The Seventh Circuit Court of Appeals with appellate jurisdiction over Illinois, Indiana and Wisconsin recently held that the standard-form title-insurance policy that lenders purchase for ongoing construction projects may not protect against construction liens if the project falls apart. In BB Syndication Services, Inc. v. First American Title Insurance Company, 780 F.3d 825 (7th Cir. 2015), the Court examined Exclusion 3(a) of the standard title policy, which excludes coverage for liens that are “created, suffered, assumed or agreed to by” the insured lender. BB Syndication Services (“BB”), a Wisconsin lender on a mixed-use $118 million construction project in Kansas City, Missouri, stopped funding the project because of cost overruns, causing the project to collapse. Several contractors filed liens and BB sought to have First American defend and indemnify BB against the liens.
The Court acknowledged that various courts disagree about how to interpret Exclusion 3(a) when a lender stops disbursing loan funds on a construction project. Eighth and Tenth Circuit decisions held that if a lender cuts off funding when the developer lacks sufficient funds to complete the project, the lender “creates” the liens and Exclusion 3(a) applies. The Sixth and Eighth Circuit (in a subsequent decision) held that when a lender advances the full commitment of a loan, the lender does not “create” liens that arise subsequently from insufficient project funds.
The Seventh Circuit Court ultimately determined that lenders’ policies do not insure against liens created due to insufficient project funds. The Court reasoned that construction lenders have significant power to ensure that projects remain financially sound throughout the construction process. In fact, they have an affirmative duty to investigate and monitor the project’s economic viability. Furthermore, the Court noted that construction lender title policies only insure against failures in the payment process, not project failures due to insufficient funds, which is a business risk that would be inappropriate to shift to the title insurer. The Court opined that lenders who fail to discover and prevent cost overruns have “created” the liens and are not entitled to coverage under the standard title insurance policy.
The Seventh Circuit decision may have limited impact on lien priority in Wisconsin because of statutory protections offered to lenders who record “construction mortgages.” However, the Seventh Circuit case makes it clear that, while the construction lenders may retain a priority lien, the project may nonetheless become burdened by junior liens that will be excluded from coverage.
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