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Half of FDIC's Claims Against Appraisal Management Company Thrown Out in $154 Million Dispute

Thursday, November 10, 2011

Blayne V. Scofield | Bloomberg LawFederal Deposit Insurance Corporation v. LSI Appraisal, Inc., 11-cv-00706 (C.D. Cal. Nov. 2, 2011) (Docket No. 35) On November 2, 2011 the U.S. District Court for the Central District of California dismissed two of the four claims filed against an appraisal management company by the Federal Deposit Insurance Corporation (FDIC) in its capacity as receiver for Washington Mutual Bank (WAMU).

FDIC Accused Company of Conducting Shoddy Appraisals

Federal banking and thrift regulations generally require an institution to obtain an appraisal for real estate loans that exceed $250,000. Required appraisalsmust comply with the Uniform Standards of Professional Appraisal Practice (USPAP) and be conducted by independent appraisers. Federal banking regulators have issued interagency guidelines that contain additional requirements for institutions' appraisal programs. In 2006, WAMU outsourced its appraisal function to LSI Appraisal, LLC (LSI). According to FDIC's complaint, LSI was involved in more than 386,000 appraisals and received over $127 million in fees from WAMU. In the agreement between the parties, LSI agreed to provide appraisals in accordance with industry standards and applicable law using qualified appraisers. LSI also agreed to indemnify WAMU for losses arising from third party claims arising from the performance of its services under the agreement. One of LSI's affiliates, Fidelity National Tax Service, Inc. (Fidelity), guaranteed LSI's performance under the agreement. In 2008, WAMU was closed by regulators and FDIC was appointed as its receiver. Thereafter, according to the complaint, FDIC reviewed 292 appraisals prepared by LSI for WAMU, and claimed that 220 contained "egregious" violations of the USPAP standards and another 62 contained less severe violations. FDIC asserted that the allegedly faulty appraisals caused WAMU more than $154 million in damages. It also claimed that LSI was the alter ego of several of its affiliates and subsidiaries. FDIC filed claims for gross negligence and breach of contract (against LSI and Fidelity), and it sought to hold LSI's subsidiaries and affiliates jointly and severally liable. LSI moved to dismiss FDIC's claims.

Some Claims Dismissed

The court agreed with LSI that the economic loss rule, which generally prohibits a plaintiff from using tort law to recover for economic losses resulting from a breach of contract, barred FDIC's gross negligence claim. Like most legal doctrines, however, the economic loss rule is subject to exceptions. FDIC claimed that two exceptions applied—one that allows tort claims where the alleged conduct violated a duty independent of the contract, and one that allows such claims where the alleged conduct breached a duty arising from a special relationship between the parties. FDIC argued that LSI owed WAMU an independent, common law duty of professional care and that it had a special, professional relationship with WAMU. In rejecting FDIC's professional care argument, the court found no difference between the common law duties alleged by FDIC and duties set forth in the contract. The court also denied FDIC's special relationship argument, concluding that the availability of other appraisers meant that no relationship other than a normal, contractual relationship existed between WAMU and LSI. The court also denied FDIC's alter ego, single business entity, and joint venture theories. FDIC asserted that LSI's subsidiaries and affiliates effectively controlled the provision of appraisal services and, therefore, they should be jointly and severally liable with LSI. The court found that FDIC's complaint failed to allege facts to sufficiently support its argument and dismissed the claim.

Contract Claims Survived

LSI argued that the breach of contract claim against it should be dismissed because the dispute was subject to mandatory arbitration. The arbitration clause was set forth in an exhibit to the agreement that addressed certain appraisal warranties provided by LSI. FDIC asserted that its breach claims were based on provisions in the agreement rather than the exhibit. The court agreed with FDIC and held that the arbitration requirement was limited to disputes involving the warranties stated in the exhibit and did not cover other breaches of the agreement. Fidelity argued that the conditions precedent to its performance guaranty had not been satisfied. It cited language in the agreement requiring that remedies be pursued against LSI first before the performance guaranty could be enforced. It argued that this condition was unsatisfied because FDIC's claims against LSI were still pending. In response, FDIC asserted that the contract required only that it assert its claims against LSI before pursuing Fidelity and not that it must exhaust its remedies against LSI. The court agreed with FDIC's interpretation and allowed the claim to stand.

Potential Difficulties With FDIC's Contract Claims

Although FDIC's contract claims survived LSI's motions to dismiss, FDIC may still face challenges in pursuing its remaining claims. For instance, FDIC's theory of damages is that the defective appraisals overstated collateral values and, as a result, WAMU made bad loans that it would not have made otherwise. Section 2 of Exhibit A, states that "appraisal quality will be monitored by WAMU." LSI may claim that WAMU breached this obligation and that, had it carried out this duty, it would have detected the problems and mitigated its damages. LSI may also question the role its appraisals played in WAMU's loan approval process. It instead may cite flaws in WAMU's underwriting process and argue that the cause of the losses was WAMU's willingness to make loans to unqualified borrowers rather than its breach of the agreement. Also, like many commercial agreements, the appraisal contract contains a limitation of liability provision. This limits LSI's liability for a breach of contract (among other things) to direct damages and caps the damages at the amount of fees paid by WAMU to LSI in the twelve months "preceding the claim". The contract is unclear when the clock for the twelve month period started—at the time the applicable appraisal was conducted or when FDIC filed its suit. The answer could significantly affect LSI's exposure. Also notable is the fact that the limitation of liability provision contains carveouts for gross negligence or indemnity claims. This explains FDIC's tort claim and its efforts to avoid the economic loss rule. It also explains why FDIC's breach claim is predicated on, among other things, LSI's alleged breach of its indemnity obligations. However, the complaint suggests that FDIC's indemnification claim is based on LSI's breach of other provisions of the agreement, i.e., that LSI must indemnify FDIC for losses FDIC sustained due to LSI's breaches of the agreement. Most indemnity provisions are intended to protect the parties to the agreement from third parties rather than from each other. The appraisal agreement was no different and applied only to third party claims. Under federal banking law, FDIC, as receiver, stands in WAMU's shoes. Consequently, it appears FDIC's indemnity claim is based on injuries it (rather than another party) suffered, which may make FDIC's indemnification argument (and its efforts to avoid the liability cap) difficult to sustain.

Several Other FDIC Cases Against Appraisers Are Pending

The only thing anomalous about this case is its size. One of the trends that has emerged in in the bank failures since 2008 is that FDIC has aggressively pursued appraisers for allegedly defective appraisals. In many instances, FDIC's litigation approach mirrors the strategy used with LSI—it pursues both tort claims and breach of contract claims against the appraiser. FDIC's defeat on its tort claim here could spell trouble for its claims in litigation with other appraisers. Selected cases filed by FDIC against appraisers are listed below.  
CaseFailed Bank
FDIC v. Ultra Escrow, Inc., 11-cv-08062 (C.D. Cal. Sept. 28, 2011)Amtrust Bank
FDIC v. Escobedo, 11-cv-05625 (C.D. Cal. July 8, 2011)IndyMac Bank, FSB
FDIC v. Zylestra & Reynolds Appraisal Services P.A., 11-cv-00383 (M.D. Fla. July 8, 2011)IndyMac Bank, FSB
FDIC v. Brock, 11-cv-00998 (C.D. Cal. July 6, 2011)IndyMac Bank, FSB
FDIC v. Mahan, 11-cv-05414 (C.D. Cal. June 29, 2011)IndyMac Bank, FSB
FDIC v. CoreLogic Valuation Services, LLC, 11-cv-00704 (C.D. Cal. May 9, 2011)Washington Mutual Bank
FDIC v. Long Island Appraisal Network, Inc., 10-cv-04249 (E.D.N.Y. Sept. 17, 2010)NetBank FSB
FDIC v. Kirkland, 10-cv-03286 (C.D. Cal. April 30, 2010)IndyMac Bank, FSB
FDIC v. JSA Appraisal Service, 10-cv-02932 (C.D. Cal. April 20, 2010)IndyMac Bank, FSB
FDIC v. Econo Appraisal, Inc., 10-cv-21197 (S.D. Fla. April 14, 2011)IndyMac Bank, FSB
FDIC v. Behr Residential Appraisal Group, LLC, 10-cv-00323 (S.D. Ind. March 18, 2010)IndyMac Bank, FSB
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