On October 18, 2010, the Federal Reserve Board of Governors (the "Board") announced a new rule setting standards for appraisals of residences offered as security for consumer credit transactions - 12 C.F.R. § 226.42 (the "Rule" or "Section 42"). The Rule amends the Board's Regulation Z, which implements the Truth in Lending Act ("TILA"). The Rule prohibits (i) undue influence on appraisers, (ii) mischaracterization of value in appraisals, and (iii) certain appraiser conflicts of interest. Section 42 also sets forth requirements for (i) compensation for licensed/certified appraisers and (ii) reporting of appraiser misconduct. Notably, the Rule places stringent requirements on creditors that employ in-house appraisers, so as to avoid conflicts of interest.
The Rule was promulgated pursuant to an amendment to TILA set forth in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The Rule will be published as an "interim final rule" and will go into effect sixty days after its publication in the Federal Register. During the sixty-day period, the Rule will be open for public commentary, which the Board may incorporate into a finalized version of the Rule. Although the Rule will be effective sixty days after its publication, compliance will not be mandatory until April 1, 2011.
Replacement of Prior Federal Appraisal Independence Standards
Once effective, the new Rule will expressly supplant prior regulations and policies regarding appraisal independence, specifically, another portion of Regulation Z, 12 C.F.R. § 226.36(b) (the "Appraisal Independence Rules"), and the Home Valuation Code of Conduct ("HVCC"). In enacting the Dodd-Frank Act and amending TILA, Congress codified the Appraisal Independence Rules, which the Board implemented in 2008. Accordingly, the Board removed them from Regulation Z effective April 1, 2011 (the mandatory compliance date for the Rule). The HVCC was announced in December 2008 by government-sponsored enterprises Fannie Mae and Freddie Mac (the "GSEs") and established appraisal independence standards for loans the GSEs would purchase. The Dodd-Frank Act provided that the HVCC would have no effect upon the Board's issuance of its new Rule. Section 42 is more expansive than either the Appraisal Independence Rules or the HVCC; it is more detailed than the Appraisal Independence Rules and, unlike the HVCC, applies to all consumer credit transactions, not merely GSE loans.
Provisions of the Rule
Application - § 226.42(a), (b)
The Rule will expand the scope of Regulation Z and TILA and previous regulations regarding appraiser independence. It will apply to consumer credit transactions secured by the consumer's principal dwelling ("Covered Transactions"). Persons covered by the Rule ("Covered Persons") will include creditors involved in Covered Transactions as well as any person who provides real estate settlement services, not just appraisers. This includes, but is not limited to, mortgage brokers, realtors, and title insurers. Section 42 is thus more expansive in its application than TILA and Regulation Z, which generally apply only to creditors. Additionally, expanding on the scope of the 2008 Appraisal Independence Rules, the new Rule applies to home equity lines of credit in addition to closed-end loans.
Prohibition of Coercion and Misrepresentation in Connection with the Valuation of Consumer's Principal Dwelling - § 226.42(c)
Notably, certain provisions of the Rule, such as subsection (c), do not refer to "appraisals" or "appraisers" but, rather, to "valuations" and "person[s] that prepare valuations." This change was made to ensure that those provisions (setting forth prohibited conduct) apply not only to licensed/certified appraisers, but to any person providing a value for a property, such as a real estate agent engaged to provide a market value. The Rule does not apply to estimates of value produced using an automated model or system exclusively.
Subsection (c) of the Rule prohibits Covered Persons from causing a valuation of a consumer's principal dwelling to be based on anything other than the independent judgment of the valuator. Prohibited conduct includes coercion, bribery, extortion, intimidation, or "inducement" of the valuator; compensation or instruction to the valuator; or collusion with the valuator. The Rule gives examples of violative conduct, all of which involve conditioning or withholding the valuator's payment or future engagement based on the results of the valuation.
The Rule additionally prohibits the mischaracterization of a dwelling's value. Valuators may not materially misrepresent the value of the dwelling. Covered Persons may not falsify or materially alter a valuation (alterations are permitted if the Covered Person is a valuator). A misrepresentation or alteration is material if it is likely to "significantly affect" the value assigned to the dwelling. Additionally, Covered Persons may not induce a prohibited mischaracterization.
The Rule provides the following examples of conduct that does not constitute improper influence or mischaracterization: (i) requesting that a valuator consider additional information; (ii) requesting that a valuator provide further detail as to his or her conclusion; (iii) asking a valuator to correct an error; (iv) obtaining multiple valuations in order to select the most reliable one; or (v) withholding compensation for breach of contract or substandard services.
Prohibition on Conflicts of Interest in Valuation - § 226.42(d)
In addition to prohibiting a creditor from expressly exerting improper influence over a valuator, the Rule also addresses conflicts of interest. It prohibits a valuator for a Covered Transaction from having any interest, direct or indirect, financial or otherwise, in the property or transaction involved in the valuation. The Rule is not violated, however, merely because the valuator is an employee or affiliate of the creditor or because the valuator provides other settlement services in addition to the valuation. Accordingly, the Rule establishes a safe harbor for creditors who use in-house valuators, provided the creditor establishes certain "fire walls" between the valuation function and the loan production function.
For a creditor (or person providing settlement services) whose assets are in excess of $250 million, the fire wall is established if (i) the valuator's compensation is not based on the value ascribed to the property; (ii) the valuator reports to a person (a) who is not responsible for generating Covered Transactions and (b) whose compensation is not based on the closing of the transaction for which the valuation is generated; and (iii) no one with responsibility for generating Covered Transactions has any role in selecting the valuator.
For a creditor (or person providing settlement services) whose assets are below $250 million, the fire wall is established if (i) the valuator's compensation is not based on the value of the valuation and (ii) any person who orders, performs, or reviews the valuation is not involved in any decision regarding the approval of the transaction or establishment of its terms. If the fire wall criteria are not met, the question of whether a prohibited conflict of interest exists will depend on the individual circumstances.
Prohibition of Extension of Credit - § 226.42(e)
In addition to setting forth prohibited conduct, the Rule further provides that a creditor may not extend credit where such prohibited conduct has occurred, unless the creditor documents that it has acted with "reasonable diligence" to determine that the valuation does not, in fact, materially misrepresent the value of the dwelling.
Appraiser Compensation - § 226.42(f)
In addition to setting forth criteria for ensuring accuracy and independence in valuations, the Rule also sets forth certain requirements with respect to licensed/certified appraisers. Accordingly, in subsection (f), the Rule uses the term "appraiser," defining a "fee appraiser" as one who is (i) licensed/certified by the state as an appraiser and (ii) not employed by the creditor. (Also included in the definition of "fee appraiser" are organizations employing licensed/certified appraisers.) The Rule obligates creditors in Covered Transactions to compensate "fee appraisers" in a manner that is customary and reasonable for comparable services in the geographic market of the appraised property. The Rule provides for two "presumptions of compliance" that a creditor may rely upon to justify the compensation paid.
Mandatory Reporting of Appraiser Misconduct - § 226.42(g)
The Rule places an additional requirement on Covered Persons with respect to licensed/certified appraisers, requiring them to report misconduct by such appraisers. In setting forth the reporting requirement, the Rule again uses the term "appraiser" (but not "fee appraiser" as appears in subsection (f)). The comment to the Rule defines an "appraiser" as a person who provides opinions on the value of dwellings and is required by the law of the state where the dwelling is located to be licensed/certified.
The Rule requires that any Covered Person who believes that an appraiser has not complied with the Uniform Standards of Professional Appraisal Practice or other ethical or professional requirements set forth by law shall report the appraiser to the appropriate state agency. This obligation exists only if the noncompliance is likely to significantly affect the property's value. The Covered Person must report within a "reasonable" period of time after determining there is a reasonable basis to believe material noncompliance has occurred.
The Rule enhances and expands existing standards for appraisal independence enacted over the past several years. The Rule is notable in that, although it is a part of TILA, which typically concerns only those extending consumer credit, it has broad application, regulating mortgage brokers, realtors, and title insurers, among others who provide real estate settlement services. Significant for those using in-house appraisers, the Rule contains stringent conflict-of-interest provisions and sets forth conditions creating a presumption of no conflict. Any creditor or other Covered Person using in-house appraisers should study the safe harbor subsections of the conflict-of-interest provision carefully to ensure compliance.