A knowing standard: HUD issues final rule clarifying lenders' accountability for faulty FHA appraisalsPhil Schulman and Emily J. BoothHUD,FHA,Compliance On July 20, 2004, the U.S. Department of Housing and Urban Development ("HUD" or "Department") issued a final rule ("Rule") codifying the Department's position regarding lender accountability for faulty appraisals. The Rule, which follows HUD's issuance of a proposed rule ("Proposed Rule") on Jan. 13, 2003, amends Parts 25 and 203 of HUD's regulations to provide that a mortgage lender will be held responsible, along with the appraiser, for the quality of an appraisal in a Federal Housing Administration ("FHA") insured mortgage loan transaction. While the Proposed Rule suggested that lenders would be held strictly liable for the quality of appraisals performed by independent appraisers in FHA transactions, the preamble to the final Rule clarifies that a lender will be held responsible only to the extent the lender knew or should have known of deficiencies in the appraisal. The Rule became effective on Aug. 19, 2004. The following is a summary of the final Rule and reviews the effects of the Rule in light of the Department's existing regulations and guidelines. The Final Rule The Rule amends three provisions of HUD's regulations. First, the Rule amends 24 C.F.R. § 25.9(ee) to provide that the Mortgagee Review Board ("MRB") may take administrative action against a mortgage lender that submits an appraisal that fails to comply with FHA guidelines. A mortgage lender will now be subject to administrative action for: "Submitting, or causing to be submitted, with an application for FHA mortgage insurance an appraisal, valuation condition sheet, or any other documentation relating to an appraisal that does not satisfy FHA requirements." Note that the MRB has authority to take various types of administrative action against a mortgage lender, including: issuance of a letter of reprimand; placement of the lender on probation; suspension or withdrawal of a lender's FHA approval; imposition of civil money penalties; and execution of a settlement agreement. Second, the Rule adds the following language to the end of Section 203.5(e)(1): "A mortgagee must select and appraiser whose name is on the FHA Appraiser Roster, in accordance with 24 CFR part 200, subpart G." Third, the Rule adds Section 203.5(e)(3), which provides: "A mortgagee and an appraiser must ensure that an appraisal and related documentation satisfy FHA requirements and both bear responsibility for the quality of the appraisal in satisfying such requirements. A Direct Endorsement Mortgagee (and any of its loan correspondent lenders) that submits, or causes to be submitted, an appraisal or related documentation that does not satisfy FHA requirements is subject to administrative sanction by the Mortgagee Review Board pursuant to 24 CFR part 25 and part 30." These amendments are identical to those set forth in last year's Proposed Rule, except that the new Section 203.5(e)(3) states that both the lender and appraiser "bear responsibility" for the quality of the appraisal, whereas the Proposed Rule had stated that the lender and appraiser "shall bear equal responsibility" for the quality of the appraisal. The Proposed Rule focused on the conduct of unscrupulous appraisers and lenders that force appraisal computations to match sales prices in order to ensure that homes sell and mortgage loans close. It referenced predatory lending practices and property flipping schemes to inflate home prices and generate excessive fees to buyers and sellers, which could have been prevented by underwriters' proper review of appraisal reports. The final Rule reiterates the Department's goals underlying the issuance of the Proposed Rule, which are: †To protect the FHA Insurance Fund; †To avoid unexpectedly and costly repairs to properties that often result in default and foreclosure; †To clarify HUD's regulations concerning the responsibilities of lenders in assuring the quality of FHA appraisals; †To promote better compliance with appraisal standards; and †To ensure that homebuyers receive an accurate statement of appraised value. The effects of the final rule: A knowing standard When HUD issued the Proposed Rule in January of 2003, it appeared that the Department was seeking to impose strict liability on lenders for deficiencies in FHA appraisals performed by independent third parties. The proposed regulatory language stated that a lender would "bear equal responsibility" with the appraiser for the quality of an appraisal, and the Summary of the preamble to the Proposed Rule indicated that lenders would be held "strictly accountable" for FHA appraisals. It, therefore, was believed that lenders ultimately would be required to guaranty the performance of independent appraisers without any finding of fault on the part of the lender. Over the past year and a half, however, the Department has considered industry comments on the Proposed Rule, and the final Rule clarifies that "lender accountability does not mean a no fault liability" and that lenders will not be subject to a strict liability standard. This position is consistent with the Department's existing guidelines, though it does raise certain concerns for loan correspondent lenders. A. Public comment on the proposed rule The Department received 34 public comments on the Proposed Rule, including comments from the Mortgage Bankers Association of America and from some of the largest mortgage lenders in the nation. These comments raised several concerns with the proposed regulatory changes. For example, commenters suggested, among other things, that: †HUD should enforce its existing requirements more strictly rather than imposing new regulations because there are already several existing statutory and regulatory systems in place to safeguard the integrity of FHA appraisals; †The Proposed Rule conflicted with the purpose of the FHA Appraiser Roster because an appraiser's placement on the Roster constitutes tacit approval by HUD of the appraiser and it is both unfair and unreasonable to hold lenders liable for faulty appraisals performed by appraisers on the Roster; and †The proposed changes would increase costs to homebuyers, discourage lenders from participating in FHA loan programs and negatively impact the quality of appraisals. Most of the public comments, however, criticized the Proposed Rule's apparent intent to hold lenders strictly liable for the quality of third-party appraisals. Commenters stated that lenders are not trained in the intricacies of the appraisal process and cannot identify inaccuracies resulting from appraisers' on-site reviews. They also suggested that HUD lacked legal authority to hold lenders strictly liable for the quality of appraisals performed by third parties. B. HUD rejects strict liability for a knowing standard HUD diligently considered the public comments that it received on the Proposed Rule and responded to the industry's concerns in the final Rule. Although the regulatory language in the Rule is substantially the same as that in the Proposed Rule, the Department has clarified that lenders will not be subject to a strict liability standard and that the standard for administrative action will be the same as that contained in Part 30 of the Department's regulations for civil money penalties, which require a knowing and material violation. Specifically, the Department explains in the Rule that the standard for accountability "is one of knowing (actual knowledge) or had reason to know." When HUD identifies deficiencies in an appraisal submitted to the Department with a loan for FHA insurance, HUD will not look solely to the appraiser as the responsible party, but will consider whether the lender knew or had reason to know the appraisal was deficient. Where it is determined that a lender knew or should have known of appraisal deficiencies, the lender will be subject to administrative sanctions and civil money penalties by the MRB under Parts 25 and 30 of the Department's regulations. The Rule states that, "if an appraisal is determined to be faulty and/or non-compliant with FHA requirements, HUD may seek administrative sanctions against either or both of the parties, depending upon the particular circumstances of the case." The knowing standard set forth in the Rule is consistent with the Department's existing regulations and guidelines. The Department's pre-existing regulations, as well as several HUD Handbooks and Mortgagee Letters, already require mortgage lenders to review and analyze appraisal documentation to verify data integrity and ensure compliance with FHA standards. For example, the existing guidelines require a lender to review the factual information in the appraisal report, assess the reasonableness of the appraiser's conclusions based on the information contained in the appraisal report, determine whether the conclusions in the appraisal report are consistent with other file documentation, and certify that the underwriter has personally reviewed the appraisal report and that the loan complies with FHA requirements. The final Rule merely codifies the Department's intent to hold lenders accountable for their failure to adhere to the existing requirements and/or their knowing submission of deficient appraisals to HUD. Such a standard would not appear to raise objections within the lending community. In fact, codification of the Department's position in the Rule could prove helpful to mortgage lenders. For instance, over the past several years, some of the HUD Homeownership Centers have taken an aggressive stance regarding lender accountability for faulty appraisals and have attempted to hold lenders accountable for deficiencies that they could not have detected. For example, HUD field personnel assigned to various Quality Assurance Divisions have requested that lenders fund property repairs and/or indemnify HUD when an appraiser neglected to identify necessary repair items or included inaccurate information in the appraisal report, despite the fact that the lender could not have known of such deficiencies. The Rule's clarification that lenders will be held only to a knowing standard will assist the industry in ensuring that strict liability does not exist. C. Loan Correspondent Lenders While the Rule is consistent with the Department's existing regulations and guidelines, it does raise a concern regarding the accountability of loan correspondent lenders. As in the Proposed Rule, the preamble to the final Rule states that the regulatory changes will apply to "lenders, sponsor lenders and loan correspondent lenders" and the new Section 203.5(e)(3) provides that a "Direct Endorsement Mortgagee (and any of its loan correspondent lenders)" may be subject to administrative action and/or civil money penalties for the submission of deficient appraisals. While a loan correspondent lender that submits an appraisal report to its sponsor and/or HUD knowing of deficiencies in the report admittedly should be subject to administrative action, the Rule potentially could be applied without consideration of the fact that appraisal review is an underwriting function that loan correspondents are not permitted to perform. FHA guidelines expressly define appraisal review as an underwriting function. The Single Family Direct Endorsement Program Handbook states: "Since loan correspondents cannot perform any underwriting function (i.e., review of the appraisal, mortgage credit examination or underwriting), no specific Direct Endorsement training is required for the correspondent." Other FHA guidelines likewise require the underwriter, not the loan correspondent, to review an appraisal report to determine whether the appraiser's conclusions are acceptable. While a loan correspondent may select a HUD-approved appraiser to perform the appraisal of a particular property, the loan correspondent is not trained in underwriting issues and is not responsible for reviewing appraisals to determine their acceptability. Thus, to the extent the Rule may be used to hold loan correspondent lenders accountable for deficiencies that the underwriter should have identified, such application of the Rule would be contrary to the very nature of a loan correspondent's business. It appears that the situations where a loan correspondent would be accountable under the new Rule should be limited to those where the correspondent knew or should have known of deficiencies in the appraisal for reasons unrelated to review of the actual appraisal report (e.g., the loan correspondent had reason to know that the appraiser intended to inflate the property value, the loan correspondent received a complaint from the borrower regarding the appraisal or other similar situations). The Department's position regarding this matter is unclear from the language of the Rule, though HUD did recognize in its response to public comments that, "under the Direct Endorsement process, the lender's Direct Endorsement underwriter (or, in case of a loan correspondent, its sponsor's Direct Endorsement underwriter) is already required to review the appraisal documentation." Although the final Rule does not appear to impose any new requirements on FHA mortgage lenders, it does reflect the Department's continued efforts to increase oversight of the appraisal process and enhance lender accountability for deficient appraisals. The Rule follows in the wake of several appraisal-related advancements, including, among other things, implementation of a Homebuyer Protection Plan, amendments of Handbook requirements, designation of a sanctions matrix for appraisers, creation of the FHA Appraiser Roster, and implementation of the Appraiser Watch Initiative. Given HUD's strenuous efforts to preserve the integrity of FHA appraisals and hold lenders accountable for appraisal deficiencies, it is crucial that lenders take their appraisal responsibilities seriously and ensure their personnel are intimately familiar with appraisal requirements. For more information regarding FHA appraisal requirements, visit www.hud.gov or www.hudclips.org. Phil Schulman is a partner with the Washington, D.C.-based law firm, Kirkpatrick & Lockhart LLP. He can be reached at (202) 778-9027 or e-mail [email protected] Emily J. Booth is an associate partner in the Washington, D.C.-based law firm, Kirkpatrick & Lockhart LLP. She can be reached at (202) 778-9112 or e-mail [email protected] Reprinted with permission from the Kirkpatrick & Lockhart AlertMortgage Banking Commentary, July 2004.