Knowing when to cut your losses and walk a deal is a difficult skill to master. In the construction loan context it is particularly difficult because a half completed building lacks the intended value anticipated on the loan. On the other hand, cutting off disbursements causes a whole other set of risks including mechanic and materialman’s liens (“M&M Liens”) which often prime the lender’s mortgage lien. While different types of insurance may help, the 7th Circuit recently held that priming M&M Liens incurred after the lender had cut off funding following borrower’s default were caused by the lender and therefore excluded from the title insurance coverage. The result was essentially a total loss to the lender of ~$61MM.
Credit: LucasFilm, Ltd. / Imigur
The project was a commercial construction project in Kansas City, MO. Basically what happened was that BB Syndication Services (the “Lender”) lent money on a construction loan to build the commercial development to its borrower. The total line of credit was ~$86MM.
In the project, First American Title (the “Title Company”), acted as disbursing agent and insured against encumbrances on the property. The idea being that prior to making a disbursement, the Title Company would check for liens, and barring liens would disburse the next construction draw. The title insurance policy contained a exclusion to coverage which excluded any liens that are “created ,suffered, assumed or agreed to” by the Lender.
The 7th Circuit mentions some notable, but stereotypical, background facts in the opinion illustrative of deal that is going to go south present in this project:
- The project was “fast tracked” and many contracts were signed before the plans were finalized. The result was that the initially cost estimate was almost immediately rendered inaccurate.
- The construction company immediately warned all the parties that the changes would increase the initial estimate of $118MM by an additional $30-$40MM.
- Notwithstanding the revised cost estimate the Lender opted to proceed even though there were no additional funds from the Lender or sponsors.
- When ~$5MM had been disbursed the projected cost overruns began to come to light.
- Undaunted, the Lender continued making disbursements and paid out over $61MM.
After the original contractor was fired by the borrower the Lender saw that the project was falling apart. The new construction company determined they would need an additional $37MM (see above). The Lender then declared the default and ceased making disbursements. Two things happened when the Lender cut off the funds:
- Over $17MM in M&M Liens were filed (which primed the Lender), and
- The Borrower filed bankruptcy
A Lawsuit About a Lawsuit
Most insurance coverage litigation is usually a lawsuit about another lawsuit in which there was a loss. This was no different. The Borrower filed bankruptcy and the bankruptcy court ultimately allowed $17MM in M&M Liens which all primed the Lender’s mortgage lien. Next, the bankruptcy court conducted a judicial auction of the property which yielded $10MM. Obviously this was not enough to pay the (now) first lien M&M Liens. In the end, the lender settled for payment of $150K on its $61MM debt.
Faced with the loss, the Lender then turned and sued the Title Company on the title insurance policy. The Title Company countered with their exclusion of liens “created, suffered, assumed or agreed to” by the Lender.
On appeal, the 7th Circuit held for the Title Company stating:
The liens at issue here related to outstanding work that remained unpaid when [Lender] cut off loan disbursements due to insufficient funds to complete the project. As such, the liens arose directly from [Lender’s] action as the insured lender, so coverage seems squarely foreclosed by Exclusion 3(a).
The 7th Circuit dismissed the Lender’ argument that it had the contractual right to cease disbursements and was therefore not responsible for the M&M Liens. The 7th Circuit reasoned that the right to cut off funding had nothing to do with the sub-contractor’s right to file M&M Lien claims.
Moreover, the 7th Circuit stated that the Lender could be seen to have caused the cost overrun itself because the Lender knew well in advance that the project was out of balance. The 7th Circuit goes so far as to state “Only the lender has the ability – and thus duty – to investigate and monitor the construction projects economic viability. When liens arise from insufficient funds, the insured lender has ‘created’ them by failed to discover and prevent cost overruns…”
What to Take Away from the Case
If anything, lenders should not rely on title insurance which contain the fairly common exclusion for M&M Liens that will arise following cut off of disbursements at issue in the case. Circuits are split regarding this issue, but it remains a risk regardless of your location. Obtaining performance bonds are likely a better option.
In addition to the legal holding about a title policy exclusion, another lesson is the cost of failing to walk away early from a project that is clearly not going to work. The opinion mentions the Lender’s knowledge of the cost overruns over and over again. Had the Lender walked at $5MM it would have almost certainly been made whole. Knowing when to cut your losses is as much an art as it is a science and it cost the Lender over $61MM on this deal.
BB Syndication Services, Inc v. First American Title, case no. 13-2785, in the United States Court of Appeals for the Seventh Circuit. Entered March 12, 2015.