Mechanics lien claims cloud the title of the property against which they are asserted, and can enjoy an advantageous priority position in potential foreclosure proceedings. Because of this, a common question is how title insurance coverage applies to situations in which mechanics liens are at issue. In a recent case arising out of a Missouri project, the United States Court of Appeals for the Seventh Circuit provided some guidance and clarification.
Does Title Insurance Protect Construction Lender’s from Mechanics Lien Claims?
In such standard-form policies, exclusion 3(a) states that liens “created, suffered, assumed or agreed to” by the insured construction lender are specifically not covered by the title insurance policy. The answer to this particular question, like many questions and answers related to mechanics liens, can be complex. However, in the recent case BB Syndication Services, Inc. v. First American Title Insurance Company, the court examined a common, and commonly litigated, exclusion in construction lender’s title policies related to mechanics liens, and provided guidance. In such standard-form policies, exclusion 3(a) states that liens “created, suffered, assumed or agreed to” by the insured construction lender are specifically not covered by the title insurance policy. Pursuant to this examination, the court determined that the exclusion extends and applies to liens that arose based on the lender’s decision to stop funding a project pursuant to a determination of default.
Background of the Case
The project at issue was a large construction project funded by cash from the developer and a construction loan of $86 million (secured by the development). Like many such loans, this loan contained provisions allowing the lender to declare default and stop payments if it determined that the project could not be completed with the available funding.
Relatively shortly after the commencement of the project, the general contractor made it known that changes to the scope and design of the project would result in serious price increases, to the tune of $20 – $30 million. When this assertion was made by the GC, only $5 million of the loan had been disbursed, and despite the assertion of the likely large cost overruns, the lender continued to fund the project. After another year of funding $56 million worth of the development, the lender determined that the project funding would be short by nearly $40 million, declared a default, and stopped funding the project. Pursuant to this decision, the developer filed for bankruptcy.
As routinely happens in bankruptcy situations related to construction projects, multiple mechanics liens were filed against the property. The mechanics lien claims amounted to more than $17 million, in addition to the lender’s $61 million claim. Much of the work giving rise to the mechanics liens at issue was performed prior to the lender’s declaration of a default, so the lender looked to the title insurance company to both defend the litigation and cover any award for claims asserted via the mechanics liens. This was ultimately unsuccessful.
The Result: Mechanics Liens Recover, Title Insurance Doesn’t Pay
Construction lenders have significant ability to ensure that the projects they finance remain economically viable. Exclusion 3(a), the standard exclusion at issue in the case noted that liens “created, suffered, assumed or agreed to” by the insured construction lender were specifically not covered by the title insurance policy. The lender argued that since much of the work performed that gave rise to mechanics liens was prior to the declaration of default that led to the funding being stopped on the project, the title insurance should cover the claims. The court disagreed with this conclusion, and agreed with the district court the title insurer had no obligation to indemnify the lender for the mechanics lien claims due to the proper application of the 3(a) exclusion. Because of this decision, the lender ultimately only received $150,000 of its original $61 million claim.
In reaching this determination, the court noted that determining whether a lien was “created, suffered, assumed or agreed to” by the insured was akin to determining whether the insured was “at fault” for the lien(s) at issue. Since, in this instance, the court determined that the liens were a direct consequence of nonpayment due to the lender’s decision to stop funding the project, the liens arose from and were the “fault” of, the lender’s actions.
In supporting this determination, the court noted that the lender is in the best position to discover and prevent cost overruns, and that “construction lenders have significant ability to ensure that the projects they finance remain economically viable—both at the beginning when deciding whether to finance a project and how much money to commit, and also throughout construction.”
In light of this decision, it would be prudent for construction lenders to take note that the responsibility to monitor the construction, and payments to parties throughout the project, falls on their shoulders, as liens related to their actions will likely not be covered by their title insurance policy.