The U.S. Court of Appeals for the Seventh Circuit recently affirmed a district court’s judgment that a lender did not owe the borrower a fiduciary duty to use the payout from a homeowners’ insurance policy to pay down the loan instead of repair the house, but reversed the dismissal of the borrower’s breach of contract claim.

A copy of the opinion is available at:  Link to Opinion.

The borrower purchased his home in 2005 with a $100,500 mortgage loan. The home was seriously damaged by a fire five years later. The borrower filed an insurance claim, and the insurer paid over $150,000 to the mortgagee as loss-payee under the policy.

The mortgagee paid $50,000 of the insurance proceeds to start the restoration, but upon inspecting the work found that it was of poor quality and needed to be re-done, by which time the borrower defaulted by failing to make several payments. The mortgagee then applied the remaining insurance money to pay down the loan instead of repairing the home.

The mortgage provided that “[i]f the restoration or repair is not economically feasible or Lender’s security would be lessened, the insurance proceeds shall be applied to the sums secured by this Security Instrument, whether or not then due, with excess, if any, paid to Borrower.”

The borrower filed a putative class action on behalf of himself and all borrowers in default whose homeowners’ insurance proceeds were applied to pay down the loan instead of to repair the home, alleging that by failing to repair the home, the mortgagee breached a fiduciary duty owed to the borrower and also breached the terms of the mortgage itself.

The mortgagee moved to dismiss for failure to state a claim. The district court granted the motion, finding that no fiduciary relationship existed and that the breach of contract claim failed because the borrower defaulted on his payment obligation before the alleged breach. The borrower filed two more amended complaints, which were also dismissed, the last with prejudice, and the borrower appealed.

Court Rejects Fiduciary Relationship

On appeal, the Seventh Circuit agreed with the district court that the complaint failed to allege sufficient facts to support the existence of a fiduciary duty, reasoning that the mortgagor-mortgagee relationship is not a fiduciary relationship that exists as a matter of law.

The Seventh Circuit also rejected the borrower’s argument that a fiduciary relationship arose because the mortgagee controlled the insurance proceeds and thus was an escrow agent, who supposedly “has a fiduciary duty to the party making the deposit and the party for whose benefit the deposit is made.” The Court reasoned that the “insurance carrier was not a party to the mortgage agreement and thus could not be the grantor in any escrow created by [the mortgage]. The insurance carrier’s involvement was completed as soon as it issued the check for the policy proceeds; it gave no instructions about how [the mortgagee] should use the money, and without instructions there can be no escrow.”

In addition, the Seventh Circuit noted that the applicable mortgage provision existed for the mortgagee’s benefit in order to ensure that its security was not impaired, the repairs were economically feasible, and that it had the opportunity to inspect the work to ensure it was completed to its satisfaction.  The Court noted that, although contract law imposes an implied duty of good faith on the parties, “that duty doesn’t create a fiduciary relationship,” and nothing in the mortgage showed that the mortgagee undertook a duty to act on the borrower’s benefit instead of its own.

Finally, the Seventh Circuit reasoned that the breach of fiduciary duty claim was properly dismissed because an escrow agent does not have title to the property it holds, whereas in the case at bar the mortgagee was not merely a custodian of the borrower’s money, but had a vested property interest because it was a loss-payee, to whom the proceeds were delivered directly.

Court Remands on Breach of Contract Issue

Turning to the breach of contract claim, however, the Court agreed with the borrower’s argument that the insurance section of the mortgage would remain enforceable even after the borrower defaulted, reasoning that the mortgagee “never indicated that repairing the house was economically infeasible or would harm its security interest” and that “the other three conditions … that would permit [the mortgagee] to use the insurance proceeds to pay down the loan — abandonment, the failure to respond to an insurance settlement, and foreclosure — did not occur.”

Given the bargained-for remedies for default contained in the mortgage, which would be superfluous if the mortgagee could apply insurance proceeds to any default, and the presumption that every contract should be construed as a whole, giving effect to every provision, if possible, the Seventh Circuit concluded that the borrower “has stated a facially plausible claim that the parties did not intend that his missed payments preclude him from enforcing [the insurance section] of the agreement. Though [the lender] could have accelerated [the borrower’s] loan in response to his missed mortgage payments, it did not do so.”

The dismissal of the breach of fiduciary duty claim was affirmed, the dismissal of the breach of contract claim reversed, and the case remanded for further proceedings.