Mortgagee clause claims in the subprime fallout.

• Author: Gerber, Daniel W.

THE SUB-PRIME lending fallout has had a ripple effect on the financial markets. A key result has been homeowners abandoning their homes and the resulting increase in foreclosure proceedings. Increased foreclosures have forced many more lenders to pursue their rights under homeowners policies as the mortgagor is no longer around or concerned in pursuing a claim for loss. While mortgagee clauses in property insurance policies issued to mortgagors are intended to protect the interest of the mortgagee, the mortgagee's interests, rights and obligations vary from those of the mortgagor. This article examines some of the basic issues presented by mortgagee claims under "standard" mortgagee clauses contained in first-party property insurance policies.

1. Mortgagee Clauses

   First-party property insurance policies issued to mortgagors usually contain one of two types of mortgagee clauses: 1) a "standard" mortgagee clause or 2) a loss-payable clause. Under the standard mortgagee clause (also known as a "union" mortgagee clause), a mortgagee is entitled to direct payment for a loss to the extent of its interest at the time of the loss, independent of whether the named insured mortgagor complied with its policy obligations. (1) Once the mortgagee has been paid for a loss to the extent of its full interest in the property, the mortgagor is entitled to payment for the remainder of the amount of loss, if any. In contrast, a loss-payable clause merely provides that insurance proceeds shall be paid to a mortgagee as "its interests may appear." Under a loss-payable clause, a mortgagee's right to recovery is dependent upon the insured mortgagor's compliance with policy obligations. (2)

   Traditionally, the standard mortgagee clause is intended to protect a mortgagee from an insurer's indiscriminate avoidance of a policy based upon the acts or neglects of the insured mortgagor or anyone other than the mortgagee or its agents. (3) The standard clause has become widely used since the 1940's, and is statutorily required by many states in fire and flood policies procured by a mortgagor pursuant to an obligation in a mortgage requiring the mortgagor to 1) insure the buildings against loss for the benefit of the mortgagee and 2) assign and deliver the policy to the mortgagee. (4) The standard mortgagee clause often contains the following (or similar) language:

   If a mortgagee is named in the Declarations, loss or damage, if any, on buildings under this policy, shall be payable to the aforesaid as mortgagee (or trustee) as interest may appear, and this insurance, as to the interest of the mortgagee (or trustee) only therein, shall not be invalidated by any act or neglect of the mortgagor or owner of the within described property, nor by any foreclosure or other proceedings or notice of sale relating to the property (emphasis added). (5) II. Rights and Obligations of Mortgagee under Standard Mortgagee Clause

   The majority of courts have held that the incorporation of the standard mortgagee clause into a mortgagor's property insurance policy creates a separate contract of insurance between the insurer and the mortgagee. (6) The notion that a standard mortgagee clause creates a separate contract between the insurer and the mortgagee means that the mortgagee has certain rights and obligations under the insurance contract issued to the mortgagor.

   As a general rule, it has been held that

   ... all the provisions in the policy, which from their nature would properly apply to the case of an insurance of the mortgagee's interest, would be regarded as forming part of the contract with him, while those provisions which antagonize or impair the force of the particular and specific provisions contained in the clause providing for the insurance of the mortgagee, must be regarded as ineffective and inapplicable to the case of the mortgagee. (7) The mortgagee has the following rights under a standard mortgagee clause.

   * The right to direct payment of a loss to the extent of its lien at the time of the loss, even without the consent of the mortgagor. (8)

   * The right to payment of a loss even where certain acts or neglects of the named insured mortgagor void coverage for the mortgagor.

   * The post-loss right to participate in appraisal proceedings which will determine the amount due to the mortgagee. (9)

   * The express right to notice of cancellation. (10)

   By the express terms of the standard mortgagee clause, a mortgagee's rights are unaffected by a mortgagor's acts or neglects. Thus, the mortgagee's rights are unaffected by the mortgagor's failure to file adequate proof of loss. (11) As a practical matter, this means that a mortgagee will be entitled to insurance payments for a loss, if the mortgagee files proof of loss with the insurer after receiving notice that the named insured property owner has failed to do so.

   Also, an insurer may not seek to avoid payment to a mortgagee based on the insured mortgagor's breach of the insurance contract through fraud or arson. (12) For example, if a fire causes property damage to a home and its contents, and it is determined that the insured homeowner conspired to burn his or her home in order to receive insurance proceeds, the insured homeowner would not be entitled to recover; but, the insured holder of the mortgage on the property would be entitled to insurance payments for the loss.

   The issue of whether a mortgagee is protected where an insurance policy is deemed void at its inception due to the acts or neglects of the mortgagor in procuring the policy, however, has not been unanimously resolved by the various states. Most courts have held that fraudulent misrepresentations in the application for insurance do not void coverage for the mortgagee. (13) However, in an early New York state case, Young Men's Lyceum of Tarrtown v. Nat'l Ben Franklin Ins. Co. of Pittsburgh, P.A., the court held that the insured mortgagor's misrepresentation as to the location of the insured property precluded coverage for both the mortgagor and the mortgagee. (14) Young Men's Lyceum of Tanytown determined that the insurer's acceptance of the risk depended upon the distance of the insured property from a water hydrant, and, therefore, the insured mortgagor's misrepresentation as to the location of the property rendered the policy void. (15)

   Although generally a mortgagor's acts or neglects will not void coverage as to a mortgagee, a mortgagee's default on its separate contractual obligations may void coverage for the mortgagee. (16) An issue often arises as to whether a particular contractual provision imposes a duty or obligation upon the mortgagee, or solely upon the mortgagor. The New York Court of Appeals addressed this issue in U.S. Fid. & Guar. Co. v. Annunziata. (17) In that case, a mortgagee sought payment for a loss under a fire insurance policy containing the standard mortgagee clause, which provided as follows.

   If a mortgagee is named in the Declarations, loss or damage, if any, on buildings under this policy, shall be payable to the aforesaid as mortgagee (or trustee) as interest may appear, and this insurance, as to the interest of the mortgagee (or trustee) only therein, shall not be invalidated by any act or neglect of the mortgagor or owner of the within described property, nor by any foreclosure or other proceedings' or notice of sale relating to the property, nor by any change in the title or ownership of the property, nor by the occupation of the premises for purposes more hazardous than are permitted by this policy, provided, that in case the mortgagor or owner shall neglect to pay any premium due under this policy, the mortgagee (or trustee) shall, on demand, pay the same. (18) After a fire occurred at the insured premises, the property owner and the mortgagee provided proofs of loss to the insurer. The property owner submitted to an oral examination under oath, pursuant to a provision in the insurance policy which provided that "The insured, as often as may be reasonably required, shall ... submit to examinations under oath at such reasonable time and place as may be designated by this Company." Thereafter, the insurer sought an examination of the mortgagee. Upon the mortgagee's refusal, the insurer commenced an action against the mortgagor and the mortgagee seeking a declaration that the mortgagee's failure to submit to an examination voided coverage. New York's highest court determined that the policy did not require the mortgagee to submit to an examination under oath. In reaching its decision, the court looked to the general rule of insurance policy construction, namely that clear and unambiguous policy provisions must be given their plain and ordinary meaning. Turning to the particular policy language in question, the court noted that the policy's declarations pages listed the mortgagor as the "Insured" and the mortgagee as the "First Mortgagee." Therefore, the provision requiring the "insured" to submit to an oral examination, was found to be clearly directed to the mortgagor, and not the mortgagee. The court noted that other portions of the policy at issue specifically referenced the mortgagee when imposing obligations upon the mortgagee. The court stated, "While a policy may be construed liberally for the purpose of protecting the interests of the insured mortgagee, it may not be rewritten against the interests of the mortgagee by imposing an obligation which the policy omits." (19)

   Thus, any questions as to which contractual obligations are separately imposed upon a mortgagee will be resolved by an examination of the particular language of the insurance policy at issue. (20) If an insurer wishes to impose a particular obligation upon a mortgagee, it should do so in express language referencing the mortgagee.

3. Changes in Ownership, Occupancy and Risk

   Most policies require the mortgagee to notify the insurer of any change in ownership, occupancy, or substantial risk of which the mortgagee is aware...