When construction on a mixed-use development project in Missouri ran short of money and eventually stopped, the “standard exclusion” included in many title insurance policies came before to the 7th Circuit Court of Appeals for another review.
This time, the court offered what some attorneys are calling a well-reasoned, careful analysis of what Exclusion 3(a) in the standard title insurance policy means. The 29-page opinion in BB Syndication Services Inc. v. First American Title Insurance Company was issued March 12 and acknowledges the struggle the Circuit courts have had with the exclusion. This provision excludes liens “created, suffered, assumed or agreed to” by the lender.
Namely, different Circuits at different times have reached different conclusions on when and how the provision applies. Federal courts have ruled for and against lenders depending on how much of the loan money they have released to the projects.
Questions about the scope of the title insurance coverage are not rare but tend to come up mostly when a commercial development derails, said Sam Laurin, chair of the construction law group at Bose McKinney & Evans LLP. The dispute involving lender BB Syndication shows when the exclusion applies is still an open issue, he said, and while the ruling does not give a clear indication of what the exclusion means, it does offer some helpful guidance.
“I think it provided a well-reasoned test for when Exclusion 3(a) should apply when a real estate project goes bad,” Laurin said. “I think of all the different explanations given of how to address this issue, this test made the most sense to me.”
Although the 7th Circuit case was decided under Wisconsin law because BB Syndication is based in the Badger State, attorneys maintain the opinion should be noted in Indiana.
“The appellate court examined the differences and factors between the lender and insurance carrier with regard to the roles they play in disbursing the commercial construction loan money,” said Mary Slade, attorney at Drewry Simmons Vornehm LLP. “These issues are concerns whether the commercial construction project is in Indiana or Wisconsin. The court did a very thorough job with these factors.”
The flow of money
The most recent exclusion dispute arose in the 7th Circuit after BB Syndication cut funding to the mixed-use commercial development called West Edge in Kansas City, Missouri.
BB Syndication approved an $86 million construction loan to the project that was initially estimated to cost $118 million. After the building began, design changes by the development company tacked on another $20 million to $30 million to the final price.
Construction stopped and many subcontractors filed liens when the development company failed to pay the general contractor and acknowledged the project was short by nearly $37 million. BB Syndication cut funding and declared the loan in default, which generated more liens.
BB Syndication looked to its insurance provider, First American, to indemnify it regarding the unpaid mechanic’s liens.
First American refused, arguing the liens were filed when the lender cut off loan funds. The title company claimed it had no duty to indemnify under the standard exclusion clause.
And that is the central question to this case and in similar cases heard in other Circuits. “The issue here,” Judge Diane Sykes wrote for the 7th Circuit, “is whether a construction lender ‘creates’ or ‘suffers’ a mechanic’s lien by cutting off loan funds when a project collapses due to cost overruns, leaving some completed work unpaid.”
The 7th Circuit found the answer in two cases, Bankers Trust Co. v. Transamerica Title Insurance Co., 594 F.2d 231 (10th Cir. 1979), and Brown v. St. Paul Title Insurance Corp., 634 F.2d 1103 (8th Cir. 1980). Those courts held the exclusion provision applied because the liens arose from insufficient project funds after the lenders stopped the money.
The panel in Chicago saw a similar set of circumstances with the West Edge project. BB Syndication – not First American – had the authority to monitor and prevent the loss but instead it “kept the spigot open” and released millions before declaring the project unable to be finished. Consequently, the liens filed are BB Syndication’s responsibility.
BB Syndication argued the 7th Circuit should rely on the reasoning in American Savings & Loan Ass’n v.
Lawyers Title Insurance Co., 793 F.2d 780 (6th Cir. 1986), and Chicago Title Insurance Co. v. Resolution Trust Corp., 53 F.3d 899 (8th Cir. 1995). These cases reached the opposite conclusion as Brown and Bankers Trust.
The courts ruled in American Savings and Chicago Title that since the lenders had advanced all the loan money, they could not have created the liens. BB Syndication asserted it had fulfilled its loan commitment by providing $61 million, which represented more than 80 percent of the property’s appraised value.
However the 7th Circuit saw a flaw in the reasoning of American Savings and Chicago Title. In those instances, the lenders had the ability to ensure the construction projects remained economically viable. Continuing to pour money into an unworkable project raises the moral hazard of lenders benefiting from the increased value brought by the additional construction while the title insurer has to bear the risk by covering the liens.
The 7th Circuit held the better interpretation was that the exclusion provision curbs coverage for liens that arise from insufficient funds.
“This interpretation makes the most sense of the respective roles of the insured lender and the title insurer in this context,” Sykes wrote. “Only the lender has the ability – and thus duty – to investigate and monitor the construction project’s economic viability. When liens arise from insufficient funds, the insured lender has ‘created’ them by failing to discover and prevent cost overruns – either at the beginning of the project or later. This interpretation also has the advantage of being a clear rule that parties can bargain around.”
To Madalyn Kinsey, partner at Kroger Gardis & Regas LLP, the decisions from the other Circuits seem strained and almost working backward from what is fair in disputes arising from the exclusion provision.
“The beauty of Indiana is we don’t have that problem,” she said.
Indiana’s mechanic’s lien statute, specifically in Indiana Code 32-28-3-5(d), brings clarity by giving the mortgage of the lender priority over all liens on commercial projects. The overhaul to the mechanic’s lien law in 2002 was a significant event in the state by clarifying “the respective lien priorities of the construction lender and the contractors working on the project,” Kinsey said.
She called it “a good law” and noted it has withstood tests in the courts. Outside Indiana’s borders, the law in this area is not as settled.
The 7th Circuit addressed the Indiana law in Home Federal Savings Bank v. Ticor Title Ins. Co., 695 F.3d 725 (7th Cir. 2012). As in the other cases, the lender, Home Federal, cut off funding to an ethanol production plant after the developer defaulted and the general contractor filed a $6 million lien for unpaid work. It then asked the title insurer to defend and indemnify for any loss, but Ticor Title Insurance refused, in part, because of Indiana’s mechanic’s lien statute.
To the court, that argument “runs flatly contrary to the most basic principle of an insurer’s duty to defend.” It decided Home Federal did not create the liens so the exclusion did not apply, and Ticor breached its duty to defend under the policy.•