Developing a construction project from the ground up is no small feat. A large construction project can require years of work and millions of dollars in up-front costs before the land attains any additional value. While the developer must put up some money, typically the brunt of the financing burden falls on a lender. In exchange for its investment, the lender receives a security interest in the project, but when a project goes belly up early in development, the site is rarely worth anywhere near the money that was spent on construction. Also, many states have mechanic’s lien statutes that grant contractor claims a higher priority on the property than the lender’s security interest. To ameliorate these risks, many lenders look to title insurance. These lenders, however, must exercise a great deal of vigilance and proper judgment or risk ending up with little to show from their investments but empty, turned out pockets.
In the recent decision BB Syndication Servs., Inc. v. First Am. Title Ins. Co., No. 13-2785, 2015 WL 1064156 (7th Cir. Mar. 12, 2015), a construction lender sought indemnification under its title insurance policy. Two and a half years into the project, realizing that cost overruns would cause construction costs to greatly exceed the original financing, the lender cut off loan disbursements and the developer filed for bankruptcy. The lender’s standard-form title-insurance policy contained a provision known as Exclusion 3(a), which excludes coverage for liens that are “created, suffered, assumed or agreed to” by the insured lender. The 7th Circuit determined that the lender had “created” the mechanics liens by cutting off funding and thus, the insurer had no duty to indemnify the lender under Exclusion 3(a). After the dust settled in the bankruptcy proceeding and the contractors had gotten their due, the insured lender who fronted $61 million on the project walked away with only $150,000.
This article discusses the operation of title insurance on a construction project, explains the state of the law regarding Exclusion 3(a), and provides some important considerations to aid construction lenders in avoiding a BB Syndications-like result.
Title Insurance In Construction
Typically, a developer will put up a percentage of the budgeted costs of a construction project and seek the balance via a line of credit from a lender. To protect the interests of the lender, most deals are structured to prevent the developer from drawing on the letter of credit until exhausting its own cash outlay, which ensures that the developer has sufficient skin in the game. Beyond the original cost of purchasing the land, most of the costs on a construction project come from the contractors’ and subcontractors’ labor and material costs. As these builders reach predetermined milestones, they submit bills to the developer, who then draws on the letter of credit for payment. If circumstances arise that increase the projected costs beyond the original financed amount and the loan goes “out of balance,” lenders typically have the right either to demand additional cash contributions from the developer or to cut off the financial spigot. When the lender pulls the line of credit, the developer, who still owes the builders for work performed since the last payment, must often seek relief through bankruptcy. The unpaid builders then receive a lien on the property for the unpaid portion of their work performed. Depending on the duration since the last payment distribution, these costs can be very significant. For instance, in BB Syndication, the builders acquired $17 million in liens on the property, even though the unfinished project sold for only $10 million in the judicial auction.
In an effort to avoid such results, lenders can purchase a title insurance policy, which covers defects in title and lien priority for as long as the lender holds a security interest in the property. Unlike most insurance contracts that provide coverage for prospective events, title insurance protects the insured for defects arising prior to the policy issuance. Thus, if a mechanic’s lien has arisen on a project prior to the effective date of the title insurance policy, the risk of non-recovery is shifted from the lender to the insurer. Since title insurance protects only against liens arising prior to the policy’s purchase, however, the lender will typically re-up the policy periodically to cover the ongoing work performed on the project. Each time the lender updates this policy, the insurer performs a date down title search to determine if any new liens have accrued since the previous policy update. Oftentimes, lenders designate the title insurer as the disbursing agent for requested draws by the developer. Following is a simplified breakdown:
• The builder performs work and bills the developer.
• The developer seeks to draw on its line of credit from the lender.
• The lender distributes the requested funds to the title insurer.
• The title insurer then verifies that the builder is properly paid, obtains lien waivers, and updates the title insurance policy.
Differing Interpretations Of Exclusion 3(a)
BB Syndication addresses the interpretation of the most litigated clause in the standard-form title-insurance policy, Exclusion 3(a), which excludes from coverage defects and liens “created, suffered, assumed or agreed to” by the insured. Courts in different jurisdictions have interpreted this clause to substantially different results when a lender cuts off funding due to a busted project budget. For instance, in Bankers Trust Co. v. Transamerica Title Ins. Co., 594 F.2d 231 (10th Cir. 1979) and Brown v. St. Paul Title Ins. Corp., 634 F.2d 1103 (8th Cir. 1980), the Tenth and Eighth Circuits determined, generally, that liens arising when a lender fails adequately to fund construction work completed prior to the developer’s default were “created” or “suffered” by the insured lender for purposes of Exclusion 3(a). These decisions appeared to create a bright line rule that precluded recovery by the lender.
The Seventh Circuit, however, determined that Exclusion 3(a) requires some fault on the part of the insured. In BB Syndication, the court found that the lender’s fault in creating the mechanics lien stemmed from the lender’s failure to pull funding earlier. Because the lender was in the best position to monitor the progress and cost estimations of the work, it was the lender’s responsibility to cut off funds, or to demand additional contributions from the developer, when the lender first had knowledge that the project loan was out of balance. Over a year before the lender ceased financing, the contractor informed the lender that design changes had created significant projected overruns, and this information would have granted the lender the right to pull the financing. At the time, the lender had only disbursed $5 million, an amount exceeded by the value of the undeveloped land. The court held that the lender’s failure to discover and prevent the cost overruns prompted the builders to continue work which “created” the disputed liens.
Additionally, the Sixth Circuit has carved out an exception for lenders that have fully disbursed their original loan commitments. In Am. Sav. & Loan Ass’n v. Lawyers Title Ins. Corp., 793 F.2d 780, 786 (6th Cir. 1986), the court determined that earlier decisions in the Eighth and Tenth Circuits impliedly required some form of wrongdoing on the lender’s behalf to fall under Exclusion 3(a), and that the lenders in those cases were culpable for failing to pay out all the funds they had committed to loan. Thus, once a lender has fully paid the committed funds, there is no wrongful act in cutting off funding based on an out of balance loan. The Eighth Circuit also adopted this reasoning in Chicago Title Ins. Co. v. Resolution Trust Corp., 53 F.3d 899, 904 (8th Cir. 1995).
Considerations For Savvy Construction Lenders
There are numerous ways that a construction lender can avoid the BB Syndication lender’s fate. First, a lender that diligently monitors the construction will be better equipped to recognize that the loan is out of balance before the significant construction costs have accrued. A shrewd lender will build mechanisms into the lending agreement that provide the opportunity to perform due diligence on the project financing prior to construction, and to actively monitor the budget as construction progresses. Site access rights and periodic financial reporting requirements can keep the lender abreast of any potential overruns or significant changes.
Furthermore, a lender can specifically draft around Exclusion 3(a) through the use of a Seattle Endorsement. With this endorsement, the title insurer specifically agrees not to invoke Exclusion 3(a) based on either (1) the insured’s refusal to disburse the full amount of the loan proceeds, or (2) if the loan proceeds are insufficient to cover the financed work. In essence, when a lender purchases the Seattle Endorsement, the title insurer agrees a priori that the lender’s failure to disburse funds is not an action that gives rise to subsequent mechanic’s liens.
It seems, also, that some courts consider whether the title insurer acted as the disbursing agent. A title insurer acting as disbursing agent can better protect its own interests by taking a more active role in monitoring the project financing. However, courts merely see this as one non-dispositive factor that helps weigh in the favor of the insured lender.
Finally, Lawyers Title may seem to encourage a lender who knows a project loan is out of balance to continue funding the project until the lender’s full loan commitment is satisfied. For instance, if a lender finds out late in the project that the financing will no longer cover the project cost, rather than cutting the funding promptly, the lender may be encouraged to continue to fund the busted project in an attempt to recover from the insurer by avoiding Exclusion 3(a). This seems like a risky proposition, however, since courts have deemed the failure to promptly cut off funding as the “bad act,” which creates the mechanic’s liens.
The BB Syndication case highlights several of the pitfalls that could trip up an unwary construction lender. Title insurance can certainly provide protection, but it is not a panacea. Courts have varying opinions as to whether and to what degree title insurance provides protection if a lender pulls the financing on an out of balance loan. Thus, a wise construction lender must take a proactive role in monitoring the budget and progress on the project and must exercise sound, prompt business judgment.