In the context of the bankruptcy proceeding to determine the validity of a mortgage, the mortgagee filed a third-party complaint against its title agent, local counsel and underwriter asserting claims for breach of contracts and negligence. The bankruptcy court granted summary judgment for the mortgagee, the district court disagreed, and the mortgagee appealed to the 5th Circuit. The decision on appeal turned on whether title insurance gives a guarantee that a mortgage is enforceable or and indemnity for losses arising from title defects.
The debtor bought a paper mill for $16 million, which it funded by a $5 million economic development grant, $2 million state loan and $10 million seller note. The state loan and seller note were secured by mortgages.
While continuing to lose money, the debtor worked out a deal with a venture capital firm (Amzak) that led to a loan of up to $15 million secured by a mortgage on the paper mill that was junior to the state loan but senior to the seller note. The title company was supposed to draft and record mortgage documents and issue a $15 million title insurance policy to Amzak.
After closing Amzak’s lawyers sent “fully executed” mortgage and subordination documents for recording that did not have property descriptions attached. Although the cover letter did not say anything, there was evidence that the lawyers told the title company that descriptions would not be included and they were to be physically attached by the title company.
However, a title company employee submitted the documents for recording without attaching any property descriptions. When Amzak received a copy of the recorded documents, it discovered the missing property descriptions. The title company recorded corrective documents.
The debtor had contracted with a third party (Fluor) to operate the mill. There were operational difficulties and Fluor left the mill after about 3 or 4 months. It filed ~$7 million in liens against the property. The debtor went into default under the Amzak loan based on both payment defaults and the Fluor liens.
Amzak and the majority owner of the debtor negotiated a restructuring deal that involved the owner investing $3 – $10 million in the debtor through Amzak’s mortgage, with the owner’s interest in the Amzak mortgage coming behind Amzak. (The objective was to use the mortgage so that the investment would be senior to the seller note and any intervening liens.)
However, after the debtor’s owner discovered the defect with the mortgage it backed out of the deal. It informed Amzak that “there are deficiencies in your mortgage that do not allow us to put money through your existing structure.” Shortly afterwards, Amzak gave notice of a claim to the title company.
The debtor’s counsel also advised its principals that they had a fiduciary duty to file bankruptcy within ninety days of the recording of the revised mortgage so that it would have the ability to void the mortgage as a preference (i.e. the mortgage was not properly perfected until the second corrective recording with the legal description, but at that point perfection of the lien constituted a transfer on account of an antecedent debt that was potentially avoidable as a preference).
From Amzak’s perspective, the mortgage defect caused it to lose the owner’s investment, which could have prevented the bankruptcy, and as a result it suffered a loss on its loan.
At the time the debtor filed bankruptcy, it owed $2 million on the senior state loan, $10 million on the seller note, $14 million in unsecured debts, and an undetermined amount to Fluor. It also owed Amzak ~$13.4 million. As of the filing the paper mill was still operating. If it shut down it would cost $10-$20 million to restart. So Amzak provided the debtor ~$4 million in debtor in possession (DIP) financing.
With respect to challenges to Amzak’s mortgage during the bankruptcy: (1) the debtor waived its rights in consideration for the DIP loan, (2) the seller filed a proceeding alleging the mortgage was ineffective, but did not appeal after the court dismissed its complaint, and (3) after the case was converted and the Chapter 7 trustee attempted to pursue a challenge, the bankruptcy court found that the trustee was bound by the debtor’s release.
In a bankruptcy sale of the debtor’s assets, Amzak was the winner with a $9.9 million bid consisting of (1) credit bid of ~$4.4 million on account of its DIP loan, (2) cash payment of ~$2.5 million to satisfy the state’s senior loan, and (3) credit bit of $3 million on its defective mortgage loan. After acquiring the paper mill, Amzak was not able to make a profit despite investing over $58 million in a thirty month period.
Amzak’s claims against the title company and local counsel included (1) a loan loss of $10.4 million due to the title defect, and (2) reimbursement for fees and expenses of ~$350,000. It asserted breach of the title policy against the title company and negligence against all defendants.
The critical question was the nature of the title insurance coverage. The 5th Circuit concluded that coverage was for actual monetary damage sustained by Amzak by reason of matters insured by the policy, and a defect could exist without any compensable loss. While everyone acknowledged that filing a mortgage without a legal description resulted in a title defect, that did not necessarily mean that there was a resulting loss.
In particular, the policy stated that it insured “against loss or damage … sustained or incurred by the Insured by reason of … (2) [a]ny defect in a lien or encumbrance on the Title.” It further stated that excluded matters included “Defects … (c) resulting in no loss or damage to the Insured Claimant.”
Amzak focused on the loss resulting from the inability to obtain additional investment because of the title defect. However, the court pointed out that the title company retroactively cured the title defect, and due to (1) the correction efforts, (2) Amzak’s negotiation for a release in connection with the DIP financing, and (3) the dismissal of the creditors’ committee suit, title did not fail. Further, Amzak was able to credit bid its mortgage as part of a purchase price. The 5th Circuit concluded that Amzak’s loss was attributable to the severe financial difficulties of the paper mill, not the title defect.
As an alternative, Amzak cited a 7th Circuit case (Citicorp Savings of Illinois v. Stewart Title Guaranty Co., 840 F.2d 526 (7th Cir. 1988)). As described by the 5th Circuit:
In Citicorp, the Seventh Circuit held that the policy was breached at the time of the loan because (i) the “lien was unenforceable ab initio,” (ii) the title policy was “intended to ensure that Citicorp could enforce the lien” when the loan was closed; (iii) that is “what the parties intended when they entered into the agreement [the policy].” Id. at 529. The court explained that the lender “would not have extended [the loan] on the basis of a voidable mortgage” and that STG “breached the policy’s guarantee of the mortgage’s enforceability.”
However, the 5th Circuit disagreed. It concluded that the title policy only indemnified against actual loss, and did not guaranty that the mortgage was valid. Thus, a defect would trigger consideration of whether there was a loss, but by itself was not a breach of the policy. According to the 5th Circuit, other courts agree with its rejection of the concept that a title policy is a guaranty, including the 1st and 8th Circuits.
Turning to the negligence claims, under state law the plaintiff must prove
(1) the [defendant] had a duty to conform his or her conduct to a specific standard of care (the duty element); (2) the defendant failed to conform his or her conduct to the appropriate standard of care (breach of duty element); (3) the defendant’s sub-standard conduct was a cause-in-fact of the plaintiff’s injuries (the cause-in-fact element); (4) the defendant’s sub-standard conduct was the legal cause of the plaintiff’s injuries (the scope of protection element); and (5) actual damages (the damages element).
Among other things, the 5th Circuit held that Amzak did not establish “cause-in-fact.” Amzak’s argument based on the failure to obtain additional capital infusion was too speculative. In addition, the defect was effectively waived when Amzak was allowed to credit bid its debt under the mortgage and so there was no defect.
Consequently, the 5th Circuit affirmed the district court.
People often don’t recognize the limits of title insurance. (For example, those who insist a borrower should obtain a $100 million title policy insuring a mortgage on property worth $10 million. A policy will never pay more than the value of the property, so there is no point.)
It is likely that many believe that a mortgagee title policy provides assurance that the mortgage is valid. While that may be the case in the 7th Circuit, in other jurisdictions including the 5th Circuit there has to be an actual resulting loss before title insurance coverage will be available.