By: Stephen Smith
Claims involving foreclosures raise special issues both for the property insurer, as well as insureds and lenders. To help understand how they work, we are undertaking, within three Parts, to 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.
Within Part II, we will discuss the timing of loss and foreclosure and how that timing can affect coverage.
The process that is generally referred to as “foreclosure” is technically “non-judicial” foreclosure because it is an alternative to traditional foreclosure, which requires court involvement.
Sale on the Courthouse Steps
Foreclosure in Texas is routinely accomplished through a "non-judicial foreclosure sale" procedure. Texas Property Code, Chapter 51. This is a process whereby the mortgagee must give certified notice to the owner of the pending foreclosure sale, and must post a notice on the county court house door at least 21 days prior to a sale. After proper notice, the property may be sold at public auction by the mortgagee's representative (the Substitute Trustee") on the courthouse steps between 10 a.m. and 4 p.m. on the first Tuesday of the month. If you go to any courthouse in Texas on a nonholiday first Tuesday, you will see foreclosure sales in process.
Mortgagee Is Usually the Purchaser
While anyone can attend and bid, in most cases only two parties attend. By far the most common is the mortgagee only. However in some cases depending on the market, location, and—if the property includes a home—the home’s condition, house flippers will also attend. However, there are often few, if any other, buyers at Chapter 51 "non-judicial foreclosures." If no one else bids, the mortgagee usually makes a "credit" bid in the amount of the remaining debt.
Mortgagee Becomes the Owner if It Makes Highest Bid
The amount of the highest bid at the foreclosure sale is deducted from the amount owed by the owner on the debt. When the mortgagee buys the property at the sale there is no actual exchange of cash; the payment is by credit given for the bid. It is purely a ledger entry. The former property owner will still owe any remaining debt to the former mortgagee.
Mortgage Security Interest in the Property Is Extinguished
The highest bidder at the foreclosure sale becomes the new owner. If the mortgagee is the highest bidder, it becomes the new owner. However, it is no longer a mortgagee, because the mortgage debt has been satisfied by the bid at the foreclosure sale. The Substitute Trustee deeds the property to the former mortgagee.
"Insurable Interest" Lost Upon Payment of the Mortgage Debt
The only insurable interest a mortgagee has in the policy is the "mortgage" interest. When the foreclosure sale occurs, the amount of the property loan is reduced by the amount of the bid. If the amount of the bid at the foreclosure sale is equal to or greater than the amount of the amount remaining on the loan note, the debt is paid, and the mortgagee's mortgage interest is, thereby, extinguished. Extinguishing the mortgagee's security interest in the property also extinguishes its insurable interest. Campagana v. Underwriter's Lloyds, 549 S.W.2d 17 (Tex. App. - Dallas 1977, writ ref d n.r.e.). Helmer v. Texas Farmer's Insurance Co., 632 S.W.2d 194 (Tex. App. - Fort Worth 1982, no writ); Peacock Hospitality v. Association Casualty, Inc. v. Association Cas. Ins. Co., 419 S.W.3d 649 (Tex. App.- San Antonio, n. pet. h. ); Ennis State Bank v. United States Liability Ins. Co., 2016 WL 560367 (N.D. Tex. 2016).
Loss Before Foreclosure vs. Loss After Foreclosure
The key question to begin any claim inquiry on a foreclosed property is whether the loss is pre or post foreclosure.
Loss Before Foreclosure
As noted, when an insured dwelling is damaged by a loss at some point in time before the mortgagee forecloses, and the mortgagee forecloses on the property, the mortgagee's "insurable interest" in the property is reduced by the amount bid at the foreclosure sale. If the amount of the bid is equal to or greater than the amount of the promissory note, the mortgagee's security interest in the insured property is extinguished. And, therefore, the Mortgagee as owner is barred from recovering on a loss which occurred while it was the Mortgagee.
To illustrate, assume a dwelling is insured for $100,000.00, and the value of the dwelling plus the lot is $110,000.00. The Mortgage on the property is $50,000.00. The Owner is behind in his payments. On April l, the home suffers a hail loss of $10,000.00. On April 15, the Mortgagee conducts a foreclosure sale. The Mortgagee makes the largest bid of $50,001.00 The Mortgagee becomes owner of the home when the Trustee gives it the deed as the result of the sale. The Mortgagee then inspects the property and discovers the hail damage. The Mortgagee demands payment from The Insurer of $10,000 to fix the roof under the mortgagee clause.
However, the Mortgagee should receive nothing. The Mortgagee's interest of $50,000.00 in the property was extinguished at the time of the foreclosure. With no insurable interest, Mortgagee cannot recover.
Where the Mortgagee loses its insurable interest because of a foreclosure after a loss, as in the example, who should receive the $10,000? There is no Texas authority addressing this scenario, but based on the above referenced rules, it would have to be the former owner. In most cases the insured should receive all or part of the proceeds, because, under Texas law, a mortgagor is entitled to any excess funds remaining after the foreclosure sale. Therefore, it follows that the insured/mortgagor would be entitled to the casualty proceeds. The insurance company cannot simply be able to retain the funds for its own benefit in the case of a valid claim. For practical reasons however, it would appear that the mortgagor rarely makes a claim for the proceeds.
Loss After Foreclosure
Insurable Interest: Delta Lloyds v. Southwest Savings
As far as who get the proceeds of a loss following foreclosure, there is no specific holding on this issue in Texas. Some courts imply a post foreclosure loss should still not be covered since the mortgagee's insurable interest is extinguished at the foreclosure sale. The only Texas court that has explicitly considered loss after foreclosure is Delta Lloyds Insurance v. Southwest Savings Association, 559 S.W.2d 372 (Tex. App.- Dallas, 1977, writ refused n.r.e.)[1]. Delta held that when a mortgagee forecloses on property prior to a loss, AND also is the highest bidder on the property at the foreclosure sale, the mortgagee steps into the shoes of the insured and, in essence, becomes an "insured" (to the limited extent of its interest in the property), until the end of the original policy period.
This would make sense: if the Mortgagee is a named insured prior to the foreclosure, and continues to pay the premium which is accepted by the Insurer, it is going to have some status under the pre- foreclosure policy. Further, the phrase “as its interests appear” allows some flexibility as to the status of the Mortgagee. Accordingly, when a foreclosure occurs before the loss, it would appear that the Mortgagee is entitled to the policy proceeds, assuming that it complies with the rest of the terms and conditions of the policy.
Split Interests Between Owner and the Mortgagee?
For example, say there is a $100,000.00 mortgage, and for whatever reason, the Mortgagee bids out its interest at $50,000.00. The property then suffers a $25,000.00 loss. Based on the above referenced principles, the mortgage company is entitled to first dollar, meaning that it is entitled to all of the loss proceeds.
What if the Mortgagee is a Stranger to the Policy? Equitable Lien
In rare occasions, usually in an owner finance situation or when a mistake is made by the mortgage company, the Mortgagee will not be listed on the policy. Even if there is no payment provision, once again, the Mortgagee is generally entitled to the first proceeds in the event the property is not repaired. This is referred to as an “equitable lien” on proceeds. In the same way that the insurable interest arises by operation of law, the right to proceeds can also arise by operation of law.
In our final installment to appear in the Firm’s next newsletter, we will address basic relevant information in a claim which involves a foreclosure.
[1] “Writ ref. n.r.e.” is a notation of case history used prior to 1997. It means that the judgment of the intermediate court of appeals is correct but the Texas Supreme Court is not satisfied that the opinion in all respects has correctly declared the law.