United States: Construction Loans And Title Policies In The Seventh Circuit

Last Updated: April 20 2015
Article by Peter C. Blain

Construction lenders almost always obtain title insurance policies to protect the property under construction from being encumbered by the mechanics' liens of unpaid contractors and materialmen. In some states, such as Missouri, mechanics' liens are given statutory priority over the previously recorded mortgages of construction lenders. Consequently, the title policies become important to ensure that the lender's loan is fully protected, especially during construction when the value of the project may be less, sometimes far less, than the loan funds advanced.

A standard title policy insures a construction lender against any losses incurred by reason of any statutory lien for services, labor or materials having priority over the lender's mortgage for improvement or work related to the land contracted for or commenced prior to the date of the policy. During the construction period, the title company frequently issues "date down endorsements," which update coverage through the date of the endorsement. A typical title policy will also have standard exclusions, including excluding coverage for liens that are "created, suffered, assumed or agreed to" by the insured lender.

When a project is plagued with unanticipated cost overruns or other problems which precipitate a default under the construction loan agreement, the construction lender is faced with a Hobson's choice: Does it stop advancing the construction loan at a time when the value of the project may be worth significantly less than the outstanding loan? This will likely cause the claims of contractors and materialmen for the work unpaid at the time of default to ripen into senior mechanics' liens and the lender to claim coverage under the title policy. Instead, does the lender engage in a work-out of the project and keep lending in the hopes that it can be successfully completed? In BB Syndication Services, Inc. v. First American Title Insurance Co., No. 13-2785, 2015 WL 1064156 (7th Cir. March 12, 2015) the Seventh Circuit Court of Appeals addressed this dilemma, analyzing a lender's claim of coverage under the provisions of a typical title insurance policy in the context of a failed project.

THE PROJECT

Trilogy Development Company, a real estate developer ("Trilogy"), contracted with J.E.Dunn Construction Company ("Dunn") to build a mixed-use commercial building in Kansas City Missouri's fashionable West Edge. The initial estimated cost of the project was $118 million. The project was to be funded by a $32 million equity investment by Trilogy and an $86 million construction loan made by BB Syndication Services, Inc., a Wisconsin lender ("BB"). BB obtained a title insurance policy containing the standard provision regarding the scope of coverage and the exclusion described above from First American Title Insurance Company ("First American"), and contracted with First American to be the disbursing agent.

The project was begun before construction designs were finalized and there were early indications that the project costs would exceed the initial estimates. Dunn claimed that design changes would increase the project costs by $20 million to $30 million, making the construction loan out of balance and potentially in default. At this point, BB had disbursed only $5 million of its $86 million commitment. However, after negotiations with Trilogy, BB chose to continue to fund. Approximately one year later, Dunn stopped construction when Trilogy failed to pay it the proceeds of the loan disbursement. Trilogy hired a new contractor and commenced an arbitration proceeding against Dunn, which resulted in an award in excess of $11 million in Dunn's favor. As a result of the award and the inability of Trilogy to fund the shortfall, BB declared a default and stopped lending. By this point, approximately $61 million of the total $86 million commitment had been disbursed.

In response, Trilogy filed a petition under Chapter 11 of the Bankruptcy Code. 11 U.S.C. §§ 101-1532. During the bankruptcy case, Trilogy initiated an adversary proceeding to determine the priority of approximately $17 million of mechanics' liens arising after BB stopped funding. Asserting its rights under the title policy, BB demanded that First American defend it in the adversary proceeding and indemnify it for any losses which may arise. First American refused, claiming that BB had created the mechanics' liens by cutting off funding. The bankruptcy court ultimately determined that under Missouri law, the mechanics' liens, including $11 million asserted by Dunn, were senior in priority to BB's construction mortgage. The project, which sat idle for over a year, was eventually sold at auction during the bankruptcy for $10 million, ironically to the party who originally sold the land to Trilogy at a greater price.

THE SUIT UNDER THE TITLE POLICY

BB filed suit against First American in Wisconsin state court alleging a breach of the duty to defend and a bad faith breach of the coverage provisions under the title policy. First American removed the case to the United States District Court for the Western District of Wisconsin, which found that First American breached its duty to defend. However, because BB caused the mechanics' liens to arise by cutting off funding, the exclusion provision precluded coverage under the policy and therefore there was no bad faith. BB appealed the District Court's decision regarding the exclusion provision, and if that was successful, sought to revive its bad faith claim. First American did not cross appeal the duty to defend decision.

THE SEVENTH CIRCUIT'S OPINION

The Seventh Circuit first determined that Wisconsin law applied and then focused on the exclusion provisions of the title policy, citing, among other things, its prior decision of Home Federal Savings Bank v. Ticor Title Insurance Co., 695 F. 3d 725, 732-33 (7th Cir. 2012), wherein it held that "The clear majority view ... is that the exclusion [provision] applies only to intentional misconduct, breach of duty, or otherwise inequitable dealings by the insured [lender]."

BB argued that it had a contractual right to stop funding the loan when the loan became out of balance. The court found that this provision was based upon an agreement between BB and Trilogy, not one between BB and First American. Moreover, if BB's action caused the cost overruns, or if BB had control over when the project was aborted, BB could be deemed at fault for the resulting mechanics' liens. BB Syndication, Inc. v. First American Title Company, 2015 WL 1064156 at *6. The central issue in the case, said the court, was whether the lender or the title company bore the risk of liens arising from the cessation of loan funds due to cost overruns. Id.

PRIOR CIRCUIT COURT DECISIONS

The court noted that four Circuit Courts of Appeals, including the Seventh Circuit, had previously addressed this question in five reported decisions. The Tenth and Eighth Circuits squarely held that when a lender cuts off funding, it "creates" or "suffers" any liens that arise, triggering the application of the exclusion. See Bankers Trust Co. v. Transamerica Title Ins. Co., 594 F.2d 231 (10th Cir. 1979); Brown v. St. Paul Title Ins. Co., 634 F.2d 1103 (8th Cir. 1980). Both courts reasoned that insufficient construction funding is not the type of risk that title insurance is built to bear. BB Syndication Services, Inc. v. First American Title Co., 2015 WL 1064156 at *7.

The Seventh Circuit noted, however, that three subsequent cases distinguished Bankers Trust and Brown, and reached an opposite conclusion. The Sixth Circuit in American Savings & Loan Ass'n v. Lawyers Title Insurance Corp., 793 F.2d 780 (6th Cir. 1986) and the Eighth Circuit in Chicago Title Insurance Co. v. Resolution Trust Corp., 53 F.3d 899 (8th Cir. 1995) addressed situations in which the construction lenders had fully disbursed their initial loan commitments. The Seventh Circuit observed that the courts in both American Savings and Chicago Title found that where a lender has released all loan funds initially committed, it cannot be said to have "created" or "suffered" liens arising from insufficient project funds. BB Syndication, 2015 WL 1064156, at *7.

Relying on these decisions, BB argued that under its loan agreement, it was only obligated to lend the lesser of $86 million or 80% of the appraised value of the property, or 75% of the total cost of the project. Because the disbursed loan proceeds were $61 million, the 80% of appraised value threshold was met. The Seventh Circuit agreed with the District Court that this argument lacked factual foundation as no appraisal had been done. Id.

BB also argued that its case was factually distinguishable from Brown and Bankers Trust, where the lenders cut off funding shortly after it became clear that the project costs would exceed the budgets. Instead, BB's case was closest to American Savings and Chicago Trust where the courts found that the lenders continued to fund even though they knew that the projects were underfunded and experiencing cost overruns. BB argued that its willingness to continue to fund and attempt to see the project through demonstrated its good faith and therefore the fault for the mechanics' liens should not be laid at its feet. Id. at *7-8.

The court disagreed, saying instead of good faith, continuing to lend may evidence poor business judgment. Id. at*8. Under the loan agreement, BB had the right to monitor the project to ensure that it continued to be viable. When it first became evident that the project was out of balance, it could have compelled the developer to supply more equity or stopped funding. At that point, the loan obligation was only $5 million, which would have been covered by the value of the land. Id. at *8. Instead, it kept the loan spigot open. BB's decision to continue to lend resulted in $17 million of liens for unpaid work, a liability it argued should be shifted to the title company. Id.

The court found that this stretched title insurance too far, especially in light of the fact that in most cases, continuing construction lending and thereby construction is in the lender's sole discretion, and likely increases the value of the lender's collateral. If the lender can also shift the business risk of unpaid mechanics' liens to the title company, it obtains an additional windfall. Id. The court found that only the lender has the ability, and thus the duty, to investigate and monitor the viability of a construction project. When liens arise from insufficient funds, the lender has "created" them by failing to discover and prevent cost overruns, whether at the beginning of construction or during the project's life. Id. at *9.

This interpretation, said the court, does not nullify the benefits of mechanics' lien coverage, as the court in Chicago Title suggested. The title policy is to insure against the failures of the payment process, such as the developer absconding with loan proceeds, not the business risks associated with the project's failure. Id. Moreover, this interpretation creates a clear rule that parties can bargain around. If the parties want to expand the coverage, they can contract for a so-called "Seattle Endorsement"—basically a promise by the insurer not to invoke the exclusion for liens arising from insufficient funds. Id.

RECONCILING ITS PRIOR HOME FEDERAL DECISION

Finally, the court turned to its prior decision in Home Federal. In that case, a lender to a project in Indiana cut off funding after the developer defaulted, leaving a $6 million lien for unpaid work by the general contractor. The lender brought a foreclosure action and the contractor counterclaimed, alleging its lien was senior. The lender tendered the defense to the insurance company. The title company refused coverage because under Indiana law, mechanics' liens are junior in priority to the lien created by a previously recorded mortgage making the lienor's claim frivolous, and because of the exclusion for liens "created" or "suffered" by the insured lender cutting off funding.

In Home Federal, the court determined that the duty to defend was broader than the duty to indemnify and therefore defense was required even if the claim was frivolous. However, the court also held that if there was an applicable exclusion to coverage, even in the face of a valid claim, there was no duty to defend. Home Fed. Sav. Bank, 695 F.3d at 732-33.

In both Brown and Bankers Trust, there existed a disbursement agreement between the insurance company and the lender, a fact which the Brown and Bankers Trust courts noted and which the Bankers Trust court found "critical." In Home Federal, however, the title company was not the disbursing agent. Because there was no disbursement agreement, the Home Federal court found that there was no obligation on the part of the lender to lend good money after bad. Id. at 734-35.

The court in BB Syndication indicated that its prior Home Federal decision may have relied too heavily on the existence of a disbursement agreement. BB Syndication, 2015 WL 1064156, at *10. While the Brown and Bankers Trust courts discussed the presence of a disbursement agreement, the court found that those decisions were really based upon the fact that title insurance is not designed to insure the risks of a broken transaction. Id. The court highlighted its view that Home Federal was not wrongly decided. Given that the law in Indiana clearly gave the mortgagee priority over subsequently filed mechanics' liens, the Home Federal court was correct in holding that the lender was under no duty to fund a subordinate lien and that the defense of such a weak claim would have cost little trouble or expense. Home Fed. Sav. Bank, 695 F.3d at 734.

In conclusion, the BB Syndication court held that the lender, not the title company, has the authority and responsibility to discover, monitor and prevent losses due to termination of a loan commitment upon default. Failure to do so compelled a finding that the lender "created" or "suffered" the resulting liens triggering the application of the standard exclusion of coverage.

CONCLUSION

The BB Syndication decision brings into stark focus a construction lender's acute dilemma. The Seventh Circuit seems to ignore its prior decision in Home Federal that the exclusion provision is triggered only by "intentional misconduct, breach of duty, or otherwise inequitable dealings by the insured," especially when the loan is in default and the lender's obligation to lend has terminated. Instead, the court has clearly imposed upon the lender the duty to monitor a project and declare a default at the first indication of trouble, or continue funding in an attempt to save the project and risk the consequences of any resulting mechanics' liens. In states like Missouri, where the mechanics' liens are given priority over the mortgage lender, this is likely a multimillion dollar choice. However, even in states like Wisconsin, where mechanics' liens are subordinate to the prior recorded mortgage lien, the BB Syndication decision could be read to provide that where there exists an applicable exclusion, a title company may be excused from the contractual duty to defend because the mortgagee would have "created" or "suffered" the lien by ceasing to advance funds to a defaulting borrower.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions