Recently, the 7th Circuit Court of Appeals released a decision that impacts the most litigated provision of title insurance policies purchased by real estate lenders. In BB Syndication Services, Inc. v. First American Title Insurance Company, Case 13-2785, the court analyzed whether a real estate lender could recover from its title insurer to pay for mechanics’ liens that had priority over the lender’s secured interest in a failed real estate development. The court analyzed the lender’s actions and held that it was at fault for “creating” the liens because it continued to disburse loan funds after the loan was out of balance. Based on a standard exclusion in the policy for liens “created, suffered, assumed or agreed to” by the lender, the court found that the title insurer was not required to pay the mechanics’ liens.
The case involved development of a mixed-use commercial development that had an initial estimated cost of $118 million. The developer, Trilogy Development Company, agreed to pay $32 million. The remaining $86 million was financed by a construction loan from BB Syndication Services, a Wisconsin-based loan syndicator. The project was troubled from the start. About a year and a half into construction, the general contractor claimed that design changes increased construction cost by $20 to $30 million. At that point, the construction loan was “out of balance,” giving BB Syndication the contractual right to cut off further funding. By then, BB Syndication had disbursed $5 million of its $86 million loan commitment. BB Syndication ultimately disbursed $61 million. The project eventually fell apart; the developer declared bankruptcy; and the contractors and subcontractors filed mechanics’ liens against the property. The bankruptcy court gave priority to the mechanics’ liens and awarded the contractors $17 million. BB Syndication received $150,000 on its $61 million claim.
BB Syndication then made a claim against its title insurer, First American, for the mechanics’ liens that were given priority over its interest. At the time the policy was updated, the mechanics’ liens were not yet on the property because BB Syndication had not yet cut off funding, though the contractors’ work had been completed. First American denied coverage, citing the most litigated exclusion in the standard policy given to real estate lenders, Exclusion 3(a), which excludes claims that are “created, suffered, or agreed to” by the insured lender. It argued that BB Syndication “caused” the mechanics’ liens by cutting off funding.
The 7th Circuit agreed with First American. It found that BB Syndication was at fault for the mechanics’ liens because it had responsibility to discover and prevent cost overruns. BB Syndication had no contractual obligation to continue funding the project once it was out of balance and they knew there would be cost overruns. It had disbursed only $5 million at that point. BB Syndication continued to disburse an additional $56 million after gaining that knowledge, and that was fatal to its title claim. The court summed it up: “in effect, it is claimed that by the issuance of a title insurance policy, the insurer became a guarantor of payment for all work actually performed. That is more than the insurance contract calls for.” Page 27 (internal bracketing removed).
Final Thoughts: The 7th Circuit has clarified that the standard construction title coverage generally does not cover liens that arise from insufficient funds for a construction project. This gives construction lenders even more reason to monitor and investigate the construction project’s viability. When liens arise from insufficient funds, the insured lender will be generally held to have “created” those liens by failing to discover and prevent cost overruns.