Posting for

Friday, June 19, 1998

by: Bert Rush

brush@firstam.com

COVERAGE ISSUES/DUTY TO DEFEND/POST-POLICY MATTERS

Last Thursday's posting titled "Mechanic's Liens" caused Oscar Beasley to suggest applicability of another new(er) decision, Rosen v. Nations Title, to the fact situation in the Schmitt case. The Schmitt case, you may remember, is the trial court decision from Shasta County, CA, now on appeal, in which a construction lender lost priority to a mechanic's lien recorded by a site improver because the lender's loan agreement did not meet certain disbursement control requirements of Calif. Civil Code section 3137(c). Of interest to Oscar was whether the Rosen decision helps answer the question of title insurance coverage for the lender's problem in Schmitt.

Rosen was certified for partial publication last August--it was in the materials handed out at our Special Underwriters Meeting in Santa Ana last February but (as I recall) not discussed. It's a good case--here's what happened:

An owner/developer took out two construction loans to build two custom homes in an exclusive area of L.A. Owner/developer defaulted and the lender began foreclosures. Owner/developer filed Chapter 11 bankruptcy and obtained a BK court order under Bankruptcy Code section 364(d) for two new loans--to be secured by "priming liens"--to complete construction. So the two new loans were secured by first deeds of trust--each in the amount of $165,000. The BK court ordered that the new loan funds be used only to complete construction or to pay expenses essential to preserve assets of the owner/developer/debtor's estate.

Eventually the original construction lender got BK court approval to foreclose--and it did so. Then the priming lenders announced defaults and they commenced foreclosure. The original lender then sued the priming lenders seeking to upset their priority, on grounds that priming loan funds had been misappropriated and used for purposes other than construction, and on grounds that the priming lenders negligently allowed this to happen by failing to monitor disbursements. This suit ended up in state court.

Priming lenders tendered defense of this action to their title insurer. The title insurer (one of our erstwhile competitors) denied the tender on grounds that the dispute (whether meritorious or not) was created by the priming lenders and that the allegations pertained not to the validity of the BK court's order but instead to post-policy disbursements and use of priming loan proceeds.

The priming lenders went on to successfully defend their priority, then they sued the title insurer for breach of contract and bad faith. On cross motions for summary judgment, the trial court ruled in favor of the title insurer--and the court of appeal affirmed.

The court of appeal based its decision on the insuring provisions of the policies--which insured validity, enforceability and priority of the subject deeds of trust "as of Date of Policy." Since the offending lawsuit was based entirely on allegations of misappropriations after the Date of Policy, it was not covered by the insuring provisions. Having made this ruling, the court of appeal found it unnecessary to consider the title insurer's further contentions that the subject matter of the lawsuit should be excluded from coverage as involving matters "created, suffered, assumed or agreed to" by the insureds, or as involving post-policy matters.

In focusing on the insuring provisions, the court of appeal cited Safeco Title Ins. Co. v. Moskopolous, 116 Cal. App. 3d 658, 172 Cal. Rptr. 248 (1981)--the landmark case on this in Calif.

But for a decision more closely appearing to match the facts of this case, the court cited National Mortgage Corp. v. American Title Ins. Co., 299 N.C. 369, 261 S.E.2d 844 (1980). National Mortgage involved a subordination agreement, later challenged because the borrower allegedly misappropriated new loan proceeds to the detriment of the subordinating party. Because the alleged misappropriations were post-policy, the NC Supreme Court found them not to be within the insuring provisions of the new lender's title policy--hence, not covered.

In making its decision, the Rosen court distinguished the case of Mark Twain Kansas City Bank v. Lawyers Title Ins. Corp., 807 F.Supp. 85 (E.D. Mo. 1992), because the decision in Mark Twain was based on the standard exclusion for post-policy matters rather than insuring provision language.

The official cite is Rosen v. Nations Title Ins. Co., 56 Cal. App. 4^th 1489, 66 Cal. Rptr. 2d 714 (1997).

Though it's a good decision--because it clarifies policy coverage where the main issue is loan disbursements--the Rosen case may prove to be of limited help to title claims handlers because priority disputes tend to involve the very subordination agreement which is the subject of our title insurance, as well as propriety of post-policy disbursements. Where the subordination agreement itself is questioned, it may not be practical to deny coverage and/or decline to provide legal defense of the insured title.

Such was the nature of the Schmitt case. The construction lender's loan agreement was itself the subject of controversy--particularly the adequacy of its disbursement controls (in light of an obscure state statute--Civil Code section 3137[c]). That's why the title insurer balked--and the lender in the Schmitt case decided to settle without being made whole.

Rosen*Schmitt--food for thought.