Photographer: Chris Rank/Bloomberg

Why Hundreds of Nearly Identical Bankruptcy Claims Yielded Vastly Different Results in the Aftermath of the Housing Bubble

"Randomly distributed justice."

In late 2006, a Spanish-speaking housekeeper bought a $425,000 property for her son in the scenic town of Richmond, Calif.

Funded entirely with two mortgages from WMC Mortgage Corp. (a senior loan in the amount of $340,000 and a junior lien for $85,000), the deal was emblematic of a frothy real estate market in which borrowers of questionable means enjoyed ready access to no-down-payment loans.

Maribel Monroy made more than $9,000 a month through her cleaning business, according to a loan application that later became the subject of a lawsuit filed by Heritage Pacific Financial LLC. By August 2008, the Richmond home—like millions of others across the U.S.—was in foreclosure.

Heritage, a limited liability company based in Texas, had purchased Monroy's junior mortgage for what was probably pennies on the dollar soon after foreclosure. In 2010, Heritage began legal proceedings against her for the outstanding $85,000 of the second mortgage plus punitive damages, alleging "intentional misrepresentation" and "fraudulent concealment" of a second property, amongst other things.

Monroy was not alone in being targeted by Heritage. After snapping up pools of junior liens on the cheap, Heritage filed more than 200 lawsuits seeking to recoup the outstanding mortgage amounts on the basis that borrowers had lied about their income or otherwise misrepresented their financial situations. What followed is an exceptional case study of the U.S. legal system's treatment of mortgage debt and bankruptcy, brought to light in a new paper from Gary Neustadter of the Santa Clara University School of Law.

Justice may or may not be blind, concluded the law professor, but it certainly is random.

"Because the proceedings were essentially identical, they offer a rare laboratory for testing the extent to which our entry-level justice system measures up to our aspirations for 'Equal Justice Under Law,'" wrote Neurstadter. "The results in the Heritage adversary proceedings evidence a stunning and unacceptable level of randomly distributed justice at the trial court level, generated as much by the idiosyncratic behaviors of judges, lawyers, and parties as by even handed application of law."

The $21 million worth of claims sought by Heritage in its 216 proceedings consisted of requests that almost 300 individuals pay it sums ranging from $11,773 to $458,596. Results from 210 of the filed cases are available, with a chunk of the proceedings yielding a big, fat nothing for the company. As the paper noted, Heritage recovered zero in 94 of the 210 proceedings, making for a 'failure' rate of 45 percent. 

However, in the remaining 116 legal proceedings for which information is available, Heritage recovered at least $2 million, representing 10 percent of its total claims and illustrating a wide dispersion of legal judgments, even as all of the defendants who responded to the suits denied having made misrepresentations, according to the paper.

"When I applied for a loan for the purchase of my house, all documentation was made by the sales agent, he only said to me: SIGN HERE, I wanted to have a home to live in with my family and fulfill my American dream, in no time I had the intension [sic] of doing some fraud on my behalf," one defendant said in a statement.

Source: Neustadter

At the heart of the discrepancies in outcomes, says Neustadter, are the varying responses from defendants' lawyers, as well as from court bankruptcy judges, some of whom accepted expert testimony put forth by Heritage claiming that lenders had relied on defendants' stated income. Other judges resisted that argument, claiming that the frothy pre-financial crisis real estate environment was one knowingly characterized by "liar loans" and questionable underwriting standards.

"This ... loan was made in 2006, when home lending practices in California and the nation as a whole were sloppy at best," said one judge who rejected Heritage's "reliance" argument. "The court has a substantial question whether any underwriting due diligence was performed by lenders. ... Given the industry practices at the time, the court is unwilling to presume that anyone even looked at the financial statements and other documents submitted in support of loan applications."

Lawyers for defendants, meanwhile, often found themselves overwhelmed by a company armed to the teeth with legal counsel and pre-prepared documents. "A paradigm 'repeat player,' [Heritage] litigated with superior information and litigated efficiently by mass-producing documents for filing," says Neustadter. Such 'information asymmetry,' was a driving force of the marked variation in legal results.

"The paths and outcomes of these materially identical cases are so different in so many surprising (and often disturbing) ways, the paper offers a really stunning look behind the curtain of our often arbitrary trial-level justice system," said Jason Kilborn, professor at John Marshall Law School.

In Monroy's case, Heritage's claim was eventually defeated on the basis that the company did not have legal standing for a fraud claim because of the way the mortgage note was transferred, or assigned, to the company. While such a defense could probably have extended to the majority of the 200 lawsuits, the decision came after many had been settled.

"This defense, standing alone (no pun intended), likely would have defeated many if not all of Heritage’s actions, in district court, in state court, and in the adversary proceedings, but the March 29, 2013 decision in Monroy came too late for perhaps hundreds of other defendants sued by Heritage and an unknown number of others who may have settled with Heritage in response to its pre-litigation collection activities."

Heritage itself filed for bankruptcy in January 2014.

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