Why it matters: A violated vacancy clause did not stand in the way of recovery for a bank holding a mortgage on an empty building that was damaged by vandals. A policyholder’s plan to use a mortgaged property fell through and the 35,000-square-foot building remained empty for several years. Vandals broke in and caused significant damage. But the insurer balked at paying for the losses, pointing to a clause in the policy that required a certain percentage of the building to be occupied. Although the insured was not entitled to payment for the losses, the mortgagee bank filed suit, arguing that a mortgage clause in the policy created a “separate and distinct” contract between the insurer and the bank. Affirming a trial court, an Illinois appellate panel agreed. The mortgage clause protected the bank from the property owner’s noncompliance or any acts or omissions under the policy, such as the failure to maintain the minimal level of occupancy, the court explained, allowing the bank to recover for its losses.

Detailed discussion: Brothers Future Holding purchased a 35,000-square-foot building in Askum, Illinois, intending to use it for a new custom contract cooking venture. One of the partners died unexpectedly and business operations never began at the location, which sat empty from the time it was purchased in 2007.

Brothers was issued a policy by Peerless Indemnity Insurance Company that provided coverage for the building. When the policy was renewed in 2009, mortgagee Old Second National Bank was added to the policy as a mortgage holder.

The policy provided coverage for a physical loss of, or damage to, the property with various conditions including one pertaining to vacancy. The building would be deemed “vacant” under the policy unless at least 31 percent of its total square footage was rented or used by the building owner. If loss or damage occurred at the building and it was vacant for more than 60 days prior thereto, coverage was not available.

A mortgage clause was also included in the policy, which stated: “If we deny your claim because of your acts or because you have failed to comply with the terms of this policy, the mortgageholder will still have the right to receive loss payment” pursuant to certain conditions.

In 2009, vandals broke into the building. Equipment such as copper pipes, wiring, and fixtures was stolen and the structure of the building was damaged, with losses totaling about $2.27 million. Both Brothers and Old Second notified the insurer, but Peerless denied coverage based upon the vacancy provision.

Old Second filed a declaratory relief action arguing that it was entitled to coverage under the mortgage clause, notwithstanding the vacancy provision.

Peerless responded that protection under the mortgage clause was never triggered because Old Second had failed to establish a covered loss. No coverage existed for vandalism or theft when the property has been vacant, the insurer told the court, so the mortgage clause never took effect. The fact that the building was allowed to remain vacant for 60 days was not an “act” or default of the insured, but simply an unacceptable condition of risk.

A trial court sided with the bank and the Illinois Appellate Court affirmed.

The mortgage clause at issue was a standard mortgage clause, which formed a separate and distinct contract between the insurer and the mortgagee, effectively shielding the bank from being denied coverage based upon the acts or omissions of the insured or the insured’s noncompliance with the terms of the policy, the court explained.

“There is no dispute, nor can there be, that the claimed loss in this case was for damage resulting from vandalism to, and theft from, the building, and that both of these are covered losses under the terms of Peerless’ policy,” the court wrote. “Although the policy articulates specific ‘exclusions,’ ‘limitations,’ and ‘property not covered,’ none of these sections contain any reference to vacant property.”

Considering the interplay between the mortgage clause and the vacancy provision, the panel looked outside of Illinois for guidance, lacking any case law in the state. Citing decisions from New York and Pennsylvania, the court said the majority view holds that a vacancy clause does not relieve the insurer of responsibility to cover the mortgagee, as long as the mortgagee met its responsibilities under the policy.

“[V]acancy of the building for a period in excess of 60 days prior to the loss gave rise to a ‘state of noncoverage’ based upon a condition of the building independent of any acts of the insured,” the court explained. “However, harmonizing the vacancy provision with the mortgage clause, as we must, we find Peerless’ interpretation unreasonable, as it would place a mortgagee in the untenable position of having to guarantee the regular occupation of the premises, effectively placing it ‘at the whim’ of the insured.”

It was the act of Brothers in failing to occupy 31 percent of the building that triggered the vacancy provisions, the panel added. “By its very terms, however, the mortgage clause provides that Peerless was nonetheless obligated to pay the mortgage holder, Old Second, as Brothers’ claim was denied because of its own act,” the court said.

Old Second met all of the requirements in the mortgage clause by paying any premiums due at Peerless’ request, submitting a sworn proof of loss, and notifying Peerless of any change in ownership, occupancy, or substantial change in risk. Brothers was the owner at all times, the court said, and the risk never changed because the building was vacant the entire term of the policy.

The panel affirmed summary judgment in favor of Old Second as well as an order that Peerless must pay the bank $816,833 plus prejudgment interest.

To read the opinion in Old Second National Bank v. Indiana Insurance Company, click here.