Wednesday, October 30, 2013

FYI: 1st Cir Affirms Dismissal of Challenge to Servicer's Requirement of Flood Insurance at More than the Federal Minimum

The U.S. Court of Appeals for the First Circuit recently affirmed the dismissal of a borrower's breach of contract claim challenging a loan servicer's requirement that borrower obtain flood insurance at more than the federally mandated minimum amount. 


The Court held that, understood in the context of the relevant regulatory schemes from which the contract provision arose, the federal requirement for flood insurance coverage was a floor -- not a ceiling -- and that lenders may require additional insurance.


A copy of the opinion is available at:


Plaintiff-appellant ("Borrower") purchased a home located in an area designated as having "special flood hazards."  To purchase the property, Borrower obtained a mortgage loan guaranteed by the Federal Housing Administration ("FHA").  The mortgage agreement contained the following Uniform Covenant, which was required to be in every FHA-insured mortgage by the Department of Housing and Urban Development ("HUD"):


4. Fire, Flood and Other Hazard Insurance.  Borrower shall insure all improvements on the Property, whether now in existence or subsequently erected, against any hazards, casualties, and contingencies, including fire, for which Lender requires insurance.  This insurance shall be maintained in the amounts and for the periods that Lender requires.  Borrower shall also insure all improvements on the Property, whether now in existence or subsequently erected, against loss by floods to the extent required by the Secretary.


Although the original mortgage lender never required Borrower to maintain flood insurance in excess of the outstanding loan balance, defendant-appellee ("Servicer") required coverage up to the replacement cost of the property.  Borrower complied and purchased such insurance on his own.


Borrower then filed a putative class action against Servicer, claiming breach of the mortgage contract and violation of the implied covenant of good faith and fair dealing by requiring additional flood insurance.  The district court granted Servicer's motion to dismiss all claims, finding that Covenant 4 unambiguously gave Servicer the right to choose the amount of flood insurance it required.  Borrower appealed and a divided panel of the First Circuit vacated the dismissal.  Subsequently, the First Circuit granted rehearing and, in an evenly divided en banc court, vacated the panel's decision.


As you may recall, under the law of contracts, courts must interpret contract language in the context of the relevant commercial or regulatory schemes within which the contract is situated.  See Simonson v. Z Cranbury Assocs. P'ship, 695 A.2d 222, 224 (N.J. 1997); Restatement (Second) of Contracts §202 cmt. b.  Because uniform contracts are interpreted the same across cases whenever reasonable, extrinsic evidence about what a particular party intended or expected when signing the contract is generally irrelevant.  See, e.g., Sharon Steel Corp. v. Chase Manhattan Bank, N.A., 691 F.2d 1039, 1048 (2d Cir. 1982).


The Court also noted that, for homes in areas designated  as having "special flood hazards," HUD requires that flood insurance must be maintained in "an amount at least equal to either the outstanding balance of the mortgage… or the maximum amount of the NFIP insurance available with respect to the property improvements, whichever is less."  24 C.F.R. §203.16a(c).


Rehearing the case en banc, the First Circuit was evenly divided on the issue of whether the amount of flood insurance coverage required by HUD is a floor or ceiling.  In the First Circuit, the result of an evenly divided vote of the en banc court is to affirm the district court's dismissal of the complaint for failure to state a claim.  See Savard v. Rhode Island, 338 F.3d 23, 25 (1st Cir. 2003).


In an opinion by the Chief Judge Lynch, joined by two Circuit Judges, the First Circuit concluded that Borrower failed to state a claim for breach of contract. 


In reaching its decision, the Court held that, when dealing with uniform contract language drafted by the United States, the meaning of the United States controls.  According to the Court, although Covenant 4 appears in a contract between private parties, it derives from a duly enacted HUD regulation, in which HUD promulgated the language and mandated that private parties include such language in FHA-insured mortgage contracts.  Thus, courts must examine the text of the Covenant in light of the purposes for which the United States imposed the language and the context of the relevant regulatory scheme.


Turning to the text of Covenant 4, the First Circuit determined that the first two sentences allow the Lender to choose the amount of insurance for "any hazards," which includes flood insurance because floods are hazards.  The third sentence, on the other hand, adds an independent requirement that Borrower maintains HUD's minimum level of flood insurance in addition to the lender's minimum.  Understood in the context of federal housing policy, the Court observed that treating this requirement as a floor was the "only reasonable interpretation" of Covenant 4.


Additionally, the First Circuit held that Borrower's claim for breach of the covenant of good faith and fair dealing failed.  Specifically, the Court determined that Borrower did not suffer any harm.  Although Borrower did end up with more insurance than he would have chosen to purchase on his own, he "unquestionably" received value for the additional cost, namely sufficient insurance to rebuild his home in the event of a flood.  Moreover, Servicer did not act unreasonably in requiring greater insurance coverage.


In an opposing opinion, Circuit Judge Lipez, joined by two other Circuit Judges, stated that the First Circuit's decision constituted an "extraordinary intervention into the contractual dealings of two parties."  For the opposing Judges, the government's "newly announced view and policies" cannot justify the Court's decision.  Rather, applying ordinary contract principles, Borrower should be entitled to show that his understanding of the hazard insurance provision reflects the actual intent of the contracting parties at the time of execution.





Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
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Chicago, Illinois 60602
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