Construction Loans And Title Policies In The Seventh Circuit

Construction lenders almost always obtain title insurance policies to protect the property under construction from being encumbered by the mechanics' liens of unpaid contractors and materialmen. In some states, such as Missouri, mechanics' liens are given statutory priority over the previously recorded mortgages of construction lenders. Consequently, the title policies become important to ensure that the lender's loan is fully protected, especially during construction when the value of the project may be less, sometimes far less, than the loan funds advanced.

A standard title policy insures a construction lender against any losses incurred by reason of any statutory lien for services, labor or materials having priority over the lender's mortgage for improvement or work related to the land contracted for or commenced prior to the date of the policy. During the construction period, the title company frequently issues "date down endorsements," which update coverage through the date of the endorsement. A typical title policy will also have standard exclusions, including excluding coverage for liens that are "created, suffered, assumed or agreed to" by the insured lender.

When a project is plagued with unanticipated cost overruns or other problems which precipitate a default under the construction loan agreement, the construction lender is faced with a Hobson's choice: Does it stop advancing the construction loan at a time when the value of the project may be worth significantly less than the outstanding loan? This will likely cause the claims of contractors and materialmen for the work unpaid at the time of default to ripen into senior mechanics' liens and the lender to claim coverage under the title policy. Instead, does the lender engage in a work-out of the project and keep lending in the hopes that it can be successfully completed? In BB Syndication Services, Inc. v. First American Title Insurance Co., No. 13-2785, 2015 WL 1064156 (7th Cir. March 12, 2015) the Seventh Circuit Court of Appeals addressed this dilemma, analyzing a lender's claim of coverage under the provisions of a typical title insurance policy in the context of a failed project.

THE PROJECT

Trilogy Development Company, a real estate developer ("Trilogy"), contracted with J.E.Dunn Construction Company ("Dunn") to build a mixed-use commercial building in Kansas City Missouri's fashionable West Edge. The initial estimated cost of the project was $118 million. The project was to be funded by a $32 million equity investment by Trilogy and an $86 million construction loan made by BB Syndication Services, Inc., a Wisconsin lender ("BB"). BB obtained a title insurance policy containing the standard provision regarding the scope of coverage and the exclusion described above from First American Title Insurance Company ("First American"), and contracted with First American to be the disbursing agent.

The project was begun before construction designs were finalized and there were early indications that the project costs would exceed the initial estimates. Dunn claimed that design changes would increase the project costs by $20 million to $30 million, making the construction loan out of balance and potentially in default. At this point, BB had disbursed only $5 million of its $86...