Sunday, August 21, 2011

What's Wrong with Most Indemnification Clauses in AMC Contractor Agreements?

AMC independent contractor agreements are now receiving more attention. A key issue that many appraisers and regulators have focused on is that many AMC contractor agreements use very one-sided indemnification clauses to attempt to shift financial liability for the appraisals the AMCs manage to individual appraisers. NAR recently wrote to federal regulators expressing serious concern that such AMC clauses are interfering with appraiser independence and hurting appraisal accuracy and quality -- i.e, if appraisers fear being sacked with unbearable liability based on an appraisal later being deemed faulty, some appraisers are more likely to "play it safe" by delivering lower opinions of value.

This post is mainly about the policy reasons why unfair indemnification clauses don't belong in AMC contractor agreements. If you're concerned, on the other hand, about the individual potential legal risk that such clauses create, I suggest that you read the following article on readimember.org (registration is required): Indemnity 101: Be Careful What You Promise.

This is not an attack on AMCs. In fact, as an attorney, I occasionally advise AMCs and assist them with
compliance and defense.  In addition, on the insurance side, LIA provides professional liability insurance and surety bonds to AMCs (and thousands of appraisers). I know that a well-operated AMC, as an alternative to a lender's in-house department, with access to a quality appraiser panel actually can improve appraisal quality, reduce collateral risk and prevent a certain amount of appraiser liability.

But the facts are the facts when it comes to the unreasonable indemnification provisions that some AMCs are using. Leaving aside the liability risk of the individual appraiser, the fact is that unfair clauses in practice have not served any useful purpose for AMCs and may result in harm to the AMCs' lender clients. Also, as of this date, it is extremely rare for AMCs to actually try to enforce their clauses against individual appraisers and, in fact, I know of only three actual cases in which AMCs have tried to do so. Thus, whatever benefit AMCs think they are receiving from having the clauses in their agreements is likely outweighed by the negative costs such as losing quality appraisers on their panels. Another reality is that much of the language in AMCs' one-sided indemnity clauses would not be enforceable in many states – so again, the net value of pushing these clauses on appraisers is further questionable. Finally, AMCs which continue to use particular language in their agreements face the risk of state discipline if regulators determine that the language violates a specific state AMC law limiting indemnification clauses or general appraiser independence protections.

Sample Indemnification Language

The following language exemplifies the typical indemnification language found in many AMC contractor agreements:
Appraiser shall indemnify, defend, save and hold harmless [the AMC] from and against any and all liability, claims, damages, losses, penalties, fines, judgments and any other costs, fees and expenses in any way related to any appraisal report submitted by Appraiser.
Some variation of that language is found in most, but not all, AMC contractor agreements.  A few AMCs also add the following twist to the basic language:
Appraiser further agrees that if a mortgage lender is required to repurchase a mortgage loan for any reason in any way related to any appraisal report submitted by Appraiser pursuant to this agreement, Appraiser shall pay [the AMC] an amount equal to the repurchase price paid by such mortgage lender to repurchase such mortgage loan. Appraiser shall also pay the reasonable attorney’s fees of [the AMC] incurred in enforcing Appraiser’s obligations under this agreement.

State AMC Law Prohibitions against Certain Forms of Indemnification

As mentioned above, some states have enacted restrictions prohibiting AMCs from requiring appraisers to sign agreements containing certain forms of indemnification -- these laws usually prohibit the AMC from requiring an appraiser to sign an agreement which requires the appraiser to indemnify the AMC for losses or claims "arising out of the services performed by the appraisal management company ... and not the services performed by the appraiser." This language comes from Washington's AMC law, which became effective July 1, 2011. From the appraiser's point of view, it is a good start at curing some of the unfairness but not a complete fix. The strongest prohibition is found in Vermont's AMC law, which prohibits an AMC from:
Requiring an independent appraiser to enter into an agreement requiring the independent appraiser to defend, to indemnify, or to hold harmless the registrant or other third party for the development, use, or contents of a real estate appraisal.
For appraisers in Vermont, that prohibition should pretty much take care of the indemnification clause issue in AMC contractor agreements.
 
The Policy Problems

AMCs that use broad indemnification language similar to the samples usually justify their position by saying something like: "We're just making sure the appraiser is accountable for faulty appraisals."  Here are the problems with that position and the one-sided clauses in general:

1.  Appraisers already are accountable.  These indemnification clauses are not about appraiser "accountability" -- they are simply about trying to shift some or all of the AMC's own financial and legal liability to the appraiser.  An appraiser is already accountable for his or her appraisal errors regardless of whether the appraiser signs a one-sided agreement in favor of the AMC.  An appraiser is accountable without these clauses by way of:  (a) regular tort legal actions for professional negligence, (b) state discipline for USPAP or other professional violations, and (c) the very real economic consequences of losing business based on poor performance.  The indemnification clauses are about shifting financial liability from the AMC beyond these fair and better-regulated forms of accountability.

2.  The objectionable clauses are entirely one-sided.  From the appraiser's point of view and for public policy reasons, if it’s reasonable to have an indemnification clause holding the appraiser “accountable” for a faulty appraisal, then it should be reasonable for the AMC to be held accountable to the appraiser and other parties and it should be reasonable for the AMC to promise to indemnify the appraiser when a faulty appraisal is the AMC’s fault.  And, when both the appraiser and AMC are at fault, it’s reasonable to expect that neither party will indemnify the other.  The reality, however, is that all liability under the language in these clauses shifts to the appraiser.  Moreover, some AMCs actually seek to limit their own potential liability for their own negligence or other misconduct to the appraiser.  Several AMCs, for example, use limitation of liability language like this (I've paraphrased and combined different companies' language into one version):
“WITH REGARD TO ANY CLAIM OR LEGAL ACTION BY APPRAISER  AGAINST [THE AMC], ITS AFFILIATES OR ANY OF THEIR EMPLOYEES, OFFICERS, DIRECTORS OR AGENTS, WHETHER BASED IN TORT, CONTRACT, OR OTHERWISE, APPRAISER'S RECOVERABLE DAMAGES SHALL BE LIMITED TO A MAXIMUM  AGGREGATE AMOUNT EQUAL TO THE FEES PAID BY [THE AMC] TO APPRAISER IN THE 12 MONTHS PRECEDING THE CLAIM."
Here are some specific examples of AMC failures for which AMCs refused to accept any liability: the AMC withheld from the appraiser information known to the AMC about an encroachment of a structure on a setback, the AMC instructed the appraiser to appraise the wrong property, and the AMC assigned a licensed appraiser to appraise a property for a $4.5 million federally-related loan.   

3.  Parties should be responsible for their own mess.  Interrelated with the above problem, the objectionable indemnification clauses purport to shift 100% of the liability to individual appraisers without regard to any complicity of the AMC.  Lenders and AMCs are as much the cause of faulty appraisals as individual appraisers.  Lenders in general set the quality of the appraisals they receive.  AMCs represent that they select the most competent and qualified appraisers, represent that they perform QC, and charge for these services.  AMCs make these representations in their contracts with lenders, to regulators, on their websites and to the public.  They shouldn’t then be permitted to use language that purports to shift the financial responsibility for their own failures to the appraiser.


4.  The clauses are affected by unequal bargaining strength.  Given the reality of the appraisal industry, the legal liability of appraisers is better and more predictably dealt with by tort law than it is by piecemeal AMC contractor agreements in which one side possesses all the negotiating power.  Appraisers sign the most unreasonable agreements because: (1) appraisers need to earn a living and eat, (2) many appraisers don’t understand the clauses -- in fact, the AMC personnel assigned to answer appraiser questions about the clauses almost never explain them correctly, or (3) some appraisers have nothing left to lose.  A good example of the “nothing left to lose” scenario is the real story of the appraiser who signed one of these AMC agreements while in bankruptcy; did some "faulty" appraisals for which he, the lender and the AMC were sued over -- which were reviewed by the AMC before delivery; and then filed for bankruptcy again at about the time the AMC came after him to enforce its indemnification clause.

5.  The clauses negatively affect the quality of an AMC's appraiser panel.  All things being equal, a rational lender should have less interest in retaining an AMC that uses an unreasonable vendor agreement.  I believe that unreasonable contract language results in an overall lowering of the quality of an AMC's appraiser panel because, on average, fewer appraisers who are better trained, economically stable, and careful about reading legal verbiage choose to work for AMCs with the worst agreements.  On average, these appraisers more likely to choose against working for AMCs with the most unfair provisions -- combined, of course, with the effect of unattractive fees.

6.  The economics don't support appraisers serving as financial guarantors.  Economic reality is probably the most important problem with the liability shifting that AMCs seek under the literal words of these clauses.  Holding the appraiser “accountable” sounds like no big deal and is a politically correct term, but “accountable” as intended in the one-sided agreements means that individual appraisers are serving as guarantors of their opinions of value (as of the date of appraisal, of course) and of strict fulfillment of all appraisal guidelines, whether under the control of the appraiser or not -- all as determined in hindsight by retrospective reviews.  It also means that the appraiser is intended to be financially liable for all claimed losses that may flow from an alleged “faulty” appraisal (unpaid principal, interest, late charges, collection fees, BPO fees, etc.) plus all the costs of defending any third party claims.  If appraisers are truly going to be held "accountable" in this sense, then the appraisal fee would need to be several thousand dollars per appraisal based on current mortgage losses of GSEs, investors and lenders blamed on “faulty” appraisals.  Even if we assume that past mortgage practices won’t repeat themselves and ignore the current losses relating to loans 2003-2008 as a measure of risk, the price for guarantying losses attributable to “faulty appraisals” as well as defending against third party claims would likely be $100-150 per appraisal on top of the appraisal fee, based on the LTV and credit of the borrower (the current “insured warranties” offered by some AMCs at $10-$20 per appraisal don’t cover anything close to the liability shifting contemplated in the one-sided indemnification agreements).  No AMCs or lenders seem willing to pay appraisers for the price of liability risk that the literal application of these clauses seeks to shift (as mentioned earlier, in practice so far and with a few exceptions, AMCs have not actually been enforcing the indemnification language in their agreements).

7.  The bottom line.  Perhaps the bottom line is that a $200-$400 appraisal can't and shouldn’t be relied on to guaranty repayment of a $1 million loan if someone later deems the appraisal “faulty.”  Every appraiser performing valuations will have appraisals that can be deemed "faulty."  Good appraisers should be selected and used because they are trusted as competent, reliable and honest and render opinions of value that are on average accurate and reliable and on average within a range of acceptable errors.  They should not be employed as financial guarantors of value -- unless AMCs or lenders are willing to pay for the price of shifting that risk.