Title Insurance Claims: What Happens When “Push Comes to Shove”

Henderson v. Cmty. Bank of Mississippi (In re Evans), 492 B.R. 480 (Bankr. S.D. Miss. 2013) –

An individual (Evans) together with thirteen entities he controlled filed bankruptcy.  In the context of an adversary proceeding brought by a chapter 7 trustee to determine the validity and priority of liens on various properties involved in the bankruptcies, three of the lenders asserted cross-claims against two title companies.  After determining that the title companies were liable for breach of an implied duty of good faith and fair dealing, the bankruptcy court went on to address damages.

Evans had obtained loans from the banks on behalf of various entities that he controlled to finance development of ~23 acres of land.  Evans had a surveyor prepare plats dividing the land into 17 lots, of which 6 lots were to secure the banks’ loans.  This was part of a fraudulent scheme that included entities signing deeds of trust on properties that (1) they did not own, and (2) were already subject to senior liens granted by different entities.  Evans was assisted in this “flim-flam” by his brother, who was an attorney approved to submit applications for title insurance policies.

After the loans went into default, the banks discovered that defects prevented them from foreclosing.  So, they submitted claims under their mortgagee title insurance policies.  The title companies attempted to cure the title defects by purchasing the affected lots, paying off the senior lenders, and conveying the lots to the banks.

However, conveyance of the 6 lots violated a local subdivision ordinance: a person may not subdivide land without approval, and it is a criminal offense to sell property that does not comply.  In prior opinions, the bankruptcy court ruled that the title companies breached their implied duty of good faith and fair dealing by conveying the properties in violation of the subdivision ordinance so that the value of the lots was reduced or eliminated.

The banks sought expectation damages as a remedy for the breach.  The goal of expectation damages is to “put the injured party in the position where [it] would have been but for the breach.”  Equating breach of a covenant with breach of a contract, the court concluded that the damages should be sufficient to put the insured banks in the same position they would have been had the title companies performed their contracts – i.e., satisfying claims under the title policies.

The title policies contained two main sections: (i) exclusions from coverage and (ii) conditions and stipulations.  In the conditions and stipulations, Section 7(a) – titled “Determination and Extent of Liability” – provided that liability under the title policy was limited to the lesser of (1) the amount of insurance as stated in Schedule A of the policy, (2) the unpaid principle debt secured by the mortgage or (3) “the difference between the value of the insured estate or interest as insured and the value of the insured estate or interest subject to the defect, lien or encumbrance insured against by this policy.”

The court concluded that the banks had the burden of proving that they had a right to recover, while the title companies had the burden of showing that any exclusions applied.

The banks submitted that their damages should be the lesser of the amount of insurance and the unpaid loan amount (which they established), and did not even attempt to present any evidence on the reduction in value as provided in Section 7(a)(3) based on the contention that it was incapable of adequate proof.

When the dust settled, the court found that the banks met their burden of proving that they sustained damages as a result of breach of the policies.  This left it to the title companies to prove that the losses shown by the banks exceeded the expectation of the parties.  In other words, the title companies had the burden of proving the amount of the reduction in value under Section 7(a)(3) of the policies notwithstanding that it was included in the “conditions and stipulations” as opposed to “exclusions” portion of the policy.

The title companies presented valuation evidence by an appraiser that included a sales comparison approach based on other land sales, and an income capitalization approach based on a projected value for the developed subdivision as a whole, with allocation of value to individual lots based on their “contribution” to value.

The banks’ appraiser did not appraise the lots based on his view that it was not possible to provide a valuation opinion that complied with USPAP; so his review was limited to comments on the title companies’ appraisal.  It is apparent that he did not have a very high opinion of the appraisal.  (The court reported comments such as references to: a “phony baloney” subdivision, an analysis as “something that my granddaughter could put into an appraisal report,” pulling the “adjustment numbers out of the air,” and mistakes that were described as unforgivable “cardinal sins,” unlike forgivable “venial sins.”)

Although it appears that the court was persuaded at least in part by the banks’ expert, it seems likely that an even more telling point came when the court asked the title companies’ appraiser how the lots had any market value if they could not be sold without violating the ordinance.  His response was: “I’m not here to testify to that particular value.”  In any event, the court found that the valuation analysis lacked credibility and the title companies did not meet their burden of proving a limit on damages based on the change in value.

The title companies also argued that if the lots had no value due to the subdivision ordinance violation, that loss was not the result of the title company conveyances, but rather the lots were also of no value at the time the title policies were issued.  The court disagreed on the theory that there was no violation of the ordinance until there was an actual conveyance.  The court also rejected an argument that the banks should have tried to mitigate their losses by trying to market or sell the lots.

As a result, the court ordered damages in amounts equal to the lesser of the insurance amounts and the outstanding loan debts (which totaled ~$1.48 million for the three banks), together with pre-judgment and post-judgment interest, as well as court costs.  In response to the title companies’ argument that they should get a credit for the value of the lots they conveyed, the court directed the banks to mark the deeds cancelled and return them to the title companies, or follow some other procedure agreed to by the parties that would have the same effect of reconveying the properties to the title companies.

In doing transactions there is a tendency to take for granted that title insurance will be available to cure any problems. Although the banks eventually received payment on their claims here, it certainly was not a foregone conclusion.

This case also highlights that when a mortgagee takes only part of a project as collateral, it should think twice about whether it is going to be able to realize on its collateral: As long as the parcels are under the borrower’s common ownership, there may not be a problem; but once a mortgagee attempts to foreclose on only part of the project, local subdivision ordinances may present a barrier.

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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