The U.S. Eleventh Circuit Court of Appeals recently held that the Federal Housing Administration (“FHA”) Model Mortgage Form unambiguously makes the federally required flood-insurance amount the minimum, not the maximum, the borrower must have.
A copy of the Court’s opinion is available at: Link to Opinion
The case arises from a residential mortgage loan on property located in a FEMA designated special flood hazard area. The borrower signed a standard FHA Model Mortgage contract which included the FHA flood insurance covenant. As you may recall, the covenant provides:
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.
See 54 Fed. Reg. 27,604 (June 29, 1989) (hereafter, “Covenant 4”).
As you may recall, the National Flood Insurance Act (“NFIA”), 42 U.S.C. §§ 4001, et seq., requires a minimum amount of flood insurance before a federal agency can provide “any financial assistance” for home purchases in areas that present “special flood hazards” as designated by FEMA. See 42 U.S.C. § 4012a(a). Specifically, the NFIA mandates that homes receiving assistance from a federal agency be covered “by flood insurance in an amount at least equal to the outstanding principal balance of the loan or the maximum limit of coverage made available under the [NFIA].” 42 U.S.C. § 4012a(b)(1)(A). The “maximum limit of coverage” under the NFIA is $250,000. 44 C.F.R. § 61.6.
HUD requires that all FHA guaranteed loans for homes in special flood hazard areas be covered by flood insurance in “in an amount at least equal to either the outstanding balance of the mortgage, less estimated land cost, 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). This requirement is implemented by HUD through Covenant 4. See 54 Fed. Reg. 27,596, 27,601 (June 29, 1989).
As the Eleventh Circuit noted, “[s]ome courts have found the covenant ambiguous because it does not clearly indicate whether the federally required flood-insurance amount is a minimum or a maximum. Other courts have held that the covenant unambiguously makes the federally required amount a minimum and allows lenders to require borrowers to have more flood insurance than federal law demands.”
Following the origination of the loan, the borrower purchased and maintained flood insurance on the property in an amount equal to the original principal balance of the loan. The original lender did not make any demand of the borrower to increase the amount of flood insurance. Subsequently, the defendant acquired the mortgage loan, and notified the borrower that she needed to increase her flood insurance coverage to either $250,000 or the home’s replacement value, whichever was less. The defendant also notified the borrower the defendant would obtain lender placed flood insurance if the borrower failed to correct the deficient flood insurance amount.
The borrower did not increase her flood insurance coverage as requested by the lender, and as a result the lender purchased the additional insurance and passed the premium cost to the borrower.
The borrower filed this lawsuit against the lender alleging breach of contract, breach of an implied covenant of good faith and fair dealing, breach of fiduciary obligations, and unjust enrichment for demanding more flood insurance than required under the applicable HUD and FHA regulations. The lower court granted the lender’s motion to dismiss the borrower’s complaint.
The borrower argued on appeal that Covenant 4 can be reasonably interpreted as limiting the insurance amount that lenders can require to the minimum set by the Secretary of HUD. In particular, the borrower relied upon the third sentence of Covenant 4 which provides “Borrower shall also insure all improvements on the Property … against loss by floods to the extent required by the Secretary.
The Eleventh Circuit was not persuaded by the borrower’s interpretation.
In rejecting the borrower’s argument, the Court noted that the traditional contract interpretation principles were inadequate for interpreting uniform provisions mandated by federal regulation. Specifically, when a contract contains a uniform, standard-form provision required by the federal government, such as Covenant 4, two supplemental considerations must be taken into account: (1) the interpretation of the provision cannot vary from place to place or from contract to contract; and (2) the federal government drafted the language to implement federal directives. Thus, interpreting the federally mandated provisions requires that the Court also interpret the regulations themselves.
The Court looked first to the language of Covenant 4 itself to discern whether the meaning is clear in light of the context and purpose of the regulatory scheme. The Court determined that the language in Covenant 4 is not ambiguous, and that the only reasonable interpretation is that a mortgage lender may require the borrower to have more flood insurance than the HUD-determined minimum.
In reaching this ruling, the Eleventh Circuit held that the first two sentences of Covenant 4 explicitly allows the lender to set the required insurance amount for “hazards” which the Court noted, clearly includes floods. The third sentence, upon which the borrower based its arguments, provides a separate and independent requirement that the borrower maintain the federally required minimum amount of flood insurance in addition to – not in lieu of – what the lender requires. The Court concluded that the language of Covenant 4 sets two minimum requirements for the borrower, one set by the lender and one set by HUD, and both of which the borrower must satisfy.
The Court noted that its interpretation of Covenant 4 is supported by other provisions of the mortgage contract and by the nature of the lender’s interest in the mortgaged property. As an example, the Court pointed to Paragraph 7 of the standard-form mortgage contract which allows the lender to “do and pay whatever is necessary” to “protect the value of the Property and the Lender’s rights” including payment of hazard insurance. The Court found that the “value of the property” was not limited to the unpaid principal balance, but rather extended to the continued receipt of the interest payments over the lifetime of the loan. Similarly, the Court found that the lender’s exposure to the risk of loss extends to the replacement value of the home and not merely the loan’s principal balance.
Moreover, the Eleventh Circuit noted that the NFIA and FHA regulations supported its interpretation. The Court found that the inclusion of the term “at least” in the HUD requirements for flood insurance are consistent with interpreting Covenant 4 to allow the lender to require more insurance than the HUD minimums, and inconsistent with interpreting the covenant to prohibit more.
The Court also determined that the statutory and regulatory context supports a determination that the lender can require insurance in excess of the HUD minimums. The FHA mortgage-guarantee scheme places the risk of flood losses on the lender, which makes the lender’s need for more flood insurance particularly acute. For instance, if a flood damages the property, the lender cannot collect from the United States until it has repaired the damage or deducted the cost of repairing the damage from the insurance benefits. 24 C.F.R. § 203.379. Thus, if the insurance were merely limited to the unpaid balance, the lender would not be able to insure against the risk the regulatory scheme imposes because the cost of repairing the damage may exceed the unpaid balance of the loan.
The Court also pointed out that the borrower’s interpretation would cause absurd results. The Court noted that HUD does not require any flood insurance for homes outside the FEMA designated special flood hazards, which under the borrower’s interpretation would prevent the lender from requiring any flood insurance at all. Moreover, the borrower’s interpretation would prevent lenders from requiring insurance for mortgages above $250,000. Accordingly, the Court concluded that the regulatory scheme supports the interpretation of Covenant 4 to allow lenders to require insurance beyond the minimum set by HUD.
The Court also determined that the borrower’s extracontractual claims failed as a matter of law. First, the Court found that because it already determined that Covenant 4 allows the lender to require insurance above the federal minimums the borrower’s claims for breach of the duty of good faith and fair dealing were without merit.
As to the borrower’s breach of fiduciary duty claims against the lender, the Court first noted under the applicable Alabama law lenders do not owe a general fiduciary duty to the borrower. Then, the Court dismissed many of the borrower’s fraud allegations for the same reasons the breach of contract claim failed.
Additionally, in rejecting the borrower’s claims of kickbacks, the Court noted that the defining characteristic of a kickback is divided loyalties, but the lender was not acting on behalf of the borrower or representing her interests. The loan agreement makes it clear that the insurance requirement is for the lender’s protection.
Accordingly, the Court affirmed the lower court’s dismissal of the borrower’s complaint for failure to state a claim.
Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
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