Underwater Underwriting: Title Insurance in the Post-Lehman Era
By: S.H. Spencer Compton
From the advent of real estate finance securitization in the early 1980s, through its rise and subsequent crash in 2007, the title insurance industry has grown from an approximately $1.404 billion per year industry in 1980 to, at its peak in 2005, an approximately $17.768 billion per year industry.1 The single company model selling only the pre- 1980s real estate title guarantee/ insurance product, has grown to a parent company owning a bundle of subsidiary companies selling specialized financial services and information as well as a variety of personal property insurance products for such things as watercraft, aircraft, and registered securities.2 Some title insurance companies even own their own banks. This profitable expansion of business lines has been accompanied by broader and increasingly sophisticated management and underwriting expertise. By the early 2000s, title insurance companies, long the quiet cousin to the large property/casualty insurance companies, had come into their own, arguably fueled by the massive amounts of money pumped into real estate by Wall Street securitizations.
Unlike government regulators, lending institutions, appraisers, and ratings agencies during the boom years leading up to the real estate bust, the title insurance industry did not materially loosen its risk management criteria nor relax its standards of ethical business conduct.3 That said, as in every period of economic decline, there was an increase in embezzlements by title insurance agents and even a bankruptcy filing by the holding company of one of the largest title insurers arising out of the misuse and loss of funds entrusted to its 1031 Exchange division. Nonetheless, the crucible of trust created by the due diligence and subsequent issuance of title insurance products backed by the deep reserves of FORTUNE® 500 insurance companies remains unbroken and largely unblemished.
So how has the title insurance industry been affected by the 2008/2009 financial meltdown? Have our business practices changed? What trends are we seeing in the marketplace?
In 2003, total title industry claims paid were approximately $558,000,000.4 In 2008, total title industry claims paid were approximately $1,068,700,000.5 The rule of thumb among claims counsel is that as premium rises, so claims follow. History has shown that when real estate values descend, many more claims are brought, some legitimate, some not. Additionally, instances of fraud increase and claims arise from that. In response, title insurance underwriters continually examine the sources of claims, and where lax underwriting was the cause, more stringent review standards are imposed or, in the case of title insurance agents with abnormally high claims rates, those agents are dropped. In 2009, this process was in high gear industry-wide.
The 2006 ALTA Owner’s and Loan Policies; Elimination of Creditors’ Rights coverage
At near the historical height of the real estate market, the New York State Insurance Department approved the 2006 ALTA Owner’s Policy and the 2006 ALTA Loan Policy, as amended by revised forms of standard endorsements, effective May 1, 2007. In addition to providing increased clarity over the 1992 Policy forms, these new policies afford expanded coverage in the following ways:
The amount of insurance will increase by 10% if the insurer pursues its rights to defend a claim and is unsuccessful in establishing the title or the lien of the insured mortgage, as insured.
The definition of “insured” has been expanded to allow for the continuation of policy coverage as of the original policy date for the benefit of, for example, a successor to the insured “by dissolution, merger, consolidation, distribution, or reorganization” and the grantee of the insured which is wholly owned by the insured or by an affiliate of the insured. The 2006 ALTA Loan Policy similarly extends the benefits of the policy to other persons or entities.
The co-insurance and apportionment provisions of the 1992 ALTA Owner’s Policy, which provided for the insured to become a co-insurer in the event of a loss under certain circumstances and the manner in which a loss would be apportioned if more than one parcel was insured under one Owner’s Policy, are not included in the 2006 ALTA Owner’s Policy.
The definition of “indebtedness” in the 2006 ALTA Loan Policy includes as compensable items the amount of principal disbursed subsequent to the policy date, prepayment premiums, exit fees, and other similar fees or penalties allowed by law, and amounts expended by the insured lender to pay taxes and insurance.
The title insurance industry considered these expansions of coverage to be consumer-friendly improvements over the 1992 Policy forms. However, as the real estate market deteriorated, a more troubling issue surfaced.
When title insurance companies compete with each other to secure business through aggressive underwriting, it is often a race to the bottom.
Until early 2010, ALTA and the California Land Title Association (CLTA) have promulgated endorsements offered in many jurisdictions, usually for an additional premium, for what has been known as “creditors’ rights” coverage. Generally, creditors’ rights coverage insured against a challenge to the insured transaction vesting title, or, with respect to a Loan Policy, the transaction creating the lien of the Insured Mortgage, on the basis of the fraudulent transfer or fraudulent conveyance provisions under federal bankruptcy or applicable state law or the preferential transfer provisions under federal bankruptcy law.
Unlike traditional title insurance coverage, which is based primarily on an evaluation of legal risk, creditors’ rights coverage in many instances is based primarily on an evaluation of financial risk—an evaluation title underwriters have never been comfortable making. Nonetheless, the marketplace has required it, and under the theory that “if we won’t issue it, our competitors will,” title insurers have reluctantly issued creditors’ rights coverage.
In 2009, as a reaction to the enforcement of a multimilliondollar claim against a major title insurance underwriter arising out of a creditors’ rights endorsement, title companies severely restricted this coverage, requiring financial statements, property appraisals, and stricter underwriting review as well as significantly increased premiums. Effective March 8, 2010, ALTA voted to withdraw/decertify the ALTA Creditors’ Rights Endorsement 21/21-06 as an official ALTA Form. On February 4, 2010, CLTA voted to decertify the corresponding CLTA Endorsement 131/131-06. The Fidelity National Title Group underwriters (which include Chicago Title, Fidelity National Title, Ticor Title, Lawyers Title, LandAmerica and Commonwealth Land Title) subsequently issued bulletins advising that they will no longer issue creditors’ rights coverage. First American Title Insurance Company, Old Republic National Title Insurance Company, and Stewart Title have followed suit. The practice of issuing creditors’ rights coverage has ceased.
Limited creditors’ rights coverage is still available in most jurisdictions under the ALTA 2006 Form, insuring against challenges arising out of a prior transfer constituting a fraudulent or preferential transfer, but that coverage does not apply to the transaction creating the lien of the Insured Mortgage or vesting title in the insured, with respect to an owner’s policy. Furthermore, these recent ALTA and CLTA decertifications do not affect creditors’ rights coverage under previously issued title insurance policies.
Today, purchasers, lenders, and their counsel should perform due diligence their transactions to root out fraudulent or preferential conveyance issues. The period under federal bankruptcy law for unwinding a transaction can be as long as two years, and some states’ fraudulent conveyance statutes set no time limit for certain types of fraudulent conveyance. Creditors’ rights coverage can no longer be a hedge against insufficient due diligence, lax underwriting, or careless structuring of the transaction.
But the trend away from marketdriven risk taking has in certain instances been counterbalanced by a greater willingness to expend underwriting resources to understand and creatively address client needs. For example, First American Title Insurance Company of New York was recently approached by a major developer, with whom it had not previously done business, for assistance with a transaction that seemed to have hit a dead end. The developer previously had entered into a financing with an institutional lender in order to construct a new project on a parcel adjacent to the developer’s existing project. Construction proceeded until, in 2008, due to the financial meltdown, the lender declared the developer to be in default under the loan due to certain financial covenant breaches. When the lender ceased funding, the developer stopped paying its contractors and materialmen and ultimately many millions of dollars in mechanics’ liens were filed. Litigation between the developer and the lender ensued with the lender seeking to foreclose its lien and the developer counterclaiming for lender liability. After over a year of negotiations, a settlement was near, but the designated title insurer was unwilling to accept the personal guaranties of the developer and its principals together with a modest escrow fund to insure over the mechanics’ and materialmen’s liens. With the assistance of the developer, First American was able to review the mechanics’ and materialmen’s liens and determine that a sufficient quantity of them were either duplicative and/or erroneously filed against the existing parcel only, and not against the expansion parcel where the work was actually performed or the materials actually supplied.
Based on this analysis, and with a few additional provisions in the escrow and indemnity agreements, First American was able to work with the proposed collateral package and co-insure the loan modification transaction.
PROTECTING UCC INSURANCE COVERAGE WHEN RESTRUCTURING MEZZANINE LOAN PORTFOLIOS
It was not uncommon in 2006 and 2007 to find multilevel mezzanine loans on major commercial real estate deals. There could be just a junior and a senior mezzanine loan, but in some cases there were as many as ten tranches. Reflecting the current economic climate, we are now seeing a restructuring of many of those deals.
With few exceptions, UCC Insurance was utilized on the mezzanine deals of that time. Most of the pledged equities fell under Article 8 of the Uniform Commercial Code. They were perfected by control which was in most cases represented by the possession of the certificated interest. Coverage under the UCC Insurance policies fell under the Mezzanine Endorsements describing the equity and the possession.
We are now seeing restructuring of those transactions as these loans come due. It is important to remember that the UCC insurance coverage was loan specific. As a loan is terminated for any reason, the coverage and the policy for the pledged equity are terminated as well.
A recent multilevel mezzanine transaction consolidated as many as seven levels of pledged equities into one. The original seven loans were satisfied with a new loan and pledge containing all of the equities in all seven loans. The issues raised included how to continue the coverage of the policies which are no longer in existence.
In order to maintain coverage, the UCC insurer needed to create a new policy. While there was no new money and this was not a refinancing, it was a new loan. The new policy would indicate all of the pledged equities and the current lender, an assignee of the original lender, would be listed as holding the considerable number of certificates.
Another area of concern was the tracking of the original certificates from the original policies to the new policy in order to maintain the perfection of the liens. A loss of any one certificate creates a considerable problem for the secured party. The certificates are negotiable instruments endorsed in blank at the time of the closing. A lost certificate sold to a party who can be classified as a protected purchaser under the Uniform Commercial Code would prime any subsequent holder of a new certificate. In order to obtain coverage for a lost certificate under a UCC policy, the provisions of the code are required which include bonding or indemnification. Neither is cheap and readily available.
In restructured deals, counsels may not be aware that they need to obtain new coverage for loans terminated and consolidated. Today, UCC insurers are seeing more and more transactions “reinventing” what was done in years past.
Furthermore, in the second quarter of 2010, we have seen new mezzanine transactions including several in the $100 million dollar range.
Like drunks facing their families after an all-night bender, Wall Street and its related service industries await new government regulations, and pledge that, going forward, transactions will be transparent and simple. Financial ads portray bad bankers and brokers being shamed by a new breed of honest lenders and advisors. But as the economic cycle grinds on, the real estate markets are reviving. Slowly, incrementally, lenders are working bad loans off their books. The title insurance industry, which has endured two years of consolidation and streamlining (read layoffs), has become sporadically occupied as all-cash foreign buyers acquire U.S. properties at bargain prices and lenders selectively cease “pretending and extending” and force loans to refinance on realistic terms. Today’s deed-in-lieu transactions present unique underwriting challenges. The sellers are financially weak, thus diluting the power of their representations and indemnities. The lenders are not wiping out subordinate liens, because they are not foreclosing.
To paraphrase Rahm Emmanuel, the financial crisis has not been wasted in the title insurance industry. Coverages have been expanded, systems and processes have been streamlined, we now do more with less—and certain market-driven risk-taking, such as creditors’ rights coverage, has been eliminated.
Reprinted with permission from the September 15, 2010 edition of the New York Law Journal ©2010 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited.
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S.H. Spencer Compton is a senior vice president and special counsel at First American Title Insurance Company, New York Division. He is also a senior vice president at First American Exchange Company.
Mr. Compton is the Budget Officer of the New York State Bar Association Real Property Law Section. He has lectured and published articles about commercial real estate law and practice as well as title insurance, UCC insurance, and 1031 exchanges.
Prior to joining First American Title Insurance Company of New York, he was a practicing real estate attorney, with an emphasis on commercial leasing and financing transactions, for 11 years in New York City.
Mr. Compton earned his undergraduate degree in 1972 from New York University and his law degree in 1989 from Brooklyn Law School, where he graduated cum laude. Prior to law school, he was a screenwriter and film producer.
1. American Land Title Association (ALTA).
2. Recently, these parent holding companies have been spinning off their title insurance subsidiaries. On October 24, 2006, all of the common stock of Fidelity National Title Group, Inc. was distributed to the shareholders of Fidelity National Financial, Inc. On June 1, 2010, First American Financial Corporation and CoreLogic, Inc., separated into two independent publicly traded companies.
3. Note that the Attorney General of the State of New York has brought a suit against First American Corporation and First American eAppraiseIT which litigation is ongoing.
6. The author gratefully acknowledges the assistance of David Wanetik, Esq., chief operating officer, First American Title Insurance Company, UCC Division.