We are a servicer with a large portfolio. We specialize in servicing FHA loans. Recently, our internal audit picked up that we did not report interest correctly on a very small percentage of loans.
Obviously, we are rectifying the situation; however, the change is coming too late for some borrowers who have already filed their tax returns.
Our external counsel has taken the position that sending out inaccurate information is a violation of the loan agreement. I don’t want to quibble with them, but I do not see how there is a violation if we have corrected the information quickly.
I told them I would be asking you, and they encouraged me to contact you.
So, does inaccurate information of interest cause a violation of the loan agreement?
ANSWER
There are a few aspects of your question that require some unpacking. And I will defer to your counsel in the legal interpretation of provisions in the loan agreement. I would like to add some context to your question.
Let’s start with the basics: a mortgage lender that receives $600 or more annually in mortgage loan interest payments from a borrower is required to complete IRS Form 1098, Mortgage Interest Statement, under specified circumstances. Specifically, Internal Revenue Code (i.e., 26 U.S.C. § 6050H, or “Section 6050H”) requires a mortgagee to issue a Form 1098 to the payor and the IRS stating the amount of mortgage interest “received” from the borrower during each year. The term “mortgage” refers to any obligation secured by real property.
But mistakes in the accuracy of such information can be made, and these mistakes are not all that unusual.
To discuss a recent matter, let’s look at a situation that wound up in court due to the “mistakes were made” scenario. Reporting of interest received by a lender may seem fairly straightforward. Still, a recent decision in Strugala v. Flagstar Bank by the U.S. Court of Appeals for the 9th Circuit illustrates how a court views this particular mistake regarding the reporting of interest.[i]
In 2007, Strugala obtained a 30-year negative amortization mortgage loan from Flagstar Bank. Strugala chose a “minimum payment” option under which she often paid less than the interest due for the month, in which case the interest was “deferred” and added to principal. According to Strugala, the bank over-reported her interest each year from 2007 through 2011 because the bank included both the actual interest amount she paid and the amount of interest she did not pay that was deferred and added to principal.
Strugala sued the bank, on behalf of herself and other borrowers, asserting breach of contract and other claims based on the bank’s incorrect reporting of both paid and unpaid interest. She alleged that the misreporting prevented her from filing correct tax returns, required her to file amended returns, and caused permanent loss of tax deductions.
Bottom Line: the district court dismissed her claims, and the 9th Circuit affirmed, because the mortgage contract contained no express terms concerning the bank’s mortgage interest reporting practices.
Let’s look a little more closely at why the court decided in favor of Flagstar Bank.
Regarding the breach of contract claim, the courts looked to California's applicable state law, which disfavors implied terms and reads them into contracts only on the grounds of necessity. California requires satisfaction of a 5-part test before accepting implied terms:
(1) the implication either arises from the contract’s express language or is indispensable to effectuating the parties’ intentions;
(2) it appears that the implied term was so clearly within the parties’ contemplation when they drafted the contract that they did not feel the need to express it;
(3) legal necessity justifies the implication;
(4) the implication would have been expressed if the need to do so had been called to the parties' attention; and
(5) the contract does not already address completely the subject of the implication.
The courts rejected Strugala’s assertion that compliance with the applicable statute was an implied term of the contract (viz., the Note).
Strugala had argued that ...
“all applicable laws in existence when an agreement is made, which laws the parties are presumed to know and to have had in mind, necessarily enter into the contract and form a part of it, without any stipulation to that effect, as if they were expressly referred to and incorporated.”
The district court quipped:
“It may be that when Strugala entered into agreement with Flagstar Bank for her loan, Section 6050H was in existence and present in her mind. However, the same cannot be said for Flagstar Bank.”
It distinguished the case Strugala cited in support of her position by noting that the decision cited had dealt with the interpretation of a contract that included language pointing to statutes that were part of the contract. The contract had stated “pursuant to the provisions of the [Burns-Porter Act] … and other applicable laws.” In contrast, Strugala’s Note contained no comparable provision and did not mention Section 6050H.
There was an alleged violation of a breach of an implied covenant. This general assumption in the law of contracts is a rather complex area of the law, but, at its essence, an implied covenant is an implied obligation that assumes that the parties to a contract will act in good faith and deal fairly with one another without breaking their word, using deceitful means to avoid obligations, or denying what the other party plainly understood.
Turning to the theory of breach of an implied covenant, Strugala alleged that the bank had a duty to act in good faith with respect to contracts with its borrowers. She alleged that the bank had breached this covenant by: (1) failing to report to the IRS payments of deferred interest it received; (2) depriving borrowers of tax deductions by providing inaccurate Form 1098s; (3) failing to inform borrowers in 2011 that previous Form 1098s were inaccurate; and (4) changing its reporting policies in 2011 without telling its borrowers.
But the courts rejected this theory because the contractual terms of the Note did not imply the alleged duty. The covenant of good faith and fair dealing, implied by law in every contract, exists merely to prevent one contracting party from unfairly frustrating the other party’s rights to receive the benefits of the agreement actually made. The covenant does not impose substantive duties or limits on the parties beyond those incorporated into their agreement's specific terms.
In this case, the Note did not contain any provision regarding how the bank should report mortgage interest, paid or unpaid. The Note also did not contain any provision or any language specifying that the bank had a duty not to conceal and/or fully and unambiguously disclose any changes the bank made regarding mortgage interest reporting.
The Note also did not confer any obligation on the bank to safeguard Strugala’s tax benefits. Those were not benefits under the Note but rather under the exclusive management and authority of the U.S. government and the IRS.
As to the fraud theory, the courts rejected it because the only facts she alleged concerning the bank’s knowledge of falsity was the bank’s changing its mortgage interest reporting practices in 2011. Although this fact was consistent with knowing deception, it was “just as much in line” with a lawful change in business practices.
Finally, regarding misrepresentation, even if the bank reported the wrong amount of interest, it did not conceal that fact. The bank clearly reflected the amount it reported for each year on all copies of IRS Form 1098 sent to Strugala and the IRS. Section 6050H did not require the bank to report any misreporting or change in reporting policy.
So, here’s what I would conclude. The district court noted the obvious – something persons perceiving themselves to be mistreated often tend to overlook – that a borrower herself had obligations, one of which was to use her knowledge of the interest she paid and independently track the status of her mortgage interest.
As a borrower, Strugala had an independent obligation to file her taxes properly. If the bank misreported her interest, she could have raised the issue with the bank or the IRS at any time. It is interesting to note that the district court observed that Strugala actually ignored the amount on Form 1098 when she filed her tax return. The amount she claimed on her tax return was neither the amount provided by the bank nor the alleged amount of interest paid, but a different amount her accountant advised her to report. It doesn’t really moot the matter, but it sure does come close!
The district court observed that another issue was at the heart of the action. That issue was whether Section 6050H was ambiguous and had lacked sufficient guidance as late as 2012. Strugala and the bank differed as to the definition of “received” and “interest” within the meaning of the statute.
According to the court, it could not be said “based on a plain reading of Section 6050H whether or not the statute’s use of the term ‘interest’ encompasses capital interest.” Interestingly, the court stayed its action for a period of time to allow for guidance from the IRS - which did not arrive. This put into question any attempt to characterize the bank’s behavior as false or misleading.
Strugala included a claim for violations of Section 6050H in her original complaint. The district court dismissed this claim without leave to amend, presumably because Section 6050H does not offer a remedy for the taxpayer to assert, while it authorizes the IRS to impose penalties.
Chairman & Managing Director
[i] Strugala v.
Flagstar Bank, FSB, 2020 U.S. App. (9th Cir. Dec. 11, 2020)
