Prepetition Fire Insurance Proceeds: Who Gets the Cash?

Crews v. TD Bank, N.A. (In re Crews), 477 B.R. 835 (Bankr. M.D.Fla. 2012) –

A mortgaged building was destroyed by fire prior to the mortgagor’s bankruptcy filing.  In an earlier opinion the bankruptcy court held in that the mortgagee had an equitable lien on the fire insurance proceeds of $350,000.  This opinion addresses the debtors’ attempt to avoid the equitable lien using their “strong arm” powers.

As discussed in prior blog posts, a debtor can assert the rights of a hypothetical bona fide purchaser of real estate or a judgment lien creditor in challenging liens and other claims.  One option is to assert the rights of a judgment lien creditor in order to avoid an unperfected lien under the Uniform Commercial Code (UCC).

In this case the debtors argued that the mortgagee was required to perfect its interest in the insurance proceeds by filing a UCC-1 financing statement, noting that any automatic perfection in proceeds of collateral under UCC Section 9-315 lapsed after 21 days.  However, the court disagreed, concluding that UCC Article 9 was not applicable.  In the court’s view, the key issue for perfecting a lien on proceeds of collateral is the nature of the underlying collateral, which in this case was improvements to real estate so that perfection was governed by the rules under the state recording statutes.

The court distinguished a case involving a collateral assignment of mortgage receivables on the basis that the mortgage receivables were personal property, and thus a lien on the receivables had to be perfected under the UCC by filing a UCC-1 financing statement or taking possession of the notes.  Since the collateral assignments were not an interest in real estate, recording was not sufficient.  In addition, in that case the mortgagor’s obligations had been released as a result of transfer of title to the mortgagee.  The court concluded that any interest in the mortgage receivables would have been extinguished when the mortgagee interests merged into the fee title interest.  For investors who argued that they had an interest in the real estate as “proceeds” of the mortgage receivables, the court agreed that there could be automatic perfection for 21 days, but after that some sort of recording in the real estate records was required for continued perfection.

In contrast, in Crews the lien on the underlying real estate collateral was perfected under the real estate recording statutes.  The Crews court emphasized that the effect of recording on bona fide purchasers or judgment lien creditors varies by state.  However, under Florida law, it found that the purchaser or lien creditor would be subject to both constructive and inquiry notice since they are deemed to have constructive notice of both the existence and the contents of documents in the chain of title, including facts they could have ascertained by a reasonable inquiry regarding the contents.

The debtors had a covenant to provide insurance and to name the mortgagee as an additional insured or loss payee.  Although the debtors apparently had not named the lender as a mortgagee or loss payee on the applicable insurance policy as required, when the lender learned of the fire loss, it made a demand for payment of insurance proceeds.  After conducting a title search, the insurance company recognized the lender’s rights and ultimately the debtors signed a sworn statement and proof-of-loss that acknowledged the lender’s interest in the building and its right to insurance proceeds.

So, as of the date the bankruptcy was filed, the recorded mortgage put people on notice that the debtors had a covenant to provide insurance, and both the sworn statement and a check issued including the lender as a payee on the majority of the insurance proceeds put people on notice of the lender’s interest in the proceeds.  Consequently, the debtors were not entitled to avoid the mortgagee’s equitable lien on the $350,000 fire insurance proceeds.

As this case illustrates, although the “strong arm” powers entitling a debtor to exercise the rights of a bona fide purchaser are not subject to any actual notice of the debtor, they are subject to constructive or inquiry notice as provided by applicable state law.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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