Consumer Compliance Outlook
The Federal Reserve Board's Interim Final Rule on Valuation Independence
In response to the financial crisis, the Board of Governors of the Federal Reserve System (Board) exercised its rulemaking authority under the Home Ownership and Equity Protection Act in 2008 to amend Regulation Z to provide several new protections for consumer mortgages.1 The final rule, which became effective October 1, 2009, included appraiser independence requirements in §226.36(b) designed to ensure the integrity of real estate appraisals used in closed-end mortgages. Subsequently, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),2 which largely codified the protections of §226.36(b) into new section 129E of the Truth in Lending Act (TILA), 15 U.S.C. §1639e, while also adding new protections. For example, while §226.36(b) was limited to closed-end consumer credit transactions secured by a principal dwelling, section 129E applies to all consumer credit transactions secured by a principal dwelling, including home equity lines of credit.
In October 2010, the Board published an interim final rule to implement section 129E's requirements, which became effective on April 1, 2011.3 The Board's rule, which creates new §226.42 of Regulation Z and replaces the Board's prior rule under §226.36(b),4 imposes the following requirements:
- Prohibits coercion and other similar actions designed to cause persons who perform property valuations to base the appraised value of properties on factors other than their independent judgment;
- Prohibits persons who perform property valuations and valuation management companies hired by lenders from having financial or other interests in the properties or the credit transactions;
- Prohibits creditors from extending credit based on a valuation if the creditor knows beforehand of violations involving coercion or conflicts of interest, unless the creditor determines that the value of the property is not materially misstated or misrepresented;
- Requires that creditors or settlement service providers that have information about appraiser misconduct file reports with the appropriate state licensing authorities; and
- Requires the payment of reasonable and customary compensation to appraisers who are not employees of the creditors or of the appraisal management companies hired by the creditors.
This article reviews these requirements and also briefly discusses the long-standing prudential appraisal regulations and guidelines of the federal banking agencies, including the recently revised Interagency Appraisal and Evaluation Guidelines issued by the agencies in December 2010.
COVERED PERSONS AND TRANSACTIONS
The interim final rule applies to a covered person, defined as a creditor with respect to a covered transaction or a person providing settlement services, as defined in the Real Estate Settlement Procedures Act (RESPA), 12 U.S.C. §2601 et seq. See 12 U.S.C. §2602(3). This latter definition includes, for example, appraisers, mortgage brokers, title insurers, and realtors. A “covered transaction” is defined as an extension of consumer credit that is or will be secured by the consumer's principal dwelling, including home equity lines of credit.
In several key provisions, the rule uses the phrase “valuation” instead of “appraisal” because in some jurisdictions appraisers are licensed or certified, and the rule is not limited to these appraisers but applies more broadly to any person valuing real estate in a covered transaction. For example, some real estate agents make valuations and are subject to the rule if they make a valuation for a covered transaction.5 “Valuation” is defined in §226.42(b)(3) as an “estimate of the value of the consumer's principal dwelling in written or electronic form, other than one produced solely by an automated model or system.” This definition specifically excludes valuations based on an automated valuation system.
REQUIREMENTS OF THE INTERIM FINAL RULE
§226.42(c): Coercing and Misrepresenting Value of Consumer's Dwelling Prohibited
Under the rule, a covered person is prohibited in a covered transaction from directly or indirectly coercing, extorting, inducing, bribing, intimidating, compensating, or colluding with a person preparing real estate valuations, or performing valuation management functions, to cause the valuation assigned to a consumer's principal dwelling to be based on any factor other than the independent judgment of the person who prepares the valuation. The meaning of these terms is based on their definition under applicable state law or contract.
A violation of §226.42(c) occurs if a person engages in one of these actions for the purpose of causing the value assigned to the dwelling to be based on a factor other than the independent judgment of the person preparing the valuation. For example, asking the person preparing the valuation to consider additional, appropriate property information does not violate §226.42(c) “because such request does not supplant the independent judgment of the person that prepares a valuation.”6 The rule covers both direct and indirect conduct. For example, if a creditor attempts to pressure an appraiser into making a valuation not based on the appraiser's independent judgment by threatening to withhold future business, the threat violates the rule.7
To facilitate compliance, the final rule provides examples of coercion violations:
- Seeking to influence a person who prepares a valuation to report a minimum or maximum value for the consumer's principal dwelling;
- Withholding or threatening to withhold timely payment to a person who prepares a valuation or performs valuation management functions because the person does not value the consumer's principal dwelling at or above a certain amount;
- Implying to a person who prepares valuations that current or future retention of the person depends on the amount at which the person estimates the value of the consumer's principal dwelling;
- Excluding a person who prepares a valuation from consideration for future engagement because the person reports a value for the consumer's principal dwelling that does not meet or exceed a predetermined threshold; and
- Conditioning the compensation paid to a person who prepares a valuation on consummation of the covered transaction.8
The rule also prohibits persons preparing valuations from mischaracterizing the value of the property by either falsifying or materially misrepresenting or altering a valuation. A misrepresentation or alteration is material if it would have a significant effect on the value assigned to the property.9
To facilitate compliance, §226.42(c)(3) identifies six examples of permissible conduct that would not violate the prohibition on coercion and on mischaracterizing, misstating, or falsifying a valuation:
- Asking a person who prepares a valuation to consider additional, appropriate property information, such as information about comparable properties, to make or support a valuation;
- Asking a person who has prepared a valuation to provide further detail, substantiation, or explanation for the value assigned;
- Asking a person who prepared a valuation to correct errors in the valuation;
- Obtaining multiple valuations for the consumer's principal dwelling to select the most reliable valuation;
- Withholding compensation because a person conducting a valuation breached contractual duties in providing the valuation or provided substandard services; and
- Taking action permitted or required by applicable federal or state statute, regulation, or agency guidance.
§226.42(d): Prohibited Conflicts of Interest in Preparing a Valuation
The final rule also prohibits conflicts of interest for appraisers to ensure that the integrity of a valuation is not compromised. To address this concern, the rule prohibits a person from preparing a valuation for a covered transaction in which he has a direct or indirect interest, financial or otherwise, in the property or transaction.10
Because some creditors employ staff members to perform valuations, the rule specifically addresses the circumstances in which employees of creditors and affiliates of creditors, as well as providers of multiple settlement services, can perform valuations without violating the conflict of interest prohibition. The conflict rules are designed to establish a firewall between the loan production department ordering the valuation and the valuation department. Because it is often not feasible to separate these functions in small financial institutions, the regulation creates two sets of firewall requirements: one for institutions with assets of $250 million or less, and one for institutions with assets greater than $250 million.
Conflict Rules for Institutions with Assets of $250 Million or Less. To qualify for the safe harbor for small institutions, a creditor must have assets of $250 million or less as of December 31 in both of the past two calendar years. An employee or affiliate of a creditor can perform a valuation provided the following conditions are satisfied:
- The compensation of the person preparing the valuation is not based on the value arrived at for the valuation; and
- The employee, officer, or director who orders, performs, or reviews the valuation must abstain from any decision to approve, deny, or set the terms of the transaction.
Conflict Rules for Institutions with Assets Greater Than $250 Million. The safe harbor rules are slightly different for institutions with assets greater than $250 million for either of the past two calendar years. For these institutions, an employee or affiliate can perform a valuation provided the following conditions are met:
- The compensation of the person performing the valuation is not based on the value arrived at in a valuation;
- The person performing the valuation or performing valuation management functions is not part of the creditor's loan production function and does not report to a person whose compensation is based on the closing of the transaction for which the valuation is prepared; and
- An employee, officer, or director in the creditor's loan function is not involved, directly or indirectly, in selecting, influencing, retaining, or recommending the person performing the valuation.
Conflict Rules for Providers of Multiple Settlement Services. The interim final rule also has a safe harbor for settlement service providers that prepare valuations or perform valuation management functions in addition to performing another settlement service for the transaction.11 For these providers, the conflict rules described above for employees or affiliates of creditors apply as follows: (1) if the creditor has assets of $250 million or less, the employee/affiliate conflict rules for creditors with assets equal to or less than $250 million apply; (2) otherwise, the employee/affiliate conflict rules for creditors with assets greater than $250 million apply.
Management Valuation Functions. It is important to note that the rule's prohibitions on coercion and conflicts of interest discussed above apply not only to valuations but also to “management valuation functions.” Section 226.42(b)(4)(iv) defines this term to include recruiting or employing a person to prepare a valuation, managing the process of preparing a valuation, and reviewing the work of a person who prepares valuations. For example, some financial institutions employ staff to review valuations to ensure they accurately reflect the value of the property.
§226.42(e): Credit Extension Prohibited
The interim final rule also prohibits creditors from extending credit when they know that one of the valuation requirements in §226.42(c) or (d) has been violated. However, the rule contains an exception if the creditor acts with due diligence to determine that the violation does not materially misrepresent or misstate the value of the consumer's principal dwelling. A valuation materially misrepresents or misstates the value of the dwelling if the misstatement or misrepresentation affects the credit decision or the terms on which the credit is extended.
§226.42(f): Customary and Reasonable Compensation
Another requirement of the interim final rule is that the compensation that creditors and their agents provide to a fee appraiser must be “customary and reasonable.” “Fee appraiser” is defined as either (1) a state-licensed or certified natural person performing appraisal services for a fee but is not an employee of the person engaging the appraiser; or (2) an organization that in the ordinary course of business employs state-licensed or certified appraisers and receives a fee for performing appraisals.12
To facilitate compliance, the rule includes two presumptions of compliance for the customary and reasonable compensation requirement. First, a creditor and its agent are presumed to comply with the rule if the fee paid to the appraiser is reasonably related to the recent rates paid for appraisal services in the relevant geographic market, and the creditor or agent has adjusted the recent rate after taking into account specified factors, such as the type of property, the scope of work, and the appraiser's qualifications and experience. To qualify for this presumption, the creditor must not have engaged in any anti-competitive actions in violation of state or federal law that affect the appraisal fee, such as price fixing or restricting others from entering the market. See comments 226.42(f)(2)(i)-1, -2, -3 and 226.42(f)(2)(ii)-1, -2.
Second, a creditor and its agent are also presumed to comply with the interim final rule if they determine the fee by relying on third-party information, such as a government agency fee schedule, an academic study, or an independent private-sector survey. Consistent with the Dodd-Frank Act's requirements, third-party surveys and similar studies must not include fees paid to appraisers by appraisal management companies. See comments 226.42(f)(3)-1, -2, -3.
Volume discounts are permitted, as long as the compensation is customary and reasonable. Comment 226.42(f)(1)-5 provides this example of permissible compensation: “[A]ssume that a fee appraiser typically receives $300 for appraisals from creditors with whom it does business; the fee appraiser, however, agrees to reduce the fee to $280 for a particular creditor, in exchange for a minimum number of assignments from the creditor.”
§226.42(g): Mandatory Reporting of Appraiser Misconduct
The final requirement of the rule is that if a covered person discovers that the Uniform Standards of Professional Appraisal Practice13 or ethical or professional requirements for appraisers under applicable state or federal statutes or regulations have been violated, the person must refer the matter within a reasonable period of time to the appropriate state agency if the failure to comply is material. A violation is material if it is likely to significantly affect the value assigned to the consumer's principal dwelling.
Section 129E(k) provides that violations of the valuation independence requirements are subject to both the regular civil remedies available to consumers in §130 for TILA violations, 15 U.S.C. §1640, as well as civil penalties. The civil penalties are $10,000 a day for each day a violation occurs for the first violation and $20,000 a day for subsequent violations. The federal agencies identified in §108 of the TILA, 15 U.S.C. §1607, are charged with assessing the penalties.
PRUDENTIAL APPRAISAL REGULATIONS AND GUIDELINES
While the Board's new interim final rule applies to covered persons in covered transactions, the Federal Reserve and the other federal agencies that regulate financial institutions adopted prudential appraisal regulations for federally regulated institutions' real estate-related financial transactions in 1990.14 Furthermore, the Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision issued Interagency Appraisal and Evaluation Guidelines in October 1994 to provide guidance on the agencies' expectations for a regulated institution's collateral valuation practices. More recently, in December 2010, the federal banking agencies and the National Credit Union Administration issued revised guidelines.15 The revised guidelines describe the agencies' risk management expectations for an effective collateral valuation function, including appraisals, that an institution should have to support its credit underwriting process, for both consumer and commercial real estate lending activity. These revised guidelines also emphasize the importance of ensuring that the appraisal process operates independently from an institution's loan production function.
The Board's interim final rule on appraiser independence addresses many of the mortgage appraisal practices that may have contributed to the recent financial crisis. Implementing these rules will help maintain the integrity of dwelling-secured consumer credit transactions. Specific issues and questions about consumer compliance matters should be raised with your primary regulator.