Clarification or change?
THE AMERICAN Land Title Association (ALTA) has issued its 1990 forms of title insurance policies. These policies contain a "creditors' rights exclusion" (the exclusion) that the industry claims merely clarifies the coverage under the existing ALTA policies. Many of the industry's customers, however, fear that the exclusion makes major changes in the scope of title insurance coverage available to mortgage lenders and property owners.
The "New York" endorsement
The 1990 ALTA policies with the exclusion have been approved for use in Maryland, West Virginia and Texas. However, in response to the strong objections of the Mortgage Bankers Association of New York, Inc. and the Savings Banks Association of New York State, Inc., the New York State Insurance Department by a memorandum decision and opinion dated November 19, 1991, has required that all 1990 ALTA policies issued in New York contain an endorsement that limits the scope of the exclusion to those areas that are typically not title insurance risks: fraudulent transfers, equitable subordination and true preferences. At the request of the department, the lender associations and the New York State Land Title Association (NYSLTA) negotiated and agreed on this "New York" endorsement that clarifies and limits the scope of the exclusion. The New York endorsement should be an acceptable compromise between the insurance coverage required by the lending industry and the desire of the title insurance industry to control its risk exposure in the event of a borrower's bankruptcy. The New York endorsement reads as follows:
Paragraph number seven of the exclusions from coverage is deleted and the following paragraph is substituted therefore:
Any claim, which arises out of the transaction creating the interest of the mortgagee insured by this policy, by reason of the operation of federal bankruptcy, state insolvency or similar creditors' rights laws, that is based on: (1) the transaction creating the interest of the insured mortgagee being deemed a fraudulent conveyance or fraudulent transfer; (2) the subordination of the interest of the insured mortgagee as a result of the application of the doctrine of equitable subordination; or (3) the transaction creating the interest of the insured mortgagee being deemed a preferential transfer, except where the preferential transfer results from the failure: (i) to timely record the instrument of transfer; or (ii) the failure of such recordation to impart notice to a purchaser for value or a judgment or lien creditor.
Clause three is included because of the title industry's concerns with the issuance of policies in connection with the workout of a defaulted loan; NYSLTA agreed that the instructions to the title companies in connection with the issuance of the endorsement will provide that clause three should be deleted in a policy insuring a new loan or a modification of an existing loan that is not in default. The New York endorsement for an owner's policy is similar, but does not include clause two because it is inapplicable.
The Texas bar has also submitted the "New York" endorsement to the Texas Board of Insurance, and has requested that it be adopted as part of the approved Texas policy form in lieu of the exclusion.
The background of the exclusion
ALTA proposed the original exclusion as a response to its members' concerns about possible title company liability arising from fraudulent transfer determinations or equitable subordination by the bankruptcy court, particularly in the context of a leveraged buyout. These are legitimate concerns and, absent a specific agreement and understanding with a proposed insured, the title insurance industry should not be in the business of insuring against the risk of future bankruptcy of any of the parties to a real estate transaction. These risks, however, are narrow and are limited to questions of fraudulent conveyance and equitable subordination. "Risks based on the accuracy of property valuation, the adequacy of consideration and a determination of solvency should probably be left to others than the title insurers." (Pedowitz, Title Industry Faces Rights of Creditors, N.Y.L.J., March 15, 1989 at 31, col. 3.) Similarly, title insurers (unless they choose to do so in a particular transaction by an endorsement) are not the appropriate party to investigate and insure that the lender did not engage in "inequitable conduct" harmful to other creditors of the borrower. Issues of a lender's fraud, overreaching or excessive control or influence over the affairs of the borrower that may result in a lender's mortgage lien being equitably subordinated under 510(c) of the Bankruptcy Code in the event of the borrower's bankruptcy are not typically considered title issues. (11 U.S.C. 101 et. seq., 510(c) Bankruptcy Code.)
In the 1987 ALTA policy forms (or the appropriate state-approved alternatives) fraudulent conveyance risks are addressed by title insurers on an ad hoc basis in particular high-risk transactions by means of an exception added to Schedule B of the title insurance policy. An example of such a creditors' rights exception is as follows:
Any loss or damage on account of the fact that under either the federal Bankruptcy Code or similar state insolvency or creditors' rights laws, the insured mortgage is attacked on the ground that such mortgage was a fraudulent conveyance or on the ground that the claim or lien of such mortgage should be subordinated to other claims or interests.
Title insurers desired this exception to be incorporated into the policy form rather than leaving it to the vagaries of particular transactions. However, as one draft of the exclusion followed another, the exclusion grew in scope until it went far beyond what it was intended to cover. As adopted by ALTA, it reads:
Any claim, which arises out of the transaction creating the interest of the mortgagee insured by this policy, by reason of the operation of federal bankruptcy, state insolvency or similar creditors' rights laws.
The language of the exclusion raises three broad areas of concern that affect insured lenders: (i) the risk that the granting of a mortgage will be deemed a preference because of recording delays, (ii) the risk of a mortgage being set aside by a trustee in bankruptcy for "routine" title defects normally covered by title insurance, and (iii) the risk that the exclusion eviscerates the insurance coverage even in non-bankruptcy contexts. These concerns are not unique to lenders. Similar if not identical problems are caused by the exclusion for real property owners, and the concerns are equally applicable to single-family residential property and commercial income-producing property.
The preference risk
Perhaps the clearest example of the overbreadth of the exclusion arises from delays in recording the mortgage and other security documents. Under 547 of the Bankruptcy Code, a trustee may avoid a transfer of the property of the debtor's estate if (1) it was made to or for the benefit of a creditor; (2) it was on account of an antecedent debt; (3) it was made while the debtor was insolvent (a debtor is presumed to be insolvent within 90 days preceding the bankruptcy); (4) it was made on or within 90 days before the filing of the petition for bankruptcy (or one year if the creditor is an insider); and (5) the creditor would receive more than it would in a Chapter 7 liquidation proceeding if the transfer had not been made. A transfer is deemed "made" at the time it takes effect between the transferor and transferee if it has been perfected within 10 days of such time; otherwise it is deemed made when perfected. (11 U.S.C. 547(e)(2)(A)) A "transfer" is deemed perfected for purposes of 547 when it has been perfected under state law so that a bona fide purchaser from the debtor cannot acquire a superior interest.
Thus if a mortgage loan is made but the mortgage is not recorded until after 10 days from the mortgage closing, the transfer will be deemed to take place on the date of recording. It is then in consideration for an antecedent debt (incurred more than 10 days before the perfection of the mortgage) and would be an unlawful preference in the borrower's bankruptcy if the other elements of a preference were proved.
In a New York-style closing, the title company is responsible for the recording of the documents. If the title company delays or if there are delays at the recording office, there is an opening for attacking the mortgage as an unlawful preference. If it should be determined that the mortgage is an unlawful preference because of the title company's failure to record promptly, a court could determine, however incorrectly, that the title company is not liable because the language of the exclusion covers claims arising "by reason of federal bankruptcy...laws."
As a result, lenders may be reluctant to conduct a New York-style closing and risk such an "inadvertent" preference if it were subject to the exclusion. The title insurance policy is a contract of indemnity: it does not contain any contractual agreement by the insurer to record the mortgage and the other loan documents at all, much less within 10 days of closing. Under the insurance contract the insurer only has to indemnify the insured in the event of a loss because of a failure to record. (See, Cruz v. Commonwealth Land Title Ins, Co., 556 N.Y.S. 2d 270--1st Dept. 1990.) A policy containing the exclusion would relieve the insurer from even the obligation to indemnify because the contract by its terms would not cover the risk of a preference.
Some title insurers have taken the position that Cruz provides a lender with protection against this risk because a title insurer cannot defend against a claim resulting from its own negligence in recording. Reliance on Cruz for protection is inappropriate. A finding of negligence in recording requires that there be a duty to record; however, the issue of a title insurer's duty to record was not litigated in Cruz: the court assumed the duty existed because the insurer conceded at trial that it was the customary practice of the title insurance industry. In litigation regarding a preference in bankruptcy, it is unlikely that the insurer would repeat such an admission, and the burden of proof would be on the insured to prove the existence of a duty to record within 10 days. The burden may be heavy, because the title insurance contract doe not require the insurer to record.
More important, the failure to record within the 10-day grace period may not be due to the insurer's negligence at all (e.g., it may be due to delays or errors in the recorder's office), in which case the lender would have no recourse against the insurer on any theory. In either event, the insured would have to defend the preference charge at its own expense and, only if it lost, sue the insurer in tort for damages: a much more expensive, time-consuming and inefficient method than making a claim under a title insurance policy.
Interestingly, although the title industry claims that the exclusion only "clarifies" existing coverage and does not change it, the risk of a "true" preference is already excluded from coverage under exclusion 3(e) in the 1987 and 1990 ALTA policies. Exclusion 3(e) excludes from coverage any loss resulting from the lender's failure to pay value for the insured mortgage. The law of New York and the majority of jurisdictions that have addressed the issue is that a transfer on account of an antecedent debt is not valuable consideration: "|a~ pre-existing debt is not valuable consideration within the meaning of the recording act." (Groves v. George, 123 N.Y.S. 2d 192, 194 |Sup. Ct. 1953~; accord, Ten Eyck v. Witbeck, 135 N.Y. 40 |1892~); see also Colletti, A Title Insurer Looks at the Avoidance Provisions of the Bankruptcy Reform Act of 1978, 15 Real Prop., Prob. & Trust J. 588, 602 |1980~; Collier, Real Estate Transactions and the Bankruptcy Code 5.03(6).) Exclusion 3(e) is not in the pre-1987 ALTA forms and was commonly known as the "accommodation party" exception and added to Schedule B of a policy insuring a collateral mortgage or a mortgage securing a guaranty or existing debt. As discussed, however, the proposed exclusion goes much further and excludes the risk of an "inadvertent" preference due to delays or errors in recording or in the execution of the mortgage, although the lender has given full value for the mortgage.
Faced with the exclusion, lenders will have two alternatives. The first would be to abandon the New York-style closing and gap coverage and adopt the California-style escrow closing. This type of closing requires the executed documents and the loan proceeds to be deposited in escrow with the title insurer or other escrow agent and the escrow agent, on recording, to disburse the funds. This arrangement is expensive and time-consuming, particularly when there are recording delays of six to eight weeks, as are common in the New York metropolitan area. There are fees to be paid to the escrow agent and increased legal costs in preparing and setting up the escrow. Although a lender may be willing in a straight refinancing to wait until the documents have been recorded before funding, a seller probably would be unwilling to let his or her deed be recorded before the loan was funded into escrow. The interest costs incurred during the escrow period will have to be paid by the borrower, even though the borrower cannot use the money, because the lender has advanced the money to the escrow agent and will be charging interest on it at the loan rate. Interest earned on the escrow account may or may not equal the interest accruing on the loan. There are also additional risks to be considered, such as the risk of insolvency or bankruptcy of the escrow agent or the other parties to the transaction before the funds have been released, which may increase the transaction costs ultimately paid by the borrower.
The lender's second choice would be to require every title insurer to affirmatively insure that it will record the mortgage and the other loan documents in the appropriate recording offices and indices within 10 days of the closing. Most title insurers are reluctant to agree to such a contractual obligation, in part because of their lack of control once the documents have been delivered to the recording office, and in part because the documents may be rejected for various reasons, such as improper acknowledgements.
Neither of these alternatives will solve the preference problem completely. Even if the mortgage were recorded within the 10-day grace period permitted under the Bankruptcy Code, the transfer still may not be perfected under state law against bona fide purchasers from the debtor. For example, the mortgage may not be perfected under state law against a bona fide purchaser if the signatures on the loan documents were not properly acknowledged; the documents were improperly delivered or executed; the person or entity executing the loan documents on behalf of the borrower was improperly authorized; the description of the collateral was incorrect, or the mortgage was indexed against the wrong name or the wrong parcel, (N.Y. Real Prop. Law 290 et seq.) Any attempt to cure these title defects in order to avoid the risk that, in the event of the borrower's bankruptcy, the trustee could avoid the mortgage under 544 of the Bankruptcy Code would be unavailing, because the act of correcting and perfecting the mortgage interest could be deemed a "transfer" on account of an antecedent debt and could be voidable as a preference.
Routine title defects: The trustee as bona fide purchaser and lien creditor
The exclusion puts the lender in an untenable position: it would not only risk being an unsecured creditor because of the trustee's avoidance powers, but it also could not avoid that risk by correcting the loan documents without incurring the additional risk that the correction would be deemed a preference. In either event, the lender would have no protection against these "routine" title defects under its title insurance policy if that policy contained the exclusion.
Under the 1987 ALTA policy the lender is insured against loss or damage resulting from a claim that the mortgage is invalid, unenforceable, or lacks priority over a subsequent lien because of defective acknowledgements of signatures; defects in the borrower's execution or delivery of the mortgage; lack of proper authority for the borrower to execute the mortgage; defects in the description of the collateral, or because the mortgage was recorded against the wrong parcels or in the wrong indices, among other things. Each of these potential "routine" title defects could, under state law, allow a bona fide purchaser or mortgagee for value without notice, a judgment creditor or lienor, or under certain circumstances, a mechanic's lienor, to avoid or take lien priority over all or a part of the lender's mortgage. In each instance the title insurer would have to defend such a claim or make payment under the title insurance policy to the insured, or both. (N.Y. Real Prop. Law 291, N.Y. Lien Law 13.)
A trustee in bankruptcy has the rights of a so-called "hypothetical lien creditor": a bona fide purchaser of real property or a judicial lien creditor, regardless of whether such purchaser or creditor exists. (11 U.S.C. 544|a~). The trustee can also assert the rights of any actual creditors of the borrower. (11 U.S.C. 54|b~). As such, if any of the "routine" title defects listed in the preceding paragraph existed, the trustee could assert its rights as a hypothetical lien creditor and the rights of any actual lien creditors and avoid the lender's mortgage lien, converting the lender into an unsecured creditor. In effect, all of the rights and remedies given to creditors under state real estate security interest laws are exercisable by the trustee.
Under the 1987 ALTA policy, the title insurer would have to defend against such action by the trustee or pay under the policy, or both. However, if the insurance policy contained the exclusion, it appears that the insurer would have no liability to defend or pay any such claim, because such an assertion by the trustee of its status as hypothetical or actual lien creditor "arises out of the transaction creating the |mortgage~ by reason of the operation of federal bankruptcy" law. The lender would, in effect, lose nearly all the protection it had contracted for in the insurance policy. Further, as discussed, the lender cannot even cure such defects before the borrower's bankruptcy without the additional risk that such cure will be deemed a preference.
Although this result may have been unintended by the drafters, it is an unfortunate by-product of the sweeping language used in the exclusion.
The meaning of "similar creditors' rights laws"
The third area of concern with the exclusion is the meaning of "similar creditors' rights laws." The phrase can have a number of interpretations, thus calling into question the entire scope of the exclusion. The phrase may even mean laws that exist and operate to benefit a creditor, even if the borrower is not bankrupt or insolvent under state or federal law.
If the word "similar" means similar in substance or content, the phrase is redundant. If "similar" means similar in operation, (i.e., any state or federal law that would operate to allow a creditor to avoid or take priority over a transfer of an interest in real property, regardless of whether the borrower is bankrupt or insolvent), then the claims of actual lien creditors or bona fide purchasers from the borrower rather than the claims of "hypothetical lien creditors" would be excluded from insurance coverage. Under this construction, all of the usual rights and remedies contained in real estate security interest statutes are "creditors' rights" statutes.
As a result, the exclusion may relieve the title company of liability for the risk that a bona fide purchaser for value without notice will record a deed after the lender has funded, but before the mortgage has been recorded, and take title free and clear of the mortgage, (N.Y. Real Prop. Law 291), or that a holder of an inchoate mechanic's lien in existence at funding and recording may later gain priority over the mortgage because of a missing or incorrect trust fund covenant in the mortgage, (N.Y. Lien Law 13).
Although these risks may appear remote, a reasonable argument can be made that the exclusion does cover the lien law, and if that argument can be made now, it is likely to be made in the future by a title insurer faced with a claim. Because it is an exclusion from coverage, the title insurer can decline to defend the title from attack and refuse to pay any claim. Even though title insurance is arguably a contract of adhesion, the insured will have a burden of proving that "similar creditors' rights laws" do not include the lien law or the recording acts. The issue will be litigated and no matter what the outcome, it will cost money, take time and tie up judicial resources.
Approval of the exclusion in its current form will result in a significant change in the nature of title insurance and a substantive reduction in the scope of title insurance coverage. For lenders in particular, a title insurance policy may become little more than a title search with an indemnity covering abstracting errors. Lenders who originate mortgage loans for sale into the secondary mortgage market and their investors in the capital markets may review the relative value of title insurance against its cost and seek to develop more efficient and less expensive means of covering title risks on a pool risk, rather than a property-specific risk, basis.
Approval of the exclusion will also have a significant impact on transaction costs for the lending industry. Courts will have to determine scope and meaning on a case-by-case basis. This litigation will be time-consuming and expensive, and ultimately the consumer will bear the cost. The likely abandonment of the New York-style closing will also significantly increase the already high closing costs paid by the public in connection with buying and financing real property.
Although this article has focused on the law and practice in New York, the problems with the exclusion exist in all jurisdictions. Adoption of the New York endorsement in other states as part of the 1990 ALTA forms would ensure uniformity of policy forms, provide lenders and owners with the insurance coverage they require, and appropriately limit the title insurer's risk exposure in bankruptcy. However, if the 1990 ALTA policy forms with the exclusion in its current form are accepted in a jurisdiction, lenders and owners should seriously consider insisting on the "New York" endorsement or similar language as specific affirmative insurance in each transaction, or face the risk of severely reduced insurance coverage.
Joseph Philip Forte heads the real estate practice group at Thacher Proffitt & Wood in New York City and Mitchell G. Williams is a senior associate with that firm. This article is reprinted with permission from Probate & Property (July/August 1992) American Bar Association.
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|Title Annotation:||Legal Affairs; includes related article; American Land Title Association's 1990 policy on creditor's rights exclusion|
|Author:||Forte, Joseph Philip; Williams, Mitchell G.|
|Date:||Sep 1, 1992|
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