Title Insurance May Not Save Secured Lenders From Priming Mechanic’s Liens

Real estate development projects sometimes go awry. Unanticipated issues and overruns can push development costs over the projected value of the project, leaving lenders to decide whether to continue funding construction. A recent decision from the U.S. Court of Appeals for the Seventh Circuit highlights the risks lenders face in deciding when to pull the plug on a failing real estate development project.

In BB Syndication Services Inc. v. First American Title Insurance Company, No. 13-2785, 2015 U.S. App. LEXIS 3956 (7th Cir. March 12, 2015), a secured lender exercised its right to cease funding after it had previously advanced $61 million on a mixed-use development project in Kansas City, Missouri. When funding ceased, unpaid suppliers and subcontractors filed mechanic's liens against the property, and under applicable state law, those mechanic's liens primed the secured lender's preexisting liens. The developer filed bankruptcy and its assets were liquidated, and the secured lender ultimately recovered only $150,000 of its $61 million in advances after satisfaction of the mechanic's liens.

Some lenders seek to address mechanic's lien risks by designating the title insurer as the disbursement agent, so when a draw request is made, the title company can verify subcontractors are paid, obtain lien waivers and update (or "date down") the title policy. In BB Syndication Services, given that the title company served as disbursing agent, the secured lender demanded coverage for the mechanic's lien obligations. As the ensuing Seventh Circuit decision shows, however, even careful lenders that obtain frequent title updates may not be protected from subsequently recorded mechanic's liens.

Title policies typically contain an exclusion for liens that are "created, suffered...