Argued December 11, 2013
As Corrected March 30, 2015.
Appeal from the United States District Court for the Western District of Wisconsin. No. 10-cv-195-wmc -- William M. Conley, Chief Judge.
For BB SYNDICATION SERVICES, INCORPORATED, Plaintiff - Appellant: John M. Gillum, Attorney, Patricia C. Till, Attorney, MANIER & HEROD, Nashville, TN.
For FIRST AMERICAN TITLE INSURANCE COMPANY, Defendant - Appellee: Steven J. Slawinski, Attorney, O'NEIL CANNON HOLLMAN DEJONG & LAING, S.C., Milwaukee, WI.
Before WOOD, Chief Judge, and FLAUM and SYKES, Circuit Judges.
Sykes, Circuit Judge.
This case involves the most litigated provision in
the standard-form title-insurance policy purchased by real-estate lenders to
protect their security interests in ongoing construction projects. The project
at issue here--a large commercial development in Kansas City, Missouri--was
aborted in the middle of construction due to cost overruns. When the developer
would not cover the shortfall, the construction lender stopped releasing
committed loan funds, and contractors filed liens against the property for their
unpaid work on the unfinished project.
Bankruptcy followed, and the contractors' liens were given priority over the lender's security interest in the failed development, leaving little recovery for the lender. The lender looked to its title insurer for indemnification. The title policy generally covers lien defects, but it also contains a standard exclusion for liens " created, suffered, assumed or agreed to" by the insured lender. The question is whether this exclusion applies to the liens at issue here, which resulted from the lender's cutoff of loan funds. We hold that it does, and thus the title insurer owes no duty to indemnify.
We begin with some background on how title insurance functions in the construction context. Large construction projects are typically funded by a combination of cash from the developer and a construction loan. The loans are secured by the construction project itself--the land and
building in progress. At the beginning, of course, the building has little value, but as it is built, its value increases. If the construction project fails and puts the developer into bankruptcy, the lender's loan is protected only by the unfinished project, which is often worth far less than the money put into it.
To protect against this risk, construction lenders structure their loans in two important ways. First, they require the developer to spend its cash investment before tapping any loan proceeds; this equity cushions the lender against losses if the project falls apart. After the developer's cash has been spent, the loan is disbursed in increments as work is completed and only in amounts necessary to fund the completed work (that is, to pay contractors, subcontractors, and so on). This second feature ensures that the lender's actual outlay (i.e., the principal balance of the loan) will slowly increase with the approximate value of its security interest.
To protect the priority of its security interest, the lender also purchases title insurance. Unique in the insurance world, title insurance differs from other forms of property and liability insurance in that it only covers losses from defects in title and lien priority (and similar title-related risks), usually requires only a one-time premium, and lasts for as long as the insured holds title (or, in this context, a security interest). See Phila. Indem. Ins. Co. v. Chi. Title Ins. Co., 771 F.3d 391, 399--400 (7th Cir. 2014) (explaining the differences between title insurance and general liability insurance). This model works because title insurance is retrospective rather than prospective; it generally protects against defects in title that arose prior to the issuance of the policy, allowing the insurer to reduce or eliminate risk by conducting a careful title search to identify defects. These features, however, cause some complications in the construction-loan context.
Many states give unpaid contractors a mechanic's lien that is superior to all other security interests. Because title insurance is retrospective, it generally doesn't protect a real-estate lender from liens arising after the issuance of the policy. If the lender wants this protection, it must contract with the title insurer for periodic updates or endorsements of the policy. Each time the policy is updated, the title insurer conducts a " date down" title search to check for new title defects. In addition, parties to construction projects often designate the lender's title insurer as the disbursement agent for the loan funds. When the developer submits a draw request as each phase of the project is completed, the lender releases loan funds to the title company, and the title company (acting as disbursement agent) verifies that the contractors are paid properly, obtains lien waivers, and updates the policy accordingly.
Especially in large construction projects, loan agreements commonly give the lender the right to stop disbursing loan funds if the loan becomes " out of balance" --that is, if revised cost estimates exceed the committed loan amount plus the cash the developer has invested. When the lender cuts off funding, there will always be some outstanding unpaid work; contractors request payment as work is completed, but there is inevitable delay from the time when work is completed to the time when bills are submitted. If the title insurer last updated the policy after the work was completed but before payment was requested or funds were cut off, an issue arises about whether the title policy covers the mechanics' liens filed by the unpaid contractors.
That's the question in this case. The standard-form title-insurance policy contains
a provision known as Exclusion 3(a), which excludes coverage for liens that are " created, suffered, assumed or agreed to" by the insured lender. The issue here is whether a construction lender " creates" or " suffers" a mechanic's lien by cutting off loan funds when a project collapses due to cost overruns, leaving some completed work unpaid. Several cases have addressed this issue (this contractual arrangement is widely used) but have come to different conclusions.
* * *
We now turn to the specific facts of this case. Trilogy Development Company, a real-estate developer, contracted with J.E. Dunn Construction Company, a general contractor, for construction of a mixed-use commercial development in Kansas City, Missouri, called " West Edge." The initial estimated cost was $118 million, and funding for the project would come from a $32 million investment by Trilogy--$12 million in land and another $20 million in cash--and a construction loan in the amount of $86 million from BB Syndication Services, Inc., a Wisconsin-based loan syndicator. The loan was secured by the West Edge project, and BB Syndication obtained title insurance from First American Title Insurance Company, a California-based title insurer operating throughout the United States. The parties designated First American as the disbursement agent for the loan funds.
Early on there were indications that costs would exceed the initial estimate. The project had been " fast tracked," meaning that the contracts were signed and work started before the design was finalized. About a year and a half after construction began, Dunn claimed that Trilogy's changes to the plans had increased the construction costs by $20 to $30 million. If Dunn's estimates were correct (as they later proved to be), the construction loan would have been out of balance soon after the project started, giving BB Syndication the right to cut off loan disbursements. But the lender chose to continue funding the project anyway. When the likely cost overruns first came to light, BB Syndication had disbursed only about $5 million of the $86 million loan commitment. By the time the project fell apart, BB Syndication had paid out more than $61 million.
The beginning of the end came about a year after Dunn first identified the probable cost overruns, when Trilogy failed to pay Dunn from the proceeds of a disbursement of loan funds. Dunn stopped all construction, and multiple subcontractors filed liens against the project. Trilogy briefly hired a new contractor to try to salvage the project, but within a few months acknowledged that the development was now short by about $37 million. Trilogy did not supply additional cash to keep the project afloat and bring the loan into balance. At this point BB Syndication cut off funding and declared the loan in default, generating more liens for work performed during the short interim period. When BB Syndication called for repayment, Trilogy filed for bankruptcy protection.
In the bankruptcy Trilogy initiated an adversary proceeding to determine the amount and priority of liens and creditors. In addition to the various subcontractor liens, Dunn had filed a $12 million lien for
its unpaid work. Many of the liens were for work performed before First American's most recent update to the title policy, so BB Syndication looked to the insurer for a defense and indemnification in the adversary proceeding. Relying on Exclusion 3(a), First American rejected the tender, taking the ...