On March 12, 2015, in BB Syndication Services v. First American Title Insurance Co., the US Court of Appeals for the Seventh Circuit held that when a construction lender stops funding because of cost overruns, it is responsible for any ensuing mechanics' liens and it cannot shift that loss to its title insurer (No. 13-2785 (7th Cir. Mar. 12, 2015)).

Trilogy Development Company, a real estate developer, contracted with J.E. Dunn Construction Company for the construction of a mixed-use commercial development in Kansas City, Missouri. The initial estimated cost was $118 million. Funding for the project came from a $32 million equity investment by Trilogy and an $86 million dollar construction loan from BB Syndication Services, a Wisconsin-based loan syndicator. BB Syndication Services obtained title insurance from First American Title Insurance Company to ensure the first priority of the mortgage lien securing the loan.

A year into construction, Dunn projected that changes made to the building plans would increase the cost of construction by $10 million. BB Syndication had already dispersed $5 million. While the construction loan agreement gave BB Syndication the right to stop disbursing loan funds if revised cost estimates exceeded the amount of funding initially arranged for the project, BB Syndication chose to continue making loan disbursements.

One year later, Trilogy stopped paying Dunn the proceeds of the loan disbursements. Dunn, along with multiple sub-contractors, stopped all work and filed mechanics' liens against the project. BB Syndication, which had disbursed $61 million total by that point, exercised its right to further disbursements and declared the loan in default. Trilogy filed for bankruptcy when BB Syndication called for repayment.

The bankruptcy court allowed $17 million in mechanics' liens with priority over BB Syndication's mortgage lien. BB Syndication looked to its insurer for defense against the mechanics' lienors' assertions of priority and indemnification for losses by those liens that were found to be prior. First American rejected BB Syndication's claim on the basis of Exclusion 3(a). Exclusion 3(a) is a provision found in standard form title insurance policies that excludes coverage for liens "created, suffered, assumed or agreed to" by the insured lender. First American claimed BB Syndication created the liens by cutting off the loan disbursements.

BB Syndication sued First American, alleging breach of title policy and bad faith denial of coverage. The district court held that First American violated its duty to defend BB Syndication, but it had no duty to indemnify because Exclusion 3(a) excluded coverage of the disputed liens. BB Syndication appealed.

The Seventh Circuit Court of Appeals affirmed the district court's decision, holding that First American properly denied coverage. Citing precedent from the Eighth and Tenth Circuits, the court found that when a construction lender cuts off disbursements in the case of cost overruns, it "creates" liens that arise from work left unpaid due to insufficient funds. This creation of liens triggers the application of Exclusion 3(a).

The court explained that the risk of loss associated with mechanics' liens should fall on construction lenders, rather than title insurers, because the lenders have a greater ability to ensure that the projects they finance remain economically viable. For example, as a condition to closing, BB Syndication required Trilogy to submit various documents to allow it to assess the project's viability before closing the loan, including:

The loan agreement also allowed BB Syndication to monitor the project throughout construction to ensure its continued viability. The agreement provided that BB Syndication could request financial reports from Trilogy and conduct monthly on-site inspections of the project.

The court also held that BB Syndication could not look to First American to cushion its losses because that would raise a question of moral hazard. By allowing the construction to continue well past the point when it knew the loan was out of balance, BB Syndication wagered that the value of the property would grow and be worth enough to pay back BB Syndication's loan at foreclosure. Allowing for coverage where the insured lender has the sole discretion to continue or cease funding a failing project would allow the lender to retain the potential benefit of this bet while shifting all the potential loss to the title insurer. Such a finding would create a windfall for the lender and create a larger risk than title insurance is meant to bear. The court found that it was precisely this situation that Exception 3(a) was designed to prevent.

This decision makes clear that construction lenders cannot rely on their title insurers to cover mechanics' liens that arise as a result of the lender's decision to stop loan disbursements. Construction lenders should take measures to reduce the likelihood of default by the borrower, such as using a third-party guarantee. Most importantly, construction lenders should: