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This article provides an overview of the right of rescission (rescission), a significant consumer protection provided under the Truth in Lending Act (TILA) and Regulation Z, TILA's implementing regulation. For covered transactions, in which a creditor extends credit to a consumer primarily for personal, family, or household purposes and takes a security interest in the consumer's primary residence (excluding purchase or construction loans), rescission provides a three-day cooling off period during which the consumer can cancel the loan without penalty. The rescission period is extended to three years if the creditor fails to provide the required rescission notice or fails to provide accurate, material disclosures. Rescission presents compliance risks for banks because a violation can be very costly. Not only does the bank have to return all finance charges and fees the customer has paid, but the bank is also liable for statutory damages, court costs, and attorney's fees.1 In addition, rescission applies to assignees of the loan, so if a bank purchases a covered loan, it could be forced to rescind the loan if the disclosures have violations triggering rescission.
An article in the fourth quarter 2006 issue of Compliance Corner discussed the damages and remedies available to a consumer when a creditor violates a section of TILA or Regulation Z subject to rescission protection. This article reviews the legislative history of rescission, its compliance requirements, and recent legal developments concerning rescission claims in class actions.
TILA's legislative history indicates that Congress included rescission to provide a cooling off period to borrowers who obtained credit secured by a lien against their primary residence. Congress heard a parade of horror stories from consumers about unscrupulous home improvement contractors who pressured them into financing expensive renovation projects (like aluminum siding) but failed to disclose that the loan was secured by a lien on the consumer's dwelling. Consumers who defaulted on the financing lost their homes. Rescission is designed to protect consumers from making an impulsive decision by disclosing the lien and providing a three-day cooling off period after the loan closing. With the salesperson gone, the consumer can reconsider whether he wants to place his home at risk.2
Rescission applies to consumer credit transactions secured by a lien on the consumer's principal dwelling.3 Congress did not believe loans to purchase or construct a home—which TILA and Regulation Z identify as a residential mortgage transaction—presented the risk of a consumer making a decision he would later regret, or would feel pressured into making, so it exempted those transactions from rescission. Rescission does apply to a home equity line of credit, a home improvement loan, the refinancing of an existing mortgage, or any other nonpurchase credit transaction secured by the consumer's principal dwelling.
The primary compliance requirements for the right of rescission are that the creditor must 1) provide two copies of the notice of rescission, to each owner of the property, and 2) provide a statement that accurately discloses, subject to a small tolerance for error, the material disclosures about the credit transaction.4 For open-end credit, the material disclosures are "the information that must be provided to satisfy the requirements in Â§226.6 with regard to the method of determining the finance charge and the balance upon which a finance charge will be imposed, the annual percentage rate, the amount or method of determining the amount of any membership or participation fee that may be imposed as part of the plan, and the payment information described in Â§226.5b(d)(5)(i) and (ii) that is required under Â§226.6(e)(2).5" For closed-end credit, the material disclosures are the annual percentage rate, the finance charge, the amount financed, the total payments, the payment schedule, and the disclosures and limitations referred to in Â§226.32 (c) and (d).6" The material disclosures are typically grouped together at the top of the disclosure statement in a box known as the "Fed Box."
The rescission notice must disclose the following information: 1) that the creditor retains or acquires a security interest in the consumer's principal dwelling; 2) the consumer's right to rescind the transaction; 3) the procedure for exercising that right, with a form for that purpose that designates the address of the creditor's place of business; 4) the effects of rescission;7 and 5) the date the rescission period expires. The notice must follow the language of the official rescission notice form or be substantially similar.
Rescission applies to both open-end and closed-end credit. The primary difference in the rescission rule for open-end credit, which appears in section 15 of Regulation Z, and closed-end credit, which appears in section 23, is that each disbursement in an open-end plan is not subject to rescission if it is made in accordance with a previously established credit limit for the plan. In that case, only the initial credit transaction establishing the credit plan is subject to rescission. For example, if the creditor establishes a $100,000 home equity line of credit, and the consumer initially borrows $10,000, the entire transaction can be rescinded during the rescission period for the $100,000 line of credit. But once the initial rescission period passes, each subsequent draw on the credit line, up to $100,000, is not subject to rescission. If the creditor extends additional credit above the credit limit of the initial plan, only the credit in excess of the prior credit limit is subject to the right of rescission.
The consumer's right to exercise rescission expires three days after the closing of the loan. However, if the creditor fails to deliver the notice of the right of rescission to the consumer, fails to provide all of the material disclosures, or makes computational errors in the material disclosures in excess of the tolerance for such errors, the rescission period is extended to three years from the date of consummation of the loan.
Assignee liability is an important issue in rescission. The general rule for assignee liability, set forth in section 131 of TILA, 15 U.S.C. Â§ 1641,8 is that the assignee of a credit transaction covered by TILA and Regulation Z is only liable for violations that are apparent on the face of the disclosure statement. However, section 131 specifically exempts rescission from this rule so a borrower could compel the assignee of a loan with violations triggering the right of rescission to rescind the loan, even though the violations are not apparent on the face of the disclosure statement.9 Thus, banks must be careful in purchasing loans subject to rescission.
Recent Legal Developments
The following sections outline recent developments from legal cases regarding rescission.
Rescission class actions. In the last year, two federal trial courts made headlines when they issued rulings certifying class actions of lawsuits seeking rescission of mortgages for thousands of borrowers.10 Until these rulings, rescission class actions had been rejected in leading court cases. Because rescission of a mortgage is an expensive remedy, the prospect of rescission class actions, with hundreds or thousands of borrowers, created intense anxiety in the mortgage industry.
In the first case, McKenna v. First Horizon Home Loan Corp., 429 F. Supp. 2d 291 (D. Mass. 2006), a federal trial court in Boston certified a class action of borrowers involving the right of rescission. However, the decision was later reversed by the United States Court of Appeals for the First Circuit [McKenna v. First Horizon Home Loan Corp., 475 F.3d 418 (1st Cir. 2007)].11 Prior to this decision, only one other federal appeals court had addressed this issue, ruling that rescission class action claims cannot be maintained under TILA [James v. Home Constr. Co. of Mobile, Inc., 621 F.2d 727, 731 (5th Cir. 1980)].
In seeking reversal of the class certification, First Horizon noted that its potential liability could exceed $200 million. This point resonated with the First Circuit in light of TILA's legislative history. Congress amended TILA in 1995 to establish a ceiling of $500,000 for statutory damages in class actions under section 130 of TILA, the civil liability provision, to protect creditors from catastrophic damage awards. Because rescission damages are governed by section 125 of TILA, the damage limitation in section 130 does not apply to rescission cases. However, the First Circuit noted that it was implausible for Congress to amend TILA to address creditors' concerns that a technical TILA violation could result in catastrophic damage awards, while still allowing unlimited rescission damage awards, stating: "The notion that Congress would limit liability to $500,000 with respect to one remedy while allowing the sky to be the limit with respect to another remedy for the same violation strains credulity."
A few days later, the California Court of Appeal affirmed a lower court ruling that a borrower's claim for rescission could not be certified as a class action in Laliberte v. Pacific Mercantile Bank, 147 Cal. App. 4th 1, 53 Cal.Rptr.3d 745 (Cal. App. 4th Dist. 2007).12 The California court was also persuaded by the legislative history of the 1995 TILA amendment limiting class-action statutory damage awards, stating: "Weâ€¦find it difficult to believe that Congress would carefully balance the deterrent effect of class actions under TILA against the potential harm to businesses in the context of statutory damages, and yet allow class action rescission to proceed without any safeguard for the affected businessâ€¦Here, 100 class members seeking rescission would mean [Pacific Mercantile Bank] could face the loss of over $37 million in security upon entry of an unfavorable declaratory judgment. In other words, a declaratory judgment authorizing all class members to rescind their loans could be â€˜catastrophic.'" Lenders were relieved that the First Circuit and California state appeal court rejected rescission class actions in well-reasoned decisions.
This rescission issue also arose in another recent case involving Chevy Chase Bank of Maryland (Chevy Chase). A Wisconsin couple filed a rescission class action against the bank because of ambiguities in the TILA disclosure statement for their option ARM loan. The disclosure statement contained the required prominent disclosure box for the APR, which was 4.047%. However, it also disclosed "note interest rate of 1.95%." Significantly, the 1.95% rate was a discounted teaser rate that only applied to the first payment. The court held that this conflicting rate information violated TILA's requirement that disclosures be made clearly and conspicuously [Andrews v. Chevy Chase Bank, FSB, 474 F.Supp.2d 1006, 1007 (E.D. Wis. 2007)].
The disclosure statement also identified the bank's name for the loan product (WS Cashflow 5-year Fixed). The borrowers alleged that this led them to believe that the interest rate was fixed for five years and became variable after that. However, while the payment was fixed for five years, the interest rate was not. The bank also stated in the promissory note that the rate may change in August 2004 when, in fact, it knew it would change, and provided a misleading definition of "APR" on the back of the disclosure statement. Based on these TILA violations, the trial court held that the loan could be rescinded and certified the case as a class action.13
This case illustrates potential pitfalls for creditors with their TILA disclosures. In particular, a bank should only include information in the disclosure statement that is required by TILA or Regulation Z. Section 226.17(a) of Regulation Z, for closed-end credit, specifically prohibits a creditor from including information in the disclosure statement that is not directly related to the required disclosures. The bank's decision to include the information noted above, none of which was required by TILA or Regulation Z, was flirting with danger, particularly in the context of an exotic mortgage product like an option ARM. TILA and Regulation Z identify the information that a creditor must disclose in a credit transaction. Creditors should fully comply with these laws, without including unnecessary information that could potentially violate TILA or Regulation Z, as happened in the Chevy Chase case.
Chevy Chase appealed the class action ruling to the United States Court of Appeals for the Seventh Circuit, which recently heard oral arguments. The Seventh Circuit's decision, which is expected in the near future, will provide further clarity on this important issue. But even if Chevy Chase wins the class action issue on appeal, it still faces liability to the original borrowers. In addition, the trial judge's decision was reported in the Wall Street Journal, the Washington Post, and other publications, creating reputational risk. These risks underscore the importance of strict adherence to the rescission compliance requirements under Regulation Z and TILA.
Spousal homestead laws do not trigger rescission rights. In 2006, a federal trial court in Illinois addressed a novel rescission argument: whether a creditor extending a loan subject to rescission to a husband, secured by property of which he is the sole owner, must provide the rescission notice to his spouse based solely on her state homestead rights in the property. Section 226.23 of Regulation Z requires that "in a credit transaction in which a security interest is or will be retained or acquired in a consumer's principal dwelling, each consumer whose ownership interest is or will be subject to the security interest shall have the right to rescind the transaction." The wife argued that she was entitled to the notice and to rescind because of homestead rights in the property. Some states have adopted homestead laws, under which when only one spouse owns a family home that both spouses have occupied during the marital relationship, the owning spouse cannot sell or encumber the property without the permission of the non-owning spouse. In this case, Bills v. BNC Mortgage, Inc., 2006 WL 3227887 (N.D. Illinois, Nov. 2006), the court rejected this argument because it concluded that a spouse's homestead rights in a property do not legally constitute an "ownership interest." The rescission notice and right to rescind only apply to a consumer with an ownership interest in a property in which a creditor is obtaining a security interest. Therefore, the spouse had no right to rescind.
Amount consumer must repay when loan is rescinded. A number of court cases have wrestled with the issue of what amounts a consumer must return to a lender when he rescinds a loan. Section 125 of TILA specifies that when a loan is rescinded, "the consumer is not liable for any finance or other charge, and any security interest given by the obligor, including any such interest arising by operation of law, becomes void upon such a rescission." In some loans, a consumer borrows not only a principal amount but also lender's fees and finance charges. In a recent case, Moore v. Cycon Enterprises, Inc., 2007 WL 475202 (W.D. Michigan, Feb. 2007), a trial court in Michigan ruled that a husband and wife who rescinded a loan were not required to repay any amounts of a loan they borrowed to cover lender's fees and finance charges because of the language in section 125 quoted above. The lender tried to argue that section 125 only applied to amounts that were finance charges under TILA. However, the court noted that section 125's plain language states "the consumer is not liable for any finance or other charge." The Court therefore ruled that the borrowers were not required to repay any of these fees and charges, which amounted to $25,237.85 out of the total loan for $215,500.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.