Trilogy development company (“trilogy”), a real estate development company, contracted with j.e. dunn construction company (“dunn”), a general contractor, for the construction of a mixed‑use commercial development in kansas city, missouri (the “project”). The initial estimated cost of the project was $118 million and it was to be funded by (i) a $32 million equity investment in the form of land and cash from trilogy and (ii) a construction loan in a maximum aggregate principal amount of $86 million (the “loan”) from bb syndication services, inc., a wisconsin‑based loan syndicator (“bb syndication”; together with trilogy, the “parties”). The loan was secured by the project and bb syndication obtained a lender’s title insurance policy (the “lender’s policy”) from first american title insurance company (“first american”) with respect thereto. Pursuant to the loan agreement between the parties (the “loan agreement”), (i) the parties designated first american as the disbursing agent for the loan agreement and (ii) bb syndication retained the right to cease making disbursements with respect to the loan in the event that the estimated cost to complete the project exceeded the committed loan amount plus the equity investment (i.e., the loan became “out of balance”). Shortly after construction began, dunn indicated that trilogy’s changes to the project increased the cost of construction by $20 to $30 million, knocking the loan out of balance and giving bb syndication the right to cease disbursing funds. At the time these overruns were discovered only $5 million of the $86 million loan had been disbursed. About a year later, trilogy had failed to pay dunn from the proceeds of a loan disbursement. Dunn subsequently stopped all construction, and multiple subcontractors filed mechanics’ liens against the project. When bb syndication cut off funding, declared the loan in default, and called for repayment, trilogy filed for bankruptcy protection. At the time the project failed, bb syndication had disbursed more than $61 million. During the bankruptcy proceedings, trilogy initiated an adversary proceeding to determine the amount and priority of its liens and creditors. In addition to the various subcontractor liens, dunn filed for a $12 million lien for its unpaid work. As many of the liens were for work performed with respect to the project before first american’s most recent update to the lender’s policy, bb syndication sought defense and indemnification from first american. Relying on the standard exclusion 3(a) of a title insurance policy, which exclusion excludes title coverage for liens that are “created, suffered, assumed or agreed to” by the insured lender (bb syndication), first american rejected the tender claiming that bb syndication created the liens at issue by cutting off the funding of the loan.
The court allowed $17 million in mechanics’ liens, all of which had priority over bb syndication’s security interest. A judicial auction of the unfinished project yielded only $10 million. All of the creditors ultimately settled thereby leaving bb syndication to receive only $150,000 on its $61 million claim. In the midst of the bankruptcy proceedings, bb syndication sued first american in wisconsin state court alleging breach of the lender’s policy and bad‑faith denial of coverage. First american removed the case to federal court. The district court delayed the proceedings until the relevant factual issues were determined by the bankruptcy court and then resolved the case on cross‑motions for summary judgment. In a split ruling, the court held that first american violated its duty to defend bb syndication, but found that first american had no duty to indemnify based on the language in exclusion 3(a), thereby negating the bad‑faith claim. Bb syndication appealed, challenging the applicability of exclusion 3(a) and seeking to revive its bad‑faith claim if the no‑coverage determination were to be reversed. At issue on appeal was whether bb syndication created mechanics’ liens by cutting off funding of the loan when the project eventually collapsed.
Examining the facts of the case at hand, the seventh circuit court of appeals (the “court”) first turned to exclusion 3(a) of the lender’s policy. Applying wisconsin law, the court noted that exclusion 3(a) encompasses a fault requirement and applies only to intentional misconduct or otherwise inequitable dealings by the insured. Addressing bb’s syndication contention that it could not be at fault because it had a contractual right to stop disbursing the funds if the loan became out of balance, the court noted that the loan agreement governed the relationship between bb syndication and trilogy and did not govern the rights and duties between bb syndication and first american. Citing cases from the 8th and 10th circuits, the court noted that several courts have adopted the position that a construction lender “creates” or “suffers” any liens that arise from insufficient funds after the construction lender has cut off funding even if the construction lender retains the contractual right to do so. The court further went on to state that insufficient construction funding is not the type of risk that title insurance policies contemplate. In reaching this position, the court noted that bb syndication, as with most construction lenders, maintained significant oversight over the project. In this instance, the court noted that the loan agreement, among other things, (i) allowed bb syndication to request financial reports from trilogy and conduct monthly on‑site inspections and (ii) granted bb syndication the right, at any point the loan became out of balance, to require trilogy to supply a cash infusion or to continue to fund. In light of this oversight, the court determined that bb syndication had the ability to investigate and monitor the project’s economic viability and could not turn to first american to cushion its losses, as that stretched title insurance too far. In the court’s view, finding coverage in this situation where bb syndication continued to fund a failing project would create a moral hazard and shift the entire business risk to first american. Accordingly, the court held in favor of first american, finding that the “liens at issue arose from insufficient project funds, a risk of loss that bb syndication — not first american — had the authority and responsibility to discover, monitor, and prevent” and therefore, bb syndication’s failure to do so can be said to have “created” the resulting liens. Consequently, the court held that the exclusion 3(a) applies and the mechanics’ liens at issue were excluded from coverage under the lender’s policy. Bb syndication services, inc. V. First american title insurance company, 780 f.3d 825 (7th cir. 2015).
