Foreclosure Issues in Property Claims and Mortgagees' Interests - Part 1

By: Stephen Smith

Claims involving foreclosures raise special issues both for the property insurer, as well as insureds and lenders. In order to help understand how they work, this is the first of a three-part article which will examine the following issues:

1.   The nature of a Mortgagee's interest in an insurance policy;

2.   How the timing of loss and foreclosure can affect coverage;

3.   Basic relevant information in a claim which involves a foreclosure.

MORTGAGEE'S INTEREST IN REAL PROPERTY

A "mortgage" is a purchase money security interest in real property (“PMSI”), which results in an encumbrance on title.  The lender and holder of the mortgage is the Mortgagee. The obligor and actual owner of the property is the Mortgagor.  In Texas, as well as other states, there are three primary documents created when a person buys property which are important for this transaction:

1. Warranty Deed.[1] Seller conveys property to the Buyer with the promise of clear title.
2. Promissory Note. A promise to pay money to the lender/mortgagee;
3. Deed of Trust - In Texas this secures the mortgage and gives the lender the right to sell the house if the loan is not paid, by virtue of vesting legal title in a trustee who holds it as security for a loan. The mortgagee is the trustor holding beneficial title. The mortgagor is the beneficiary.

Most states require some form of these instruments, even if they call them by a different name. It is the Deed of Trust which allows a mortgagee to conduct a nonjudicial foreclosure.

MORTGAGEES' RIGHTS TO CLAIM INSURANCE PROCEEDS
 

"Insurable Interest" of Mortgagee

A fundamental rule of Texas insurance law is that a person cannot recover on an insurance claim unless they have an "insurable interest" in the property which is damaged. A mortgagee's "insurable interest" is limited to the amount of debt still owed by the borrower/insured and which is secured by the mortgage interest.

How the claim process works between a Mortgagee and Mortgagor depends on the form of the Deed of Trust. There are different forms promulgated in each state, in addition to custom forms that can be drafted for a particular situation (primarily in commercial transactions). As might be expected, not all forms are alike. For instance, the State Bar of Texas "Deed of Trust," rev. 06/09, reads in pertinent part below (Paragraphs: B.3. and B.4.):

3. Lender may apply any proceeds received under the property insurance policies covering the Property either to reduce the Obligation or to repair or replace damaged or destroyed improvements covered by the policy. If the Property is Grantor’s primary residence and Lender reasonably determines that repairs to the improvements are economically feasible, Lender will make the insurance proceeds available to Grantor for repairs.
4. Notwithstanding the terms of the Note to the contrary, and unless applicable law prohibits, all payments received by Lender from Grantor with respect to the Obligation or this deed of trust may, at Lender’s discretion, be applied first to amounts payable under this deed of trust and then to amounts due and payable to Lender with respect to the Obligation, to be applied to late charges, principal, or interest in the order Lender in its discretion determines.

This form gives the mortgagee/lender an ability to elect payment for repairs vs. applying the proceeds to the mortgage, and essentially control disposition of the proceeds.

On the other hand, the Fannie Mae/Freddie Mac UNIFORM INSTRUMENT Form 3044 (10/17), reads as follows at paragraph 5. “Property Insurance.”  :

Unless Lender and Borrower otherwise agree in writing, any insurance proceeds, whether or not the underlying insurance was required by Lender, shall be applied to restoration or repair of the Property, if the restoration or repair is economically feasible and Lender’s security is not lessened. During such repair and restoration period, Lender shall have the right to hold such insurance proceeds until Lender has had an opportunity to inspect such Property to ensure the work has been completed to Lender’s satisfaction, provided that such inspection shall be undertaken promptly.  Lender may disburse proceeds for the repairs and restoration in a single payment or in a series of progress payments as the work is completed.  Unless an agreement is made in writing or Applicable Law requires interest to be paid on such insurance proceeds, Lender shall not be required to pay Borrower any interest or earnings on such proceeds.  Fees for public adjusters, or other third parties, retained by Borrower shall not be paid out of the insurance proceeds and shall be the sole obligation of Borrower.  If the restoration or repair is not economically feasible or Lender’s security would be lessened, the insurance proceeds shall be applied to the sums secured by this Security Instrument, whether or not then due, with the excess, if any, paid to Borrower

This form would require that the insurance payment should be used to repair the house unless the mortgagee can show repairs are not economically feasible. However, it still places control of the mortgage funds in the hands of the Mortgagee.

 

“Standard Union” Mortgage Clause”

While the interest is established by the fact of the Mortgagee's rights in an insurance policy is based on the PMSI, and the control of the proceeds based on the Deed of Trust, the insurer’s obligation "Mortgagee" clause, which is found in virtually every modern homeowner’s or commercial building coverage. The mortgage clause in widest use is the “Standard Union Mortgage Clause.” The exact wording may vary slightly from policy to policy, but the content would be the same.

"Payment" Clause - Paragraph k.1. - "As Interests Appear"

The key provision in a Standard Union Mortgage Clause reads as follows:[2]

K. Mortgage Clause

1. If a mortgagee is named in this policy, any loss payable under Coverage A or B will be paid to the mortgagee and you, as interests appear ...

(Underscoring and emphasis added).

''As Interests Appear".

The phrase "as interests appear" is read in conjunction with the Deed of Trust. It defines the extent of mortgagee's rights to casualty insurance proceeds in the event of a covered loss. While the Deed of Trust contractually defines the mortgagee's rights to the insurance proceeds as between the insured and the Mortgagee, the Mortgagee’s rights under the insurance policy by virtue of the above referenced clause.

Some clauses contain language like paragraph 10.c. of the Standard Union Mortgage Clause found in the HO-B addressing the mortgagee's rights in the event foreclosure has begun:

10. Mortgage Clause (without contribution)

c.   The mortgagee has the right to receive loss payment even if the mortgagee has started foreclosure or similar action on the building or structure.

This language states that even if the foreclosure has begun- such as by posting the property for sale- that the Mortgagee can collect any insurance proceeds paid for covered damage to the house as provided in the Deed of Trust. Accordingly, simply beginning the foreclosure process does not affect the Mortgagee’s rights under the policy of insurance.

In the Event of a Loss, Insurer is Required to Protect the Interests of Both the Insured and the Mortgagee

When a loss occurs and is paid, even if not specifically set out in the insurance policy, traditionally the best practice was to simply put both the Insured and Mortgagee as payees on any settlement draft relating to real property. In that event, if one of the parties to the draft forged the other parties’ signature, the insurance company would not be liable as it was considered proper tender to place both names on the check and tender to one party. However, this is no longer the best practice. Under recent caselaw, the insurance company must take steps to assure that the draft is endorsed by the proper party. ViewPoint Bank v. Allied Property and Cas. Ins. Co., 439 S.W.3d 626 (Tex. App.- Dallas 2014 rev. den.); McAllen Hospitals, LP v. State Farm Mutual Insurance Company of Texas, 433 S.W.3d 535 (Tex. 2014). Otherwise, if either the Mortgagee or the Insured forges the signature of the other, the cheated party can sue the issuing insurer, would be liable for the amount of the cheated parties’ interest based on Viewpoint Bank and McAllen Hospitals,

One way that this can be done is through apportionment. Applying general principles, the Mortgagee has an insurable interest only to the extent of its lien. Therefore, assuming there is an accurate knowledge of the lien, they can be apportioned. However, this does put some responsibility on the Insurer to accurately determine the Mortgagees interest, with the assistance of the Mortgagee.