Homeownership, Flood Insurance, and Stupid Land Uses: The Kolbe Decision
First, thanks to Concurring Opinions for inviting me back. It’s been years. What took you so long?
I plan to spend some of my month’s effort here discussing coastal land use and disasters and the law. In light of Superstorm Sandy and likely future megastorms, and given climate change and sea level rise, I can’t help noting that, whatever is going on with managing CO2 levels at a global scale, one class of disasters results from what I have come to call in conversation (and now in writing) Stupid-A** Land Use Decisions (SALUD). We build houses in harm’s way. I’ve written about the folly of allowing homes on the parts of barrier islands that are most likely to flood or wash away, noting in passing the folly of building homes on scenic hillsides subject to rock- and mudslides. In the news lately, there’s much about the costs of rescuing homes built in forests that are just waiting to catch fire. At some point, we have to disincent SALUD, or at least insist that the full cost of risk and rescue and rebuilding be reflected in the market cost of building in Stupid-A** places, and let that expense disincent. It’s very hard to do. As my own dear New Jersey Governor Chris Christie said after Superstorm Sandy, we will rebuild!
Which brings me to the case I’m discussing today. It came down last Friday. The case is Kolbe v. BAC Home Loans Servicing, LP (1st Cir. No. 11-2030, Sept. 27, 2013) (en banc), 2013 WL 5394192. It is a First Circuit en banc decision, on a 3-3 vote, failing to reverse the District of Massachusetts, which granted a motion to dismiss a putative class action seeking an interpretation of a form mortgage contract provision concerning flood insurance. Warning, I’m not an expert in all of the doctrinal areas involved, so please forgive if I miss something, but boy, is it interesting.
The provision in dispute is Covenant 4, a three-sentence paragraph required by the Department of Housing and Urban Development (HUD) to be included in all single family dwelling mortgage contracts insured by the Federal Housing Administration (FHA). Covenant 4 was established by a regulation promulgated in 1989 after notice and comment rulemaking. It allows a lender to require that the homeowner purchase insurance for “any hazards . . . in the amounts and for periods that the Lender requires.” Covenant 4 also requires the borrower to insure against loss from floods to the extent required by the Secretary of HUD. HUD requires flood insurance whenever a property is located in a “special flood hazard area,” the most risky category under the National Flood Insurance Program (NFIP) classification scheme. HUD requires flood insurance at least equal to the outstanding balance of the mortgage, that is, the lender’s stake in the property, but there is a cap of $250,000. Thus, as to hazard (but not flood), the lender clearly has authority under Covenant 4 to require further hazard insurance. But it is, arguably, unclear whether Covenant 4 empowers the lender to require a homeowner to purchase additional flood insurance. Perhaps the provision of Covenant 4 referring to requirements by HUD insulates the homeowner from lender requirements as to purchasing flood insurance. Perhaps Covenant 4′s authorization for lenders to require additional hazard insurance includes flood insurance, because floods are a type of hazard. That’s the interpretation question.
Kolbe purchased a house in a special flood hazard area in Atlantic City, NJ, with an FHA-insured mortgage. He purchased federal flood insurance only to cover the amount of the loan because that what his lender let him do. But the mortgage was sold when the lender went bankrupt in 2009. Loan servicer BAC Home Loan Servicing, acting on behalf of Bank of America, took over. BAC told Kolbe he must purchase additional flood insurance up to replacement cost of the house, or else Bank of America would purchase the insurance itself for him and charge him. Kolbe, under protest, spent another $273 for a year for $46,000 worth of additional flood insurance. And he filed suit.
This may sound like a petty dispute. It’s certainly arguably an unfair changeup on Kolbe. But it’s a big issue. There are millions of mortgage contracts containing Covenant 4. Many involve flood insurance, and flood insurance is expensive. In fact, there are a number of pending lawsuits on Covenant 4–putative class actions–and several district court decisions concerning what authority lenders have over flood insurance under Covenant 4. The opinions do not all come out the same way. The Kolbe opinion is the first federal appellate opinions on Covenant 4 and lender power over flood insurance. Because of the 3-3 split, the en banc decision doesn’t settle anything precedentially. But it sure lays out the arguments.
One issue not in the case, because Kolbe went ahead and purchased the additional flood insurance, is the question of force-placed (also referred to as lender-placed) insurance. This can be a shady practice, as lenders may buy unnecessary or unnecessarily expensive insurance for which the homeowner must pay. Sometimes that insurance is purchased from affiliate companies and looks a lot like self-dealing. Kolbe tried to make the issue of a mere threat of force-placed insurance a feature of his case. But it’s just the wrong facts for challenging that practice.
So Kolbe found his mortgage operating on different, somewhat more costly terms than he and the original lender had agreed to because of Covenant 4. He and the lender proposed to present extrinsic evidence on contractual intent, to the effect that they had only agreed that Kolbe would insure the mortgage amount, not the full replacement cost. BAC took the position that Covenant 4 authorized it to impose an additional flood insurance purchase on Kolbe, regardless of what he intended to agree to or reasonably thought Covenant 4 meant.
Cost is the reason why the Association for the Advancement of Retired People (AARP) and the National Consumer Law Center (NCLC) filed an amicus brief on Kolbe’s behalf. Those organizations seek to keep homeownership affordable, especially for the elderly and those of modest means. Kolbe’s experience was not only unfair, it raised the cost of his house, and increased the chance of default as well. AARP and NCLC would like to limit housing cost by limiting the amount of insurance a purchaser can be compelled to buy. It’s a species of the force-placed insurance concern. As they point out, flood insurance is extremely expensive. And, after all, shouldn’t the borrower, not the lender, be allowed to decide how much insurance s/he needs and can afford?
Because Covenant 4 effectively embeds a federal regulation in individual mortgage contracts, the United States also filed as amicus. It supported BAC as to a lender’s power to insist on additional flood insurance under Covenant 4. The United States also argued that its view was entitled to great deference, citing Auer v. Robbins, 519 U.S. 452 (1997) and Bowles v. Seminole Rock & Sand Co., 325 U.S. 410 (1945). These are the classic administrative law cases that stand for the proposition that a court should give great deference to an agency’s interpretation of its own regulations.
Opinions by Chief Judge Lynch and Judge Kayatta, both for all three judges, reason that as a matter of contract interpretation principles and New Jersey law, the FHA terms in the mortgage contract must be interpreted uniformly, without reference to extrinsic evidence wherever it is reasonable to do so, because Covenant 4 is a uniform contract used by many. Both also argue that the court’s interpretation of language drafted by the government must be determined by traditional tools of legislative and regulatory construction. Here the view of the United States prevails, pursuant to Auer/Seminole Rock deference and parallel New Jersey law. The judges find both that the language is clear and, to the extent it is not, that the United States prevails.
Perhaps things might be different if there had been a contrary, longstanding, and consistent interpretation of Covenant 4 that might have misled Kolbe, such that he could have some equitable argument. But there was not.
I’m not a contracts maven, but I do know something about administrative law, and this whole arrangement strikes me as unusual enough to pause and reflect. Parties making a contract in light of some free-standing regulatory provision located elsewhere cannot argue that because of what they both agreed it meant, the government cannot come in, disagree, and seek Auer/Seminole Rock deference. You can’t contract around a regulation.
Perhaps it is relevant that, for a time, the Federal Housing Authority (FHA) required its own forms to be used for single family home mortgages. This might have alerted the parties to a mortgage agreement as to who was in charge of interpreting the federally-required terms of the mortgage contract. Perhaps making the parties use someone else’s form might be a serviceable cautionary measure, like making you initial the little paragraphs in your rental car agree as a way of making sure they will stick later. Shortly after the FHA settled on the currently required Covenants in 1989, it gave up on its own forms and just required the Covenants to be included in whatever contract the lender put together. So maybe the lender now more readily assumes that it is in charge of the language in the contract. In any event, here the contracting parties were surprised that someone extraneous to their negotiations would show up in court and tell the court what they had agreed to. They’re not alone. Three of the First Circuit judges found that extrinsic evidence about what the contracting parties meant should be let in; the federal government should butt out. Wow. There’s perhaps a possibility that some regulation is so poorly drafted that it can’t be read sensibly at all even by the agency that promulgated it, and that extrinsic evidence is therefore relevant. But here it has to be correct that the United States’ view should prevail, unfair as that might be to Kolbe and others like him.
So much for the contract and administrative law aspects of Kolbe. But what about the position of AARP and NCLC, advocating, on behalf of homeowners of modest means, that lenders have no authority under Covenant 4 to require a homeowner in special flood hazard areas to purchase flood insurance for the replacement cost value of the house? Why are they doing this? These advocacy groups want to keep housing affordable, and also are motivated by the pressing issue of force-placed insurance, which can truly harm such homeowners and takes advantage of them. And flood insurance is way expensive.
From the point of view of disaster planning, in 2007 the Federal Emergency Management Agency (FEMA) stated that it would be advisable for lenders to maintain insurance up to replacement cost in special flood hazard areas. Here’s one reason why. When a borrower defaults on an FHA-insured mortgage, the lender forecloses, usually assigns the property to HUD, and HUD pays the lender the mortgage insurance proceeds. HUD then sells the property in order to replenish the mortgage insurance fund. If the house is destroyed, there is nothing for HUD to sell. Since 1971 HUD has prohibited the lender from re-conveying damaged property without first repairing flood damage. So the lender needs replacement cost insurance.
In terms of why an initial lender would not always require replacement cost flood insurance (other than not reading Covenant 4 to confer that authority), I’m also wondering how often the initial lender anticipates a quick sale of the mortgage and is willing to agree to a lesser amount of insurance to induce the homeowner to take the mortgage offer.
There’s an underlying policy question here of incentives to build or not to build in special flood hazard areas in general, one which the Kolbe opinions do not address at any length. Less than replacement cost insurance is essentially taking a gamble as to future flood damage. But most people do not process information about flood risks in any rational way. And no one is very good at calculating the risk of floods from storms, one reason private flood insurance has not succeeded. Climate change and sea level rise don’ts help. Moreover, even supposedly actuarially sound federal flood insurance probably isn’t, despite some attempts recently to improve the calculations. And there are lots of disaster relief and recovery costs that don’t get covered by insurance and are picked up by governmental (and to a small extent private) efforts. It’s costly to society to encourage building in the most risky areas. SALUD.
Why would those respected consumer advocacy groups seek to make it easier for elderly people of modest means to live in especially flood-prone areas? Sure, such folks need affordable housing, including homeownership. But is it good policy to facilitate their living in risky flood zones? Without full insurance? That places the assets of those with modest means at risk. Sounds like pre-Katrina New Orleans. And when that storm hit, the poor lived in the low-lying flood-prone places and, without insurance, were disproportionately harmed.
The United States wrote in its brief that the flexibility afforded to lenders under Covenant 4 would allow different business judgments on flood insurance. But this doesn’t help with SALUD. In my view, the best policy from a disaster prevention viewpoint is to go beyond Covenant 4 as interpreted by the United States and applied in Kolbe. Rewrite the regulation to require that the prospective homeowner in a special flood hazard area purchase flood insurance for the replacement cost value of the property. That will avoid unpleasant surprises when mortgages are sold to banks. It will protect lenders against risks that even they don’t assess well. And it will deter homeownership by poor folks in the areas most prone to flooding.
That’s all for now. SALUD!