Joel Solomon | Foley & Lardner LLP | March 26, 2015
The 7th Circuit has ruled that a lender is not insured by a title company for liens that arise after a construction loan became significantly out of balance and the lender stopped funding. In BB Syndication Services, Inc v. First American Title Insurance Company, decided March 12, 2015 by the Unites States Court of Appeals, Seventh Circuit, the court found the following facts:
When the likely cost overruns first came to light, BB Syndication had disbursed only about $5 million of the $86 million loan commitment. By the time the project fell apart, BB Syndication had paid out more than $61 million.
The borrower filed Bankruptcy, and at the end of the day the construction lender only received $150,000 on its $61 million dollar claim.
The Court stated: “The liens at issue here relate to outstanding work that remained unpaid when BB Syndication cut off loan disbursements due to insufficient funds to complete the project. As such, the liens arose directly from BB Syndication’s action as the insured lender, so the coverage seems squarely foreclosed by Exclusion 3(a)” (Exclusion 3(a) precludes liens that are “created, suffered, assumed or agreed to” by the insured).
After discussing cases by other circuits that have reached a different conclusion, the 7th Circuit stated: “A better interpretation is that Exclusion 3(a) excludes coverage for liens that arise as a result of insufficient funds. This interpretation makes the most sense of the respective roles of the insured lender and the title insurer in this context. 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.”
The court also noted that construction lenders can protect themselves with performance bonds or third-party guarantees. The court also raised a very specific endorsement (the “Seattle Endorsement”) where the title company basically waives its 3(a) defense. I suspect that moving forward such coverage will be difficult to obtain in the 7th Circuit.
This case is remarkable for the fact that the lender knew the loan was grossly out of balance after less than 10 percent of the loan had been disbursed. It also should be noted that if the lender had exercised its remedies and finished the project, the additional investment in completing the project would have likely resulted in a recovery of a far greater percentage of its investment (better than $150,000/$61 million). I think the moral is that a construction lender must be rigorous in managing whether the loan is in balance. In addition, in many circumstances, once a lender moves beyond the early stages of a loan, a project must be funded to completion one way or the other for the lender to recover its loan.