Can a lender stop advancing funds under its construction loan due to the loan imbalance, and then demand that the title company cover the liens filed by unpaid contractors?

In BB-Syndication Services, Inc. v. First American Title Insurance Co., 780 F.3d 825 (7^th Cir. 2015), the United States Court of Appeals for the Seventh Circuit answered no, holding that a lender’s title insurance policy does not cover construction liens that arise from insufficient construction funding. The BB-Syndication Services litigation arose from the financial collapse of a major Kansas City mixed-use construction project. At the inception of construction, a dispute arose between the general contractor and the owner-borrower regarding the cost of construction. The contractor claimed that design changes made by the owner and its architect after the construction contract had been signed entitled the contractor to a price increase of over $22 million. If the contractor’s allegations were true, then the construction project would be significantly underfunded. The borrower disputed the price increase, but construction continued while the dispute between the contractor and the borrower progressed through arbitration.

With knowledge of the potential funding shortfall, the construction lender chose to proceed with financing the costs of construction as it progressed. After having disbursed about 70 percent of the committed loan amount, the lender finally elected to cease all further construction loan disbursements, citing the large loan imbalance and other defaults by the borrower. Construction stopped, unpaid contractors filed construction liens totaling millions of dollars against the property, and the borrower ultimately lost its arbitration with the contractor and filed for bankruptcy protection.

In response to the liens, which had priority under Missouri law, the lender made a claim against the title insurance policy that insured the priority of its mortgage. The lender demanded that the title insurer satisfy all of the liens under the loan policy’s construction lien coverage. The title insurer, First American Title Insurance Company, denied coverage on grounds that the lender’s own conduct – ceasing all funding of construction and refusing to release remaining undisbursed loan proceeds to pay the contractors - had caused the liens to be filed, thereby triggering policy exclusion 3(a). Exclusion 3(a) bars coverage for liens and encumbrances that are “created, suffered, assumed or agreed to” by the insured.

The lender, BB-Syndication, filed suit in Dane County Circuit Court, and First American removed the case to federal court. Judge Conley granted summary judgment in favor of First American, holding that the lender had “created” the liens, and therefore, exclusion 3(a) barred coverage. BB-Syndication appealed. Applying different reasoning, the Seventh Circuit affirmed the Judge Conley’s decision, holding that the lender had “created” the liens.

In the few prior reported decisions addressing this issue, the outcome had turned upon the following factors: 1) whether there was a disbursement agreement between the construction lender and the title company creating a duty on the lender’s part to fund loan disbursements; and 2) whether the lender had disbursed the entire committed loan amount. The courts tended to hold that coverage for the liens existed where there was no such disbursement agreement, or where the lender had fully disbursed the entire committed loan amount. The Seventh Circuit expressly criticized the reasoning of such decisions and charted its own course. The Court recognized that construction lenders typically possess the power to exercise significant control over a construction loan transaction and over the construction project, particularly its finances. The Seventh Circuit therefore ruled that construction lenders have both the ability and the duty to investigate, monitor, and to ensure the construction project’s economic viability, both at inception and throughout construction. The Court held that “[w]hen liens arise from insufficient funds, the insured lender has ’created’ them by failing to discover and prevent cost overruns – either at the beginning of the project or later.” Consequently, the Seventh Circuit adopted a simple rule that “exclusion 3(a) excludes coverage for liens that arise as a result of insufficient funds.”

Lenders can no longer rely upon title insurance as a safety net against construction liens that arise due to insufficient construction funding or a loan imbalance. They must instead rely upon their own due diligence and upon other financial instruments, such as guarantees or performance bonds. Title insurers, on the other hand, may take comfort that they will not be left holding the bag when a construction lender decides to quit disbursing a construction loan due to inadequate financing.