With the subprime mortgage crisis in full swing, the first wave of lawsuits has already hit and the number and scope will soon grow larger. Class action lawyers are already refining theories about mistakes made throughout the mortgage-backed securities (MBS) process, from loan originations through syndication, and shorter statutes of limitation may be hastening more filings as well. Because of the particular nature of the factors involved in this subprime implosion, real estate industry professionals – including real estate appraisers, mortgage brokers, real estate agents, investment vehicle general partners, accountants, and indeed lawyers themselves – will likely be in the direct line of litigation fire. They need to be prepared for the next wave.
Expected Legal Theories and New Factual Twists
It is likely that almost all conventional legal theories will be advanced against the real estate professionals, including common law fraud, negligent misrepresentation, breach of contract, unlawful business practices, RICO, professional negligence, and breach of fiduciary duty causes of action. As to each of these legal theories, the question of whether a real estate professional is liable will turn in part on his or her relationship and consequent duty to the complaining party. For example, appraisers probably have no fiduciary duty to anyone and a direct contract relationship with only a few of the parties, while mortgage brokers and real estate agents have duties of loyalty to many, including some who may not even be their direct clients.
The new and interesting twists in the subprime lawsuits will lie primarily in the factual theories asserted as to how specifically people and institutions in the investment chain were misled. In particular, what did the professionals suspect to be incomplete and/or misleading in the assembled packages of MBS information? For example, how did the mix of information assess (or not) the risk of continued property value increases? The answers to questions like how to deal with ARM reset dates, whether 100% financing together (with the added burden of subsequent home equity seconds) was an acceptable risk, and indeed the selection of many appraisers’ individual comparables, were probably all heavily influenced by the underlying assumption that past appreciation would continue. But could such an assumption, even if wrong, constitute negligence or deceit?
Applying the Theories to Appraisers and Brokers
Plaintiff’s theories of misrepresentation in the MBS process can be illustrated by taking appraisers and real estate agents as examples.
Experience in representing real estate appraisers in litigation over the years demonstrates that many written disclaimers will be upheld, and certainly an appraiser has a great deal of flexibility in selecting comparable sales in a process that has often been described as more of an art than a science. Nonetheless, and despite all the standard disclaimers, there must be valid comparables to support a professional opinion of value. Plaintiffs’ attorneys will therefore likely target claimed widespread practice of manipulating such data. Indeed, one real estate appraiser has recently sued his lender for undue pressure to inflate prices, and the way in which such pressure translated into higher values will be illuminating to many observers. If, for instance, there is a recorded sale of a property in a neighborhood significantly superior to that of the subject property being appraised, then, of course, that would not normally be an appropriate comparable. But if the sale date were several months old, then the appraiser may have selected the superior property as a legitimate comparable on the theory that the subject property’s neighborhood was thought to have caught up in the ensuing months through continued upward historical trends. Such bootstrapping is forbidden by professional and MAI standards, plaintiffs will argue, and yet these practices and similar ones may have been embedded in various ways in the thousands of appraisals being processed. In addition, the general phenomenon of historical upward trending may have overcome doubts by the lenders as to any individual (and hence potentially all) MBS packages being considered. In other words, the whole may have been seen as much less risky than the sum of the risks of many weaker parts. And, anyway, how often do mortgage brokers or loan officers really drill down to the level of individual comparables to second- guess the appraiser at the risk of forgoing substantial fees contingent upon closing in an upbeat market where the same borrower may have already qualified in prior re-financings?
Experience in representing real estate brokers over the years suggests that they too will probably be targeted along parallel lines. While they typically have lengthy disclaimers that significantly limit their exposure to claims of inadequate financial or investment advice, they are still fiduciaries with obligations to reveal all material facts. So, if a broker knew that the prudence of a transaction hinged upon an assumption of increasing values, but at the same time he or she suspected that there has been or might be a slowing in the trend, then plaintiffs’ lawyers will no doubt argue that this information constituted a set of material facts that needed to be disclosed. And if such information became known to the broker’s supervising manager, then the risk of punitive damages comes into play.
Where Do We Go From Here?
As the year unfolds, given the enormous financial impact being absorbed by many hurt in the crisis, widespread litigation seems inevitable almost no matter what the merits of the claims may be. Highly compensated real estate professionals might be viewed by their litigation opponents as relatively unsympathetic to civil juries often comprised of those with lesser incomes. In the end, however, just how well the legal and factual theories are put together, and how well they will survive the professionals’ expected counterattacks, both remain very much to be seen.