FDIC Law, Regulations, Related Acts
5000 - Statements of Policy
STATEMENT OF POLICY ON FORECLOSURE CONSENT AND
12 U.S.C. 1825(b), the codification of section 15(b) of the Federal Deposit Insurance Act (FDIA), was added by section 219 of FIRREA. Section 1825(b) dealt with the immunity from state taxation enjoyed by the FDIC under section 15 of the FDIA applied when the FDIC acted in its receivership capacity. The section also protected receivership property from both involuntary alienation as well as involuntary liens.
Since the passage of FIRREA, the Corporation has received many requests for consent to foreclosure, waivers of the right to consent, interpretation of the scope of section 1825(b)(2) and its applicability, and specific explication of the Corporation's policy. After analysis, the Corporation has determined that in the interests of promoting efficiency in the Corporation's operations, providing certainty as to title upon foreclosure, and minimizing the impact the statute has on the secondary mortgage market in general, with respect to voluntary liens, the Corporation would, pursuant to its statement of policy, grant the consent required pursuant to section 1825(b) and, as to any property to which section 1825(b)(2) applies, state it will not assert any rights to which it may have been entitled pursuant to 28 U.S.C. 2410(c). The Corporation also has determined that it will continue to require holders of involuntary liens to obtain the Corporation's consent prior to foreclosing pursuant to an involuntary lien, provided the interest of the FDIC in the liened property is of record.
Scope and Applicability
The policy statement applies to the Corporation in its corporate and receivership capacities. It confirms that section 1825(b) applies to all property held by the Corporation acting as receiver or in its corporate capacity, including property of the financial institutions for which the Corporation has been appointed receiver or property which the Corporation holds for liquidation.
The policy statement further confirms that property of the Corporation encompasses any interest in real and personal property held by the Corporation, including security and equity interests. This is consistent with the Corporation's Policy Statement on the Payment of State and Local Property Taxes, which holds that section 1825(b)(2) covers both the Corporation's fee and lien interests in property. The statement of policy also makes clear that section 1825(b)(2) applies to both tax and non-tax liens.
The policy statement does not authorize, and shall not be construed as authorizing the waiver of the prohibitions in 12 U.S.C. 1825(b)(2) against levy, attachment, garnishment, or sale of property of the Corporation, nor does it authorize or shall it be construed as authorizing the attachment of any involuntary lien upon the property of the Corporation.
Policy and Guidelines
Section 4.a.(ii)(A) of the policy statement provides that where the Corporation holds a lien interest as a result of a mortgage, deed of trust or other similar security instrument, consent is granted to the holder of a consensual security interest which is senior to the Corporation's interest. Similarly, consent is also granted where the Corporation holds a title interest.
Section 4.a.(ii)(B) of the policy statement is a specific case of the general policy set forth in section 4.a.(ii)(A). Subsection (B) does not expand the consent granted under subsection (A), but, in light of the large number of mortgages insured or held by the Federal Housing Administration, the Department of Veterans Affairs, the Farmers Home Administration and the Secretary of Housing and Urban Development, the policy specifically refers to these organizations in order to make clear that it applies to interests they hold.
The statement of policy is explicitly limited to the application of 12 U.S.C. 1825(b)(2). The consents granted under the statement of policy do not act to waive or relinquish any rights granted to the Corporation, in any capacity, pursuant to any other applicable law or any agreement or contract. By way of example without limitation, if any local law requires notice to a property owner prior to foreclosure, or if a loan agreement provides notice shall be given, the consent granted under the policy statement will not act to excuse such requirement to give notice.
Statement of Policy Regarding 12 U.S.C. 1825(b)(2) and 28 U.S.C. 2410(c)
To establish a uniform policy for determining when the Federal Deposit Insurance Corporation (the "Corporation"), in its various capacities, will consent, pursuant to 12 U.S.C 1825(b)(2), to permit third parties to foreclose upon mortgages and other liens where title to the affected property is held by the Corporation or the property is encumbered by a security interest held by the Corporation; to provide the consent of the Corporation pursuant to 12 U.S.C. 1825(b)(2) in certain specified instances; to establish a uniform policy regarding the assertion of the one year right of redemption and other rights which may be applicable to the Corporation, in its various capacities, pursuant to 28 U.S.C. 2410(c); and to modify, to the extent inconsistent herewith, the Corporation's Statement of Policy Regarding the Payment of State and Local Property Taxes.
2. Scope and Applicability
This policy addresses the application of 12 U.S.C. 1825(b)(2) to the Corporation in its corporate and receivership capacities, and provides that with regard to foreclosures under bona fide mortgages and other security instruments, the Corporation will not assert its rights under that section when acting as conservator, or on behalf of subsidiary corporations of receiverships and conservatorships. This policy also indicates that the Corporation will not assert any rights under 28 U.S.C. 2410(c).
This policy is limited in scope to the right of the Corporation to consent under 12 U.S.C. 1825(b)(2) to permit foreclosure actions, and the rights of the Corporation under 28 U.S.C. 2410(c). This policy shall not be construed as authorizing the waiver of the prohibitions in 12 U.S.C. 1825(b)(2) that no property of the Corporation shall be subject to levy, attachment, or garnishment, or as permitting any sale not specifically authorized in accordance with this policy, without the consent of the Corporation; nor does it authorize waiver of 12 U.S.C. 1825(b)(2)'s prohibition against any involuntary lien attaching upon the property of the Corporation.
12 U.S.C. 1825(b)(2) provides that no property of the Corporation shall be subject to levy, attachment, garnishment, foreclosure, or sale without the consent of the Corporation. The Corporation has received many requests for consents to foreclosure, waivers of the right to consent to foreclosure, and specific statements of the Corporation's policy with respect to that provision.
In addition, 28 U.S.C. 2410(c) provides certain protections when a federal lien or mortgage interest in property is to be extinguished through foreclosure, condemnation, partition or quiet title action. In particular, 28 U.S.C. 2410(c) provides that a sale to satisfy a lien inferior to one of the United States shall be made subject to and without disturbing the lien of the United States, unless the United States consents; and, the United States has a one year right of redemption in the case of any sale of real estate made to satisfy a lien prior to that of the United States.
4. Policy and Guidelines Regarding 12 U.S.C. 1825(b)(2)
a. Receivership and Corporate Capacities
(i) Generally. The provisions of 12 U.S.C. 1825(b) apply to all property held by the Corporation acting as receiver or in its corporate capacity, including property of the financial institutions for which the Corporation has been appointed receiver. Property of the Corporation encompasses any interest in real and personal property held by the Corporation, including security interests as well as equity interests. Therefore, no property of the Corporation shall be subject to levy, attachment, garnishment, foreclosure, or sale without the consent of the Corporation.
(ii) Voluntary Liens Affecting Property Interests of the Corporation. It is the policy of the Corporation that it will grant its consent to permit foreclosure actions in certain instances as contemplated by 12 U.S.C. 1825(b)(2). The consent of the Corporation is granted in this policy for certain specific matters, and the Corporation will endeavor to consider other appropriate consent requests in a timely manner. More specifically:
(A) Property Interests. Where the Corporation has an interest in real or personal property, whether a lien interest as a result of a mortgage, deed of trust or other similar security instrument, or a title interest, the Corporation hereby grants its consent under 12 U.S.C. 1825(b)(2) as to any foreclosure by the holder of a consensual security interest in such property, pursuant to any bona fide mortgage, deed of trust, pledge (with respect to personalty) or other similar security instrument which is senior to the Corporation's interest.
(B) Real Property Encumbered by Government-Related Mortgage. In accordance with paragraph 4.a(ii)(A) above, where the Corporation holds title to a single family residence encumbered by a bona fide mortgage insured or guaranteed by the Federal Housing Administration, the Department of Veterans Affairs, or the Farmers Home Administration, or a mortgage held by the Secretary of Housing and Urban Development, the Corporation hereby grants its consent under 12 U.S.C. 1825(b)(2) as to any foreclosure by the holder of such mortgage, deed of trust or other similar security instrument which encumbers such property.
(iii) Involuntary Liens. This policy does not permit the attachment, garnishment, execution, levy or distraint of property held by the Corporation. In accordance with 12 U.S.C. 1825(b)(2), holders of mechanics' and materialmen's claims, tax liens and other non-consensual, involuntary liens must obtain the consent of the Corporation to permit foreclosure actions affecting property in which the Corporation's interest is of record. If the Corporation's interest is not of record, the Corporation hereby grants its consent under 12 U.S.C. 1825(b)(2) as to any foreclosure by the holder of any bona fide lien which encumbers such property.
The consent of the Corporation under 12 U.S.C. 1825(b)(2) may be requested in accordance with the procedures (the "Procedures") set forth in, and as otherwise established by the Director, Division of Liquidation, pursuant to, paragraph 6 below, with the understanding that consent may be granted or withheld in the sole and absolute discretion of the Corporation.
For purposes of this policy, the interest of the Corporation shall be considered "of record" if, as of the notice date (as defined below): First, for real property, such interest appears vested in the Corporation in its corporate capacity or as receiver for a financial institution in the public land records in accordance with local law, or such interest appears vested in a financial institution for which the Corporation has been appointed receiver in the public land records in accordance with local law and the Corporation has published notice in the Federal Register that it has been appointed receiver for that financial institution; and second, for personal property, the property is in the possession of the Corporation, or the lien interest has been perfected in accordance with applicable law. Financial institutions shall include any predecessors identified in the notice published in the Federal Register. For purposes of this policy, the "notice date" shall be for judicial foreclosure actions, the date on which service of notice of the foreclosure sale has been perfected on all persons required to be provided with notice in accordance with applicable law, and for nonjudicial foreclosure actions, the date on which notice of the foreclosure sale has been given to all persons required to be provided with notice in accordance with applicable law.
(iv) Limited Effect. The effect of consents to foreclosure under 12 U.S.C. 1825(b)(2) as described above, shall be limited solely to the application of 12 U.S.C. 1825(b)(2). Such consents shall not act to waive or relinquish the rights granted to the Corporation, in any capacity, pursuant to any other applicable law (including any rights under local foreclosure statutes), or with respect to (A) any note, indebtedness, claim or other obligation that has been secured by the property, or (B) the terms of any mortgage, guaranty, security agreement or other document relating to any obligation.
Any foreclosure actions by the lienholder must still be effectuated in accordance with all other applicable laws.
Failure to obtain the consent of the Corporation where required shall not render the subject foreclosure action void or voidable, so long as the interest of the Corporation survives and is not extinguished by such foreclosure action.
b. Conservatorships and Subsidiary Corporations
The Corporation will not assert any right to consent under 12 U.S.C. 1825(b)(2) with regard to a foreclosure action relating to any property interest held by a conservatorship or a subsidiary corporation of a receivership or conservatorship. In accordance with this position, when a Corporation conservatorship, or a subsidiary of an institution, has an interest in property, foreclosure actions undertaken in accordance with applicable state law may proceed without the consent of the Corporation. In the event an interest has economic value, conservatorships and subsidiary corporations must take appropriate actions to protect their interest in the property under local foreclosure law.
It is the policy of the Corporation that in no event shall the right to consent under 12 U.S.C. 1825(b)(2) be assigned or transferred to any purchaser of property from the Corporation.
5. Policy Regarding 28 U.S.C. 2410(c)
As to any property to which section 1825(b) applies, the Corporation, in its various capacities, shall not assert any rights it might possess under 28 U.S.C. 2410(c). In no event shall any rights under 28 U.S.C. 2410(c) be assigned or transferred to any purchaser of property from the Corporation.
Where the consent of the Corporation is required hereunder, lienholders, or their authorized designee(s), shall submit to the Corporation a written request for the consent of the Corporation to the foreclosure. The request for consent shall be in writing, in the form attached hereto as Exhibit A (as it may be amended from time to time), delivered to the Corporation at the place and address specified in the Federal Register, by certified mail or as otherwise specified in the Federal Register notice. The place and address specified and the means of delivery may be subject to change from time-to-time. All amendments and changes shall be published in the Federal Register. The Director of the Division of Liquidation is hereby authorized and directed to establish and make publicly available such other procedures as the Director deems appropriate to implement this policy.
Consent requests will be ruled upon after the Corporation has gathered the necessary information, analyzed such information, and made a decision as to an appropriate course of action.
If a consent is to be granted, those parties with Power of Attorney may execute the Consent to Foreclosure form. Appearing as Exhibit B is a sample Consent to Foreclosure form for the Corporation acting as receiver. This form should be modified appropriately to reflect the Corporation's capacity or ownership interest.
7. Limitation of Actions
Consents to be granted under this policy are to be provided solely at the discretion of the Corporation. No person shall have any right to bring any action to direct or compel the granting of any consent under this policy, or to pursue any claim or cause of action based on the alleged failure of the Corporation or any person acting on its behalf to take any action whatsoever under this policy.
Subject to the limitations of paragraph 4.a.(iii) above, the Corporation will not assert any right under either 12 U.S.C. 1825(b)(2) or 28 U.S.C. 2410(c) to which it may have been entitled (in either its receivership or corporate capacity) which it agreed not to assert hereunder, with respect to any foreclosure action completed prior to the effective date of this policy. A nonjudicial foreclosure action shall be considered completed upon recordation of the trustee's deed conveying property to the purchaser at a foreclosure sale. A judicial foreclosure shall be considered completed upon entry of a final, nonappealable judgment.
This policy is not retroactive with respect to any matters in litigation on the date hereof, the continuation of which will be reviewed on a case by case basis.
Request and Information Form
[To accompany Request for Consent to Foreclose]
Instructions: This form is to be used by the holder of an involuntary or nonconsensual lien when requesting consent to foreclose in accordance with 12 U.S.C. 1825(b)(2) and Paragraph 4.a.(iii) of the FDIC Statement of Policy regarding 12 U.S.C. 1825(b)(2) and 28 U.S.C. 2410(c) (the "Policy"). In order for a Request to be valid and proper, all information must be completed (unless the form indicates that the information may be completed as available). All forms must be typewritten.
Name of Requesting Party: ____________________________________________
Address of Requesting Party: ____________________________________________
Telephone Number: ____________________________________________
(Area Code) (Number)
Relationship to Lienholder: ____________________________________________
The above named Requesting Party hereby requests the consent of the
Federal Deposit Insurance Corporation, in the appropriate capacity, to
the foreclosure of the property more particularly identified below.
Failed Institution Name: ____________________________________________
Failed Institution Information:
(Reference Number) ____________________________________________
Property Address: ____________________________________________
(City) (County) (State) (Zip Code)
Legal Description of Property: ____________________________________________
(Use extra sheet if necessary)
Legal Owner of Property: ____________________________________________
Lienholder (Foreclosing Party): ____________________________________________
Face Amount Lien/Outstanding Amount
Date of Lien
(e.g., Folio and Liber or Instrument Number)
Failed Institution Lien:
Face Amount Lien ____________________________________________
Date of Mortgage/Deed of Trust
Name of Trustee
Recording Information (e.g., Folio, Liber or Instrument Number)
Foreclosure Sale Information (If applicable)
Date of Sale: ____________________________________________
Place of Sale: ____________________________________________
Manner of Sale: ____________________________________________
Telephone Number of Contact Person: ____________________________________________
Appraised Value of Property: $ ____________________________________________
as of ____________________________________________
For FDIC Use Only
Date Received: ____________________________________________
(Month) (Day) (Year)
Assigned Account Officer: ____________________________________________
Date Response Mailed: ____________________________________________
Attach copy of response and Consent to Foreclosure (as applicable).
Consent to Foreclosure
In accordance with its rights pursuant to 12 U.S.C. 1825(b)(2) and 29 U.S.C. 2410(c), the FEDERAL DEPOSIT INSURANCE CORPORATION ("FDIC"), in its capacity as [insert capacity] does hereby consent to foreclosures by _______ ("Lienholder"), pursuant to that certain lien dated _______ , and recorded at _______ [city/county], among the land records in _______ _______ [state], which encumbers certain real property more particularly described in Exhibit "A" attached to and incorporated in this Consent (the "Property").
This consent is limited to the consent to foreclosures set forth above pursuant to the provisions of 12 U.S.C. 1825(b)(2) and 28 U.S.C. 2410(c), only in connection with the above-described foreclosure action. This consent does not affect the rights of the FDIC, in any capacity, pursuant to any other applicable law (including local foreclosure statutes) or with respect to (i) any note, indebtedness, claim or other obligation ("Obligation") which has been secured by the Property or (ii) the terms of any mortgage, guaranty, or agreement or other document relating to any Obligation.
Federal Deposit Insurance Corporation, as [insert capacity]
Print Name: _____________________
Title or Capacity: ____________________________________________
[Add Appropriate Notarial Acknowledgement]
By order of the Board of Directors, June 16, 1992.
INTERAGENCY ADVISORY ON THE UNSAFE AND UNSOUND USE OF LIMITATION
OF LIABILITY PROVISIONS IN EXTERNAL AUDIT
This Advisory, issued jointly by the Office of Thrift Supervision (OTS), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC) (collectively, the "Agencies"), alerts financial institutions,1 boards of directors, audit committees, management, and external auditors to the safety and soundness implications of provisions that limit external auditors' liability in audit engagements.
Limits on external auditors' liability may weaken the external auditors' objectivity, impartiality, and performance and, thus, reduce the Agencies' ability to rely on Audits. Therefore, certain limitation of liability provisions (described in this Advisory and Appendix A) are unsafe and unsound. In addition, such provisions may not be consistent with the auditor independence standards of the U.S. Securities and Exchange Commission (SEC), the Public Company Accounting Oversight Board (PCAOB), and the American Institute of Certified Public Accountants (AICPA). Scope
This Advisory applies to engagement letters between financial institutions and external auditors with respect to financial statement audits, audits of internal control over financial reporting, and attestations on management's assessment of internal control over financial reporting (collectively, "Audit" or "Audits").
This Advisory does not apply to:
Non-Audit services that may be performed by financial institutions' external auditors;
Audits of financial institutions' 401K plans, pension plans, and other similar audits;
Services performed by accountants who are not engaged to perform financial institutions' Audits (e.g., outsourced internal audits, loan reviews); and
Other service providers (e.g., software consultants, legal advisors).
While the Agencies have observed several types of limitation of liability provisions in external Audit engagement letters, this Advisory applies to any agreement that a financial institution enters into with its external auditor that limits the external auditor's liability with respect to Audits in an unsafe and unsound manner.Background
A properly conducted audit provides an independent and objective view of the reliability of a financial institution's financial statements. The external auditor's objective in an audit is to form an opinion on the financial statements taken as a whole. When planning and performing the audit, the external auditor considers the financial institution's internal control over financial reporting. Generally, the external auditor communicates any identified deficiencies in internal control to management, which enables management to take appropriate corrective action. In addition, certain financial institutions are required to file audited financial statements and internal control audit/attestation reports with one or more of the Agencies. The Agencies encourage financial institutions not subject to mandatory audit requirements to voluntarily obtain audits of their financial statements. The Federal Financial Institutions Examination Council's (FFIEC) Interagency Policy Statement on External Auditing Programs of Banks and Savings Associations2 notes, "[a]n institution's internal and external audit programs are critical to its safety and soundness." The Policy also states that an effective external auditing program "can improve the safety and soundness of an institution substantially and lessen the risk the institution poses to the insurance funds administered by the Federal Deposit Insurance Corporation (FDIC).
Typically, a written engagement letter is used to establish an understanding between the external auditor and the financial institution regarding the services to be performed in connection with the financial institution's audit. The engagement letter commonly describes the objective of the audit, the reports to be prepared, the responsibilities of management and the external auditor, and other significant arrangements (e.g., fees and billing). The Agencies encourage boards of directors, audit committees, and management to closely review all of the provisions in the audit engagement letter before agreeing to sign. As with all agreements that affect a financial institution's legal rights, legal counsel should carefully review audit engagement letters to help ensure that those charged with engaging the external auditor make a fully informed decision.
While the Agencies have not observed provisions that limit an external auditor's liability in the majority of external audit engagement letters reviewed, they have observed a significant increase in the types and frequency of these provisions. These provisions take many forms, making it impractical to provide an all-inclusive list. This Advisory describes the types of objectionable limitation of liability provisions and provides examples.3
Financial institutions' boards of directors, audit committees, and management should also be aware that certain insurance policies (such as error and omission policies and director and officer liability policies) might not cover losses arising from claims that are precluded by limitation of liability provisions.
Limitation of Liability Provisions
The provisions the Agencies deem unsafe and unsound can be generally categorized as an agreement by a financial institution that is a client of an external auditor to:
Indemnify the external auditor against claims made by third parties;
Hold harmless or release the external auditor from liability for claims or potential claims that might be asserted by the client financial institution, other than claims for punitive damages; or
Limit the remedies available to the client financial institution, other than punitive damages.
Collectively, these categories of provisions are referred to in this Advisory as "limitation of liability provisions."
Provisions that waive the right of financial institutions to seek punitive damages from their external auditor are not treated as unsafe and unsound under this Advisory. Nevertheless, agreements by clients to indemnify their auditors against any third party damage awards, including punitive damages, are deemed unsafe and unsound under this Advisory. To enhance transparency and market discipline, public financial institutions that agree to waive claims for punitive damages against their external auditors may want to disclose annually the nature of these arrangements in their proxy statements or other public reports.
Many financial institutions are required to have their financial statements audited while others voluntarily choose to undergo such audits. For example, banks, savings associations, and credit unions with $500 million or more in total assets are required to have annual independent audits.4 Certain savings associations (for example, those with a CAMELS rating of 3, 4, or 5) and savings and loan holding companies are also required by OTS regulations to have annual independent audits.5 Furthermore, financial institutions that are public companies6 must have annual independent audits. The Agencies rely on the results of Audits as part of their assessment of the safety and soundness of a financial institution.
In order for Audits to be effective, the external auditors must be independent in both fact and appearance, and must perform all necessary procedures to comply with auditing and attestation standards established by either the AICPA or, if applicable, the PCAOB. When financial institutions execute agreements that limit the external auditors' liability, the external auditors' objectivity, impartiality, and performance may be weakened or compromised, and the usefulness of the Audits for safety and soundness purposes may be diminished.
By their very nature, limitation of liability provisions can remove or greatly weaken external auditors' objective and unbiased consideration of problems encountered in audit engagements and may diminish auditors' adherence to the standards of objectivity and impartiality required in the performance of Audits. The existence of such provisions in external audit engagement letters may lead to the use of less extensive or less thorough procedures than would otherwise be followed, thereby reducing the reliability of Audits. Accordingly, financial institutions should not enter into external audit arrangements that include unsafe and unsound limitation of liability provisions identified in this Advisory, regardless of (1) The size of the financial institution, (2) whether the financial institution is public or not, or (3) whether the external audit is required or voluntary.
Currently, auditor independence standard-setters include the SEC, PCAOB, and AICPA. Depending upon the audit client, an external auditor is subject to the independence standards issued by one or more of these standard-setters. For all credit unions under the NCUA's regulations, and for other non-public financial institutions that are not required to have annual independent audits pursuant to either Part 363 of the FDIC's regulations or § 562.4 of the OTS's regulations, the Agencies' rules require only that an external auditor meet the AICPA independence standards; they do not require the financial institution's external auditor to comply with the independence standards of the SEC and the PCAOB.
In contrast, for financial institutions subject to the audit requirements either in Part 363 of the FDIC's regulations or in § 562.4 of the OTS's regulations, the external auditor should be in compliance with the AICPA's Code of Professional Conduct and meet the independence requirements and interpretations of the SEC and its staff.7 In this regard, in a December 13, 2004, Frequently Asked Question (FAQ) on the application of the SEC's auditor independence rules, the SEC staff reiterated its long-standing position that when an accountant and his or her client enter into an agreement which seeks to provide the accountant immunity from liability for his or her own negligent acts, the accountant is not independent. The FAQ also states that including in engagement letters a clause that would release, indemnify, or hold the auditor harmless from any liability and costs resulting from knowing misrepresentations by management would impair the auditor's independence.8 The SEC's FAQ is consistent with Section 602.02.f.i. (Indemnification by Client) of the SEC's Codification of Financial Reporting Policies. (Section 602.02.f.i. and the FAQ are included in Appendix B.)
Based on the SEC guidance and the Agencies' existing regulations, certain limits on auditors' liability are already inappropriate in audit engagement letters entered into by:
Public financial institutions that file reports with the SEC or with the Agencies;
Financial institutions subject to Part 363; and
Certain other financial institutions that OTS regulations (12 CFR 562.4) require to have annual independent audits.
In addition, certain of these limits on auditors' liability may violate the AICPA independence standards. Notwithstanding the potential applicability of auditor independence standards, the limitation of liability provisions discussed in this Advisory present safety and soundness concerns for all financial institution Audits.
Alternative Dispute Resolution Agreements and Jury Trial Waivers
The Agencies have observed that some financial institutions have agreed in engagement letters to submit disputes over external audit services to mandatory and binding alternative dispute resolution, binding arbitration, other binding non-judicial dispute resolution processes (collectively, "mandatory ADR") or to waive the right to a jury trial. By agreeing in advance to submit disputes to mandatory ADR, financial institutions may waive the right to full discovery, limit appellate review, or limit or waive other rights and protections available in ordinary litigation proceedings.
The Agencies recognize that mandatory ADR procedures and jury trial waivers may be efficient and cost-effective tools for resolving disputes in some cases. Accordingly, the Agencies believe that mandatory ADR or waiver of jury trial provisions in external Audit engagement letters do not present safety and soundness concerns, provided that the engagement letters do not also incorporate limitation of liability provisions. The Agencies encourage institutions to carefully review mandatory ADR and jury trial provisions in engagement letters, as well as any agreements regarding rules of procedure, and to fully comprehend the ramifications of any agreement to waive any available remedies. Financial institutions should ensure that any mandatory ADR provisions in Audit engagement letters are commercially reasonable and:
Apply equally to all parties;
Provide a fair process (e.g., neutral decision-makers and appropriate hearing procedures); and
Are not imposed in a coercive manner.
Financial institutions' boards of directors, audit committees, and management should not enter into any agreement that incorporates limitation of liability provisions with respect to Audits. In addition, financial institutions should document their business rationale for agreeing to any other provisions that limit their legal rights.
This Advisory applies to engagement letters executed on or after February 9, 2006. The inclusion of limitation of liability provisions in external Audit engagement letters and other agreements that are inconsistent with this Advisory will generally be considered an unsafe and unsound practice. The Agencies' examiners will consider the policies, processes, and personnel surrounding a financial institution's external auditing program in determining whether (1) the engagement letter covering external auditing activities raises any safety and soundness concerns, and (2) the external auditor maintains appropriate independence regarding relationships with the financial institution under relevant professional standards. The Agencies may take appropriate supervisory action if unsafe and unsound limitation of liability provisions are included in external Audit engagement letters or other agreements related to Audits that are executed (accepted or agreed to by the financial institution) on or after February 9, 2006.
Examples of Unsafe and Unsound Limitation of Liability Provisions
Presented below are some of the types of limitation of liability provisions (with an illustrative example of each type) that the Agencies observed in financial insitutions' external audit engagement letters. The inclusion in external Audit engagement letters or agreements related to Audits of any of the illustrative provisions (which do not represent an all-inclusive list) or any other language that would produce similar effects is considered an unsafe and unsound practice.
1. "Release From Liability for Auditor Negligence" Provision
In this type of provision, the financial institution agrees not to hold the audit firm liable for any damages, except to the extent determined to have resulted from willful misconduct or fraudulent behavior by the audit firm.
Example: In no event shall [the audit firm] be liable to the Financial Institution, whether a claim in tort, contract or otherwise, for any consequential, indirect, lost profit, or similar damages relating to [the audit firm's] services provided under this engagement letter, except to the extent finally determined to have resulted from the willful misconduct or fraudulent behavior of [the audit firm] relating to such services.
2. "No Damages" Provision
In this type of provision, the financial institution agrees that in no event will the external audit firm's liability include responsibility for any compensatory (incidental or consequential) damages claimed by the financial institution.
Example: In no event will [the audit firm's] liability under the terms of this Agreement include responsibility for any claimed incidental or consequential damages.
3. "Limitation of Period To File Claim" Provision
In this type of provision, the financial institution agrees that no claim will be asserted after a fixed period of time that is shorter than the applicable statute of limitations, effectively agreeing to limit the financial institution's rights in filing a claim.
Example: It is agreed by the Financial Institution and [the audit firm] or any successors in interest that no claim arising out of services rendered pursuant to this agreement by, or on behalf of, the Financial Institution shall be asserted more than two years after the date of the last audit report issued by [the audit firm].
4. "Losses Occurring During Periods Audited" Provision
In this type of provision, the financial institution agrees that the external audit firm's liability will be limited to any losses occurring during periods covered by the external audit, and will not include any losses occurring in later periods for which the external audit firm is not engaged. This provision may not only preclude the collection of consequential damages for harm in later years, but could preclude any recovery at all. It appears that no claim of liability could be brought against the external audit firm until the external audit report is actually delivered. Under such a clause, any claim for liability thereafter might be precluded because the losses did not occur during the period covered by the external audit. In other words, it might limit the external audit firm's liability to a period before there could be any liability. Read more broadly, the external audit firm might be liable for losses that arise in subsequent years only if the firm continues to be engaged to audit the client's financial statements in those years.
Example: In the event the Financial Institution is dissatisfied with [the audit firm's] services, it is understood that [the audit firm's] liability, if any, arising from this engagement will be limited to any losses occurring during the periods covered by [the audit firm's] audit, and shall not include any losses occurring in later periods for which [the audit firm] is not engaged as auditors.
5. "No Assignment or Transfer" Provision
In this type of provision, the financial institution agrees that it will not assign or transfer any claim against the external audit firm to another party. This provision could limit the ability of another party to pursue a claim against the external auditor in a sale or merger of the financial institution, in a sale of certain assets or a line of business of the financial institution, or in a supervisory merger or receivership of the financial institution. This provision may also prevent the financial institution from subrogating a claim against its external auditor to the financial institution's insurer under its directors' and officers' liability or other insurance coverage.
Example: The Financial Institution agrees that it will not, directly or indirectly, agree to assign or transfer ay claim against [the audit firm] arising out of this engagement to anyone.
6. "Knowing Misrepresentations by Management" Provision
In this type of provision, the financial institution releases and indemnifies the external audit firm from any claims, liabilities, and costs attributable to any knowing misrepresentation by management.
Example: Because of the importance of oral and written management representations to an effective audit, the Financial Institution releases and indemnifies [the audit firm] and its personnel from any and all claims, liabilities, costs, and expenses attributable to any knowing misrepresentation by management.
7. "Indemnification for Management Negligence" Provision
In this type of provision, the financial institution agrees to protect the external auditor from third party claims arising from the external audit firm's failure to discover negligent conduct by management. It would also reinforce the defense of contributory negligence in cases in which the financial institution brings an action against its external auditor. In either case, the contractual defense would insulate the external audit firm form claims for damages even if the reason the external auditor failed to discover the negligent conduct was a failure to conduct the external audit in accordance with generally accepted auditing standards or other applicable professional standards.
Example: The Financial Institution shall indemnify, hold harmless and defend [the audit firm] and its authorized agents, partners and employees from and against any and all claims, damages, demands, actions, costs and charges arising out of, or by reason of, the Financial Institution's negligent acts or failure to act hereunder.
8. "Damages Not to Exceed Fees Paid" Provision
In this type of provision, the financial institution agrees to limit the external auditor's liability to the amount of audit fees the financial institution paid the external auditor, regardless of the extent of damages. This may result in a substantial unrecoverable loss or cost to the financial institution.
Example: [The audit firm] shall not be liable for any claim for damages arising out of or in connection with any services provided herein to the Financial Institution in an amount greater than the amount of fees actually paid to [the audit firm] with respect to the services directly relating to and forming the basis of such claim.
SEC's Codification of Financial Reporting Policies, Section 602.02.f.i and the SEC's December 13, 2004, FAQ on Auditor Independence
Section 602.02.f.i--Indemnification by Client, 3 Fed. Sec. L. (CCH) ¶ 38,335, at 38,603--17 (2003)
Inquiry was made as to whether an accountant who certifies financial statements included in a registration statement or annual report filed with the Commission under the Securities Act or the Exchange Act would be considered independent if he had entered into an indemnity agreement with the registrant. In the particular illustration cited, the board of directors of the registrant formally approved the filing of a registration statement with the Commission and agreed to indemnify and save harmless each and every accountant who certified any part of such statement, "from any and all losses, claims, damages or liabilities arising out of such act or acts to which they or any of them may become subject under the Securities Act, as amended, or at common law,' other than for their willful misstatements or omissions."
When an accountant and his client, directly or through an affiliate, have entered into an agreement of indemnity which seeks to assure to the accountant immunity from liability for his own negligent acts, whether of omission or commission, one of the major stimuli to objective and unbiased consideration of the problems encountered in a particular engagement is removed or greatly weakened. Such condition must frequently induce a departure from the standards of objectivity and impartiality which the concept of independence implies. In such difficult matters, for example, as the determination of the scope of audit necessary, existence of such an agreement may easily lead to the use of less extensive or thorough procedures than would otherwise be followed. In other cases it may result in a failure to appraise with professional acumen the information disclosed by the examination. Consequently, the accountant cannot be recognized as independent for the purpose of certifying the financial statements of the corporation. (Emphasis added.)
U.S. Securities and Exchange Commission; Office of the Chief Accountant: Application of the Commission's Rules on Auditor Independence Frequently Asked Questions; Other Matters--Question 4 (issued December 13, 2004)
Q: Has there been any change in the Commission's long standing view (Financial Reporting Policies--Section 600--602.02.f.i. "Indemnification by Client") that when an accountant enters into an indemnity agreement with the registrant, his or her independence would come into question?
A: No. When an accountant and his or her client, directly or through an affiliate, enter into an agreement of indemnity that seeks to provide the accountant immunity from liability for his or her own negligent acts, whether of omission or commission, the accountant is not independent. Further, including in engagement letters a clause that a registrant would release, indemnify or hold harmless from any liability and costs resulting from knowing misrepresentations by management would also impair the firm's independence. (Emphasis added.)
By order of the Board of Directors February 1, 2006.
[Source: 71 Fed. Reg. 6852, February 9, 2006, the Advisory is effective for engagement letters executed on or after February 9, 2006]
1As used in this document, the term financial institutions includes banks, bank holding companies, savings associations, savings and loan holding companies, and credit unions. Go back to Text
2Published in the Federal Register on September 28, 1999 (64 FR 52319). The NCUA, a member of the FFIEC, has not adopted the policy statement. Go back to Text
3Examples of auditor limitation of liability provisions are illustrated in Appendix A. Go back to Text
4For banks and savings associations, see Section 36 of the Federal Deposit Insurance Act (FDI Act) (12 U.S.C. 1831m) and Part 363 of the FDIC's regulations (12 CFR Part 363). For credit unions, see Section 202(a)(6) of the Federal Credit Union Act (12 U.S.C. 1782(a)(6)) and Part 715 of the NCUA's regulations (12 CFR Part 715). Go back to Text
5See OTS regulation at 12 CFR 562.4. Go back to Text
6Public companies are companies subject to the reporting requirements of the Securities Exchange Act of 1934. Go back to Text
7See FDIC Regulation 12 CFR Part 363, Appendix A--Guidelines and Interpretations, Guideline 14, Role of the Independent Public Accountant--Independence; and OTS Regulation 12 CFR 562.4(d)(3)(i), Qualifications for independent public accountants. Go back to Text
8In contrast to the SEC's position, AICPA Ethics Ruling 94 (ET § 191.188--189) currently concludes that indemnification for "knowing misrepresentations by management" does not impair independence. On September 15, 2005, the AICPA published for comment its proposed interpretation of its auditor independence standards. In that proposal the AICPA specifically identified limitation of liability provisions that impair auditor independence under the AICPA's standards. Most of the provisions cited in this Advisory were deemed to impair independence in the AICPA's proposed interpretation. At this writing, the AICPA has not issued a final interpretation. Go back to Text