dr. #100
San Rafael, CA 94903
Cecelia Ann Hill
Norman Henry Hill
3621 Ponderosa Trail
Pinole, CA 94564
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