Posting for

Thursday, June 11, 1998

by: Bert Rush

brush@firstam.com

MECHANIC'S LIENS/DUTY TO DEFEND/COVERAGE ISSUES

Our track record with mechanic's lien claims has been excellent lately.

Consider: In the three years between 1990 and 1992 First American's actual loss payments for mechanic's lien claims totaled $24.3 million, but for the past three years (1995-1997) the total's been $7.5 million. And last year's total of $1,729,541 is the lowest figure we've seen in this category for more than fifteen years. Probably First American's best year ever when you consider mechanic's lien losses as a percentage of gross revenue from title operations.

But we always need to be thinking about the next downturn--and making plans now. Economic downturns, as we all know, cause even well-conceived projects to fail. They go over budget, the builder lacks cash to keep them afloat, or the builder is motivated to misappropriate construction funds to meet other needs--whatever.

In such times lenders are faced with having to take over troubled projects, sometimes while mechanic's liens have already started to show up in the public records. This is when lenders sometimes decide to cut their losses by declaring their construction loan to be in default, triggering immediate cessation of funding. Work already completed may go unpaid for--causing contractors and material suppliers to file mechanic's lien claims including claims of priority over the construction mortgage or deed of trust.

Now the lender will turn to the title company and request defense and indemnity. Assuming mechanic's lien coverage has been provided, the title company will likely investigate and deny the claim on grounds that the M/L claims are excluded from coverage as matters created, suffered, assumed or agreed to by the insured lender--the theory being that the lender's conduct in refusing to pay for work already completed, and for which loan funds were committed under the loan agreement, has caused the lien claim. The title company may also believe that the lender would be unjustly enriched if the title company were to pay for improvements which will benefit the lender's equity position and for which the lender is contractually obligated to pay under its loan agreement with the builder/borrower.

At least two reported case decisions have strongly supported the title company's denial of claims under these circumstances in the past: Bankers Trust Co. v. TransAmerica Title Insurance Co., 594 F.2d 231 (10th Cir. 1979), and Brown v. St. Paul Title Insurance Corp., 643 F.2d 1103 (8th Cir. 1980).

But in another case, American Savings and Loan Association v. Lawyers Title Insurance Corp., 793 F.2d 780 (6th Cir. 1986), the court took a slightly different view--holding that the title company did have a duty to defend and indemnify where it (the title company) knew the work was underfunded (from the standpoint of loan proceeds) when the title coverage was issued, and where the lender was not perceived as being unjustly enriched. Implicit in this holding was the view that the lender should not be obligated to advance additional funds when the original construction loan was depleted. I, for one, have always felt the American Savings case was one title companies could live with.

But the most recent (reported) case in this vein really troubles me. It is Mid-South Title Insurance Corp. v. Resolution Trust Corp., 840 F.Supp. 522 (W.D. Tenn. 1993). In Mid-South, as many of you will recall, the construction loan agreement provided for a loan of $9,800,000 and it contained a schedule for disbursement of loan proceeds (sometimes called "progress payments"). The title company provided mechanic's lien coverage--taking the owner/builder's indemnity and specifying that coverage would be provided by endorsements as progress payments were made. Work ensued and $8,028,000 was disbursed. As completion approached the lender prepared to disburse $892,000 (the balance of $880,000 was for disbursement if 96% occupancy was timely achieved). When the lender asked for its endorsement the title company reported that mechanic's liens had been recorded, so the lender declined to make the disbursement. The owner went belly up. The lender declared the loan in default, accelerated the note, and foreclosed. The lender took the property with a credit bid of $7,200,000--then completed the project for $502,026.

The lender pursued a claim under its title policy, and the title agent and underwriter sued for declaratory relief to support denial of the claim. Plaintiffs (agent and underwriter) claimed that the lender was not damaged by the mechanic's liens because the amounts needed to pay them and finish the project were less than the undisbursed $892,000. Plaintiffs also argued that if they were forced to pay the lender would enjoy a windfall profit because it would get the benefit of the work without having to pay for it, and that the lien claims were excluded from title policy coverage as matters "created, suffered, assumed or agreed to" by the lender.

The lender (by this time RTC) claimed that the nature of the claim, broken priority, was precisely the type of risk insured against by the policy. The lender was damaged in the sense that the liens would have been wiped out by foreclosure were it not for broken priority, and the price received at the trustee's sale was $828,000 short of the $8,028,000 actually disbursed under the loan agreement.

The court ruled in favor of the lender, saying that the Brown and Bankers Trust cases were "inapposite," which (I take it) means he didn't agree with them. Instead, the judge treated this case as one involving contract interpretation. The title policy involved provided coverage against loss or damage resulting from broken priority. It did not purport to obligate the lender to provide sufficient funds to pay for work done before any declaration of a default under the loan agreement. This judge declined to find such an obligation to have been implied--despite plaintiffs' expectations. Likewise, the judge found no obligation in the disbursement provisions of the loan agreement which could be relied upon by plaintiffs.

On the windfall profit issue, the judge found there was "no profit in this case, much less a windfall profit."

And on the "created, suffered" issue, the judge found that by merely exercising its contractual right to declare the loan in default, and cease funding, the lender did not intentionally create the lien claims. Moreover, the real problem was broken priority--which was expressly insured against by the title company.

I doubt there are many in the title industry who can agree with the reasoning in this decision. It seems, to me anyway, to be particularly worrisome because it promotes litigation of such fact-intensive issues as contract interpretation and the unwritten understandings of parties involved in loan transactions. If or when we have another downturn, we'll probably hear a lot more about the Mid-South case.

But we (at least in California) may have even more to worry about. Last October a trial court in Shasta County (CA) issued a decision--now on appeal--that threatens priority of construction loans in a way we haven't seen before. Here's what happened.

Owner/builders entered into a construction loan agreement with a lender bank. This was a standard from construction loan agreement provided by LaserPro (a software company, I take it). Owner/builders were operating on a shoestring. Toward the end of the project owner/builders hired a paving contractor. Paving contractor learns there's insufficient money left in the construction loan account, so they bargain for title to two lots (known as Lots 11 and 18). By letter the lender agrees paving contractor will get lots 11 and 18 if certain requirements are met. Paving contractor completes work valued at $243,979--gets paid $36,000--pursues mechanic's lien claim for unpaid balance of $207,979. Lender's priority seems OK.

Owner/builders default and lender forecloses--lender declines paying contractor's request for deed to Lots 11 and 18.

Case goes to trial on mechanic's lien and equitable lien (as to Lots 11 and 18) issues. Judge rules in favor of paving contractor, holding that paving contractor may enforce mechanic's lien and is not wiped out by foreclosure because lender's construction loan agreement was not a "binding agreement" within the meaning of California Civil Code section 3137, and may also enforce equitable lien against Lots 11 and 18 because lender so agreed and requirements to conveyance have been satisfied.

Now what, you may ask, is section 3137? I don't know anyone who had ever really noticed or thought about section 3137 before this case--it was enacted in 1971, but there don't appear to be any reported cases involving it.

Section 3137 protects the lien rights of site improvers. I haven't really figured out why this section is in our mechanic's lien law--but our mechanic's lien statutes are very convoluted and make all sorts of distinctions between types of lien claimants, so it may have been plugged in along the way as "special interest" legislation. Anyway, section 3137 provides (in pertinent part):

In this case, the judge found that $228,108 was disbursed to the owner/builders "absent satisfactory evidence that all claims were paid." In fact, there was testimony that some of this money was used to pay off a loan used for the owner/builders' down payment, and to buy ditch-digging equipment.

So the lender in this case loses priority because of sloppy disbursement practices--or maybe just failure to prove due diligence--even though the paving contractor signaled that it wasn't looking for payment from the loan account by having bargained for the two lots! (I've seen some of the "controlled disbursement" language in the construction loan agreement--and it looks OK--although an attorney for the lender calls it "faulty.")

To view the Court's nine-page "Statement of Decision" just double-click on the link below.

The California Land Title Assn. has been asked to help on appeal--and I think it will. But failing that effort, and in the absence of legislative relief, we will be left with even more uncertainty in our mechanic's lien laws (at best) or a bad appellate court decision (at worst).

The point of all this: Let's not allow recent good claims experience cause us to forget about--or under-train for--the mechanic's lien risk. Economic downturns are a fact of life. Since these laws differ so much between the states it may not be practical to get much more specific underwriting requirements here--instead just review your current practices with Mid-South (and maybe the Calif. case) in mind--and if you're not feeling particularly bullet-proof it may be a good time to chat with your favorite Home Office underwriter. It wasn't raining, they say, when Noah built the ark.

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Following last Thursday's posting Cliff Morgan wrote:

I agree with the court's decision in the Tennessee mechanics lien case. The other cases you cited Bert are distinguishable. The lender in the Tennessee case was not involved in misconduct as was the case in those other cited decisions. I don't think a title insurer can insure a broken priority loan based on an indemnity where the loan agreement clearly calls for datedowns and the issuance of lien free endorsements per disbursement, refuse to issue the lien free endorsement because they find some liens recorded, have the lender refuse to fund and then blame the lender for the problem. That would be fundamentaly unfair unless the title insurer could show misconduct on the lenders part. That does not seem to be the case here. It is because of this type of claims handling that the title industry has such a bad reputation.

Reply to Cliff: I agree with you--but the court in the Tennessee case (Mid-South) failed to explain in its decision that the lender ceased funding because the title insurer refused to issue its "pending disbursement" endorsement (in turn because some mechanic's liens had been recorded). (Cliff's reply is based in part on conversations he had with a senior underwriter for the title insurer involved in the Mid-South decision--at an ALTA meeting). It follows that I wouldn't be so worried about the precedent value of the Mid-South decision if it said what the judge really had on his (her?) mind--which was that the title insurer shouldn't be allowed to deny coverage for mechanic's liens when the liens only existed because the title insurer wouldn't endorse over them so that the lender could fund and pay 'em off. A real chicken or egg proposition.