Insurance & Environmental Risks

Knowing when to cut your losses and walk a deal is a difficult skill to master.  In the construction loan context it is particularly difficult because a half completed building lacks the intended value anticipated on the loan.  On the other hand, cutting off disbursements causes a whole other set of risks including mechanic and materialman’s liens (“M&M Liens”) which often prime the lender’s mortgage lien.  While different types of insurance may help, the 7th Circuit recently held that priming M&M Liens incurred after the lender had cut off funding following borrower’s default were caused by the lender and therefore excluded from the title insurance coverage.  The result was essentially a total loss to the lender of ~$61MM.

Credit: LucasFilm, Ltd. / Imigur

The Project

The project was a commercial construction project in Kansas City, MO.  Basically what happened was that BB Syndication Services (the “Lender”) lent money on a construction loan to build the commercial development to its borrower.  The total line of credit was ~$86MM.

In the project, First American Title (the “Title Company”), acted as disbursing agent and insured against encumbrances on the property.  The idea being that prior to making a disbursement, the Title Company would check for liens, and barring liens would disburse the next construction draw.  The title insurance policy contained a exclusion to coverage which excluded any liens that are “created ,suffered, assumed or agreed to” by the Lender.

The 7th Circuit mentions some notable, but stereotypical, background facts in the opinion illustrative of deal that is going to go south present in this project:

  • The project was “fast tracked” and many contracts were signed before the plans were finalized. The result was that the initially cost estimate was almost immediately rendered inaccurate.
  • The construction company immediately warned all the parties that the changes would increase the initial estimate of $118MM by an additional $30-$40MM.
  • Notwithstanding the revised cost estimate the Lender opted to proceed even though there were no additional funds from the Lender or sponsors.
  • When ~$5MM had been disbursed the projected cost overruns began to come to light.
  • Undaunted, the Lender continued making disbursements and paid out over $61MM.

After the original contractor was fired by the borrower the Lender saw that the project was falling apart.  The new construction company determined they would need an additional $37MM (see above).  The Lender then declared the default and ceased making disbursements.  Two things happened when the Lender cut off the funds:

  1. Over $17MM in M&M Liens were filed (which primed the Lender), and
  2. The Borrower filed bankruptcy

 A Lawsuit About a Lawsuit

Most insurance coverage litigation is usually a lawsuit about another lawsuit in which there was a loss.  This was no different.  The Borrower filed bankruptcy and the bankruptcy court ultimately allowed $17MM in M&M Liens which all primed the Lender’s mortgage lien.  Next, the bankruptcy court conducted a judicial auction of the property which yielded $10MM.  Obviously this was not enough to pay the (now) first lien M&M Liens.  In the end, the lender settled for payment of $150K on its $61MM debt.

Faced with the loss, the Lender then turned and sued the Title Company on the title insurance policy.  The Title Company countered with their exclusion of liens “created, suffered, assumed or agreed to” by the Lender.

On appeal, the 7th Circuit held for the Title Company stating:

The liens at issue here related to outstanding work that remained unpaid when [Lender] cut off loan disbursements due to insufficient funds to complete the project.  As such, the liens arose directly from [Lender’s] action as the insured lender, so coverage seems squarely foreclosed by Exclusion 3(a).

The 7th Circuit dismissed the Lender’ argument that it had the contractual right to cease disbursements and was therefore not responsible for the M&M Liens.  The 7th Circuit reasoned that the right to cut off funding had nothing to do with the sub-contractor’s right to file M&M Lien claims.

Moreover, the 7th Circuit stated that the Lender could be seen to have caused the cost overrun itself because the Lender  knew well in advance that the project was out of balance.  The 7th Circuit goes so far as to state “Only the lender has the ability – and thus duty – to investigate and monitor the construction projects economic viability.  When liens arise from insufficient funds, the insured lender has ‘created’ them by failed to discover and prevent cost overruns…”

 What to Take Away from the Case

If anything, lenders should not rely on title insurance which contain the fairly common exclusion for M&M Liens that will arise following cut off of disbursements at issue in the case.  Circuits are split regarding this issue, but it remains a risk regardless of your location.  Obtaining performance bonds are likely a better option.

In addition to the legal holding about a title policy exclusion, another lesson is the cost of failing to walk away early from a project that is clearly not going to work.  The opinion mentions the Lender’s knowledge of the cost overruns over and over again.  Had the Lender walked at $5MM it would have almost certainly been made whole.  Knowing when to cut your losses is as much an art as it is a science and it cost the Lender over $61MM on this deal.

BB Syndication Services, Inc v. First American Title, case no. 13-2785, in the United States Court of Appeals for the Seventh Circuit.  Entered March 12, 2015.

Last month, the Office of the Comptroller of the Currency published the Commercial Real Estate Lending handbook (August 2013).  The 128 page handbook gives guidance to bank examiners and bankers on risks inherent in commercial real estate (“CRE”) lending.  It replaces a 95 page version published in 1995 (and revised in 1998). For this new school year and since commerical real estae lending is increasing in the “recovering” economy, I expected the OCC’s CRE lending handbook to grade-out with an “A+.” Instead, it is a solid, gentleman’s “C.” Make that a fraternity “C.”

Your Company is in this picture, too!
And probably make that a “C” for your company, too.   Like the OCC’s handbook, in many companies there is a disconnect or chasm between the business platform and legal issues undergirding the platform.  The “C” grade is NOT limited to the OCC and the banking sector. The OCC’s Commercial Real Estate Lending handbook takes an inconsistent approach in the role or importance of basic legal issues as a subset of risk management.  The approach swings from:

  • “legal light”: a few topics list legal issues and mention lawyers, but the topics are limited in number –
    • in the context of environmental risks,  handbook lists specific legal issues (p. 71)
    • the term “counsel” appears 5 times:
      • in the review of (ground) lease documents  (p. 53)
      • in assessing environmental risks (p. 70)
      • in the review of loan docs and other agreements “to determine if the improvement” comply with applicable laws and restriction (p. 104)
      • in the review of takeout agreements (p.107)
      • in the review of completion insurance bonds (p. 108)
  • “I know it when I see it – but you have to guess what I see”: some topics include the use of the phrases “legally bound” and “legally enforceable,” but with no guidance on “how” an examiner or banker is to verify or arrive at these legal conclusion (assuming the examiner or banker is not an experienced commercial real estate lawyer) –
    • what do these phrases mean or require?  They are not defined in the Glossary (Appendix C). Are legal opinions required? Does this require hiring a lawyer? If “yes,” this sidesteps the reality that most Companies are seeking ways to spend LESS money on lawyers.
    • similarly, the handbook contains references to “appropriate” loan documentation and “loan documentation policies.”  Again, what do these phrases mean or require?  Broad generalizations give no guidance on loan document provisions, and are not helpful in addressing or mitigating risk.
  • neglect: most topics simply do not include any reference to anything legal –
    • maybe for purposes of the OCC handbook, legal issues simply are outside the scope of the OCC handbook.  If this is the OCC’s approach, then legal issues should be disclaimed, with no mention of legal issues.
    • one of my problems with this “neglect” approach is that it denies reality.  Legal issues are part of the DNA of safe and sound lending, and risk management.  Banks and the OCC acknowledtge this by spending millions of dollars on legal services.  Indeed, guidance might even help to control legal fees.

My expectation was that the handbook would give lists of “no” change provisions, or a list of legal topics that need to be addressed (with the ability of a bank to explain any deviation from the provisions or list). Clearly, either I misunderstand the uses of the handbook, or the OCC missed an opportunity to give more meaningful guidance. Perhaps the gentleman’s “C” is too gentle. In future posts, I’ll describe a few of my favorite “no-no change” provision, and give an overview on current legal topics covered at several recent seminars. Please post your comments and perspectives below.

In many cities, urban growth now fills the farmland that once surrounded Navy and Air Force airfields.  Real estate development and finance near Navy and Air Force runways, however, requires special attention to a special set of restrictions called “AICUZ.”  These Department of Defense regulations severely restrict land located near military runways.  It is easy to overlook (or overfly) them in your review of real estate title, because they sometimes are implemented as zoning restrictions – and typically not expressly listed in the real estate title commitment or report. Think of AICUZ as “stealth” or hidden restrictions on the development and use of real property. As an Air Force brat, I literally lived under the sights and sounds of the F-86 Sabre, the F-101 Vodoo, the F-4 Phantom and the B-52 Stratofortress, with an occasional U-2. They were LOUD, but as Air Force brats, we barely noticed them.  (Ok, you always stopped to watch the U-2s).  (And yes, since Dad worked in base ops, I did sit in the cockpit of a U-2.) However, we did stop one day when the sound of an approaching F-101 didn’t have the usual rhythmic pulse.  The sound stopped us as the bird wobbled overhead, and then over the ridge line toward the runway. Almost immediately after the plane disappeared (on what Dad called “final approach” to the runway), the pilot popped up over the ridgeline (sitting in his seat), his parachute deployed, he lifted off the seat, next came a muffled explosion, and then a black cloud.     In a few minutes, a helicopter raced toward the spot where the parachute disappeared. We jumped up and down – we were part of the action!  Of course, no one believed any of this the next day at school. Today, reviewing title as part of financing a project will never has us jumping up and down – unless you fail to discover the AICUZ restrictions associated with the neighboring military airbase. Here’s how the City of Virginia Beach describes AICUZ: “The purpose of the AICUZ (Air Installation Compatible Use Zone) Program is to protect the health, safety and welfare from noise and hazards through compatible development in the airport environment. The program was instituted by the Department of Defense to address the problem of land development surrounding military air installations. It provides for the development and implementation of a plan to determine those land areas for which development should be significantly influenced by the operation of the airfield. These land areas are then designated as the AICUZ for that installation.” This depiction of the AICUZ south of the runway (at the Joint Reserve Base) in Fort Worth will help you understand the impact of an AICUZ: Fort Worth AICUZ at Joint Reserve Base (Thanks to Elizabeth Solender for bringing the Fort Worth AICUZ to my attention.) Next time you’re dealing with real property located near a military airfield, don’t overlook AICUZ restrictions. Missing AICUZ restrictions could be a “hard landing” for the profitability of your project. It could even turn the investment into a ball of smoke. If you have experience in dealing with AICUZ restriction, please comment below.

A recent and well-publicized lawsuit against a lender shows our appetite for headlines even extends to insurance issues.  Yes, insurance. My comment here is NOT about the merits of the lawsuit.  (I’m not evening giving you a link to it.) Instead, I marvel at the headline, and our ability to not focus on another very large and very important insurance problem: the fact that more often than not, a lender can NOT obtain reliable evidence of property insurance before it finances commercial real property.  Millions of dollars are funded with the “hope” that appropriate insurance is in place. Hope Insurance.  Commercial lenders sail away from closings “hoping” that the insurance policy is as promised. This very dangerous disconnect, between the insurance industry’s refusal to furnish a certificate that a lender may rely upon and the need of the commercial real estate finance industry for reliable evidence, will never be a banner headline.  Until the unthinkable happens – perhaps when an insolvent insurer simply refuses to honor policy, after policy , after policy. Or perhaps when investors or regulators stop ignoring this situation and . . . . It is, however, a situation that has many volunteers in the finance industry working hard to resolve. I’ll unpack the disconnect:

  • commercial mortgage lenders are not able to verify, review and rely upon evidence that the borrower has appropriate property insurance in place, which is needed when the lender originates the loan, or as the servicer accepts replacement insurance
  • insurance industry groups refuse to approve an insurance certificate (verifying insurance) that may be relied upon
  • the problem has been discussed at length, for several years, in key industry (insurance and finance) groups
  • compounding the problem, there are legitimate concerns of the unauthorized issuance of insurance policies (my early posting)
  • . . . the problem remains unresolved – since 2006 (MBA announcement)
  • so now it is being addressed on a a one-state at time basis – at the legislative and regulatory level in each state

Verifying the existence of appropriate property insurance is an important element in financing commercial real estate because the collateral . . . is the commercial real estate.  (Moody’s paper on modeling commercial real estate risk.)

  • If verifying insurance is NOT important, then . . .  why buy it? Why is there a market to sell it?

Insurance contracts (policies) are very, very complicated.  Indeed, commercial finance lenders and servicers have insurance experts on staff so that if and when they receive a policy, they can review and understand it. (My 2009 post of a short overview of insurance basics for commercial lenders and servicers illustrates the complexity of insurance.)

  • But why are we making it so difficult to deliver reliable evidence of insurance; or to present the actual policy when needed (at or before the loan closing)?
  • Are tech dollars (solutions) simply being allocated to the consumer side of the insurance shop, and not to the commercial side of the tech platform in insurance companies?  (Just guessing.)

To the volunteers who work for a resolution of this dangerous disconnect: THANK YOU.  IN YOU WE HOPE. To the rest of us who find entertainment in banner headlines: it is understandable, but not excusable

This seems to be insurance week for me. Later this week, I’ll jump into a recent court case that recently hit the headlines. Today, however, I received an e-mail warning of the POSSIBLE unauthorized issuance of property insurance polices by “an unathorized third party purporting to represent the insurers listed below and not to policies properly issued by the insurers or their authorized representatives . . . (emphasis added by me) :

  • North American Specialty Insurance Company
  • North American Capacity Insurance Company
  • AIX Specialty Insurance Company

Again, the problem is not the policies propertly issued by these companies.  The alert or focus is on POSSIBLE unathorized policies hitting the market. If NOT properly issued, then the insurance just goes  – So, what is lender or servicer to do? When you receive an acceptable certificate of insurance (more on that topic tomorrow), or when you receive the policy itself, consider taking these steps:

  • Verify: receive written confirmation that it was issued by an authorized employee of the insurance company (and not the broker or agent)
  • Reputable Brokers & Agents: deal only with reputable brokers and agents (but even then, evaluate the merits of my first bullet point)

Questions: Do you have other suggestions or choices for us?  What are other ways to protect against this type of fraud? What steps should you take in order to comply with Company policy, regulatory requirements, rating agency requirements or contractual standards of care? Please post your comments below.    

Latent (and even flaming) environmental risks play an important role in the monitoring of problem commercial real estate loans, in the decision to foreclosure and in the sale of foreclosed properties.

For many servicers and lenders, these risks are not fully understood – perhaps simply because in the "good economy" (prior to 2008), lenders relied heavily upon third party reports.  Once a loan hits the watch list, however, the topic goes to the top of the list, and receives all sorts of attention.

At noon (CST) on Tuesday, October 11, 2011, Winstead attorneys Andrew Fono & Rebecca Rentz will broadcast a free webinar designed to help improve your ability to identify and mitigate environmental risks related to monitoring and selling of real property that is impacted with environmental problems.

During the webinar, a brief overview of key environmental laws will be followed by a discussion of various environmental risk planning and mitigation tools, and the application of such tools into "real life" case studies.

For more information and to register, click here.

You’ll enjoy meeting Andrew or Rebecca.  Each brings a "real life" and unique experience and perspective to this topic:

  • During his service as a reserve officer in the U.S. Marine Corps, Andrew was a Deputy Environmental Counsel for the Office of Counsel to the Commandant of the U.S. Marine Corps.
  • In In 2007, Rebecca was named Environmental Regulator of the Year by the Texas Association of Environmental Professionals.

This webinar should be both interesting AND helpful to you.

Effective February 23, 2011 (next month), the new 2011 ALTA Survey Standards become effective (download a copy).  (Link to ALTA website and current 2005 requirements.)

What could this mean for you?  How is this relevant for distressed commercial real estate?

  • REO purchasers could require a survey prepared according to these standards (in part, because purchaser’s lender could require this); so, be aware of this possibility as you negotiate the REO sales contract
  • If you’re doing a deed in lieu of foreclosure, and you’re up-dating the existing survey, then consider doing the up-date with these standards – for the same reason set forth in the prior bullet point (i.e,, your buyer might require using the new standards)

I’m tying to locate a black-line of the new standards, so that we can quickly understand the changes (when compared to the current 2005 standards). **black-line found; see below***

If  you have comments about the new 2011 standards, then please comment below.

** Kudos to Ginger Simon (with Situs) for following up with me about the American Congress on Surveying & Mapping website, and giving me a link to the page  on the site that contains links to the black-line, a summary of changes and other helpful information.  Wow.  Thank you, Ginger!!


If you collateral is a green building, then a litany of unique issues and approaches come into play.

Recently I discussed this topic with Bill Weinberg – my green building expert.

Here are a few "high level" issues offered up by Bill to get our attention (prior blog) –

  • What is nature of the collateral?
  • What are some unique operational and maintenance features, including contract warranties?
  • Get a green building expert involved

These high level issues impact due diligence, and terms of negotiation and forbearance agreements (prior blog).

Now let’s focus on more specific topics and tasks:

  • Identify latent or "hidden" green building features

A green building may include a mix of obvious and subtle green building technologies. It will be easy to spot the fifty foot windmill, but you might overlook –

– the non-toxic paint
– low-emitting carpet
– recycled content building materials
– pesticide free landscaping
– specialized software to operate lighting, shades, solar panels, HVAC and other building operating systems

Just because a building looks like every other normal building, do not assume that it does not have green features.

As Bill previously noted, you risk losing the value of innovative features if you do not identify and properly maintain these features. 

  • Is the building recognized, or pursuing recognition, under a certification program?

Examples include these programs: LEED, Green Globes and Energy Star

  • If the building is pursuing certification (for example, during a construction loan or a "repositioning" of it in the market), what additional steps are necessary to cross the finish line?
  • If the building has already obtained certification, what steps are required to maintain the status?  (For example, periodic reporting and associated book keeping requirements.)

Here are a few ways that I’d address all of this:

  1. Due Diligence: expand scope of work for third party (environmental) reports –
    – look for green building features
    – examine local building records to determine if the building is certified or has applied for certification
    – what are the record keeping and re-certification requirements for the particular certification (and evidence of compliance or status of re-certification)?
  2. Negotiation agreement term
    – list green building features (and warrant that the list is all-inclusive)
    – list certifications and permits, or applications for same (and warrant that the list is all-inclusive)
    – add covenants regarding applicable record keeping (with delivery of copies to lender or servicer)
    – include these features in legal compliance covenants (and related default events)
  3. Forbearance agreement term (same as #2)

If you have suggestions, comments or war stories, please add them below.

We’re investigating green buildings, from the perspective that some portion of the huge amount of distressed commercial real estate will include some green buildings.

Earlier this week, Bill Weinberg focused us on these preliminary topics:

  • is the collateral raw land or does it include improvements (buildings or other structures)?
  • operational and maintenance issues, including the possibility of warranties on equipment or systems 

These are all topics that are new to me – green buildings were science fiction to us as we worked through the commercial real estate busts in the late ’80s and early ’90s.

Let’s stop here and get these quick thoughts on the board: what do I need to be doing right now if I discover that the collateral has some "green building" feature to it?

  • Due diligence (one prior; second prior post):
    • hire a qualified expert to assist in the evaluation of the building, the laws and regulations relating to green buildings, and the materials that you need to complete your files (and corresponding changes to your loan documents) – so that you will be prepared to operate the building
    • dig into the loan files to find any materials collected at the loan closing (or during servicing)
    • review your loan documents to identify provisions relating to green buildings, in particular provisions relating to compliance with laws, collateral assignment of vendor warranties (and service contracts), identification of any local permitting requirements (and renewal dates), etc.
    • expand your ESA procedures to cover any green building features, compliance, etc.
  • Negotiation letter: to the extent that you identify any deficiencies, add covenants covering them in the negotiation letter
  • Forbearance agreement: again, to the extent that you identify any deficiencies, add –
    • covenants covering them
    • make compliance with those new covenants  –
      • a condition to the forbearance terms
      • a new default under the loan

 Question: what do you want to add to this preliminary list?

More to come from Bill Weinberg, and my conversation with him.

Please post any comments, questions or war stories below.

Enough of MERS and technology – but, how about technology but from a different angle?

The amount of commercial real estate debt in distress is huge:

  • delinquent unpaid balances on CMBS loans exceeding $62 billion (October 2010), and heading toward $70-$80 billion by year end ’10 (per Realpoint)
  • delinquency ratio of 8.04% (September, 2010) (per Realpoint)
  • Fitch predicts special servicing volume of @ $110 billion of CMBS loans by the end of 2010 
  • @ 3,000 banks and savings institutions have more than 300% of their risk based capital in commercial real estate loans (per JLL)

Late in the good economy, "green buildings" became a new distinctive for the newest construction.

This is the "technology-smart" building – designed, built and operated to be environmentally friendly for all of us, and resource efficient and healthier for the occupants.  And the rent is a little higher.  A good thing.  Unless the tenant moves out or goes bankrupt.

Combining the large number of distressed investments with the green building concept:

  • What does a "green building" mean for real estate lenders dealing with distressed debt? How much extra trouble is a green building?

A green building is an operational and legal disaster in the making for a foreclosing lender.

I brought this concern and my questions to Bill Weinberg, a friend and partner at my law firm.  As you’ll read in his answers to my questions, it depends on the nature of the collateral, where it is located, and what the lender intends to do with it.  But since Bill is the expert . . . . 

Keith: "first, Bill, thanks for that tip about adding this topic to my ‘watch list’ on distressed debt, and for alerting me on changes in local building codes that come into play on a construction loan – I actually blogged on it . . . over a year ago."

Bill Weinberg: "yeah, but you forgot to mention me in that blog . . . should I say ‘thanks?’"

Keith: "well the bet at the firm was that I wouldn’t still be blogging. . . so here’s your opportunity to see your name a bunch of times out there in the vastness of the internet . . . "

Bill Weinberg: "you need my help . . .  remember, your distressed debt decision tree list after ACMA did NOT even mention this topic"

Keith: "guilty . . .  bad oversight . . . this is a topic begging for trouble. . . Question #1: What is the first question, or step that needs to be taken?"

Bill Weinberg: "let me make this simple for you . . . and I know that you like bullet points –

  • What is the nature of the collateral?
  • Is it raw land, an occupied building, or something else like a half-finished building?
  • If the collateral is raw land, it is fairly safe to say that there is no green building issue. 
    • First of all, there is no building. 
    • Secondly, the lender will probably be long gone before anyone lifts a shovel to start work on a building.
    • BUT: you still need to get that environmental study BEFORE you take possession or take title 
  • If the collateral is improved . . . 
    • and an occupied building, the lender may have to maintain it appropriately
    • or is a half-fished building, the lender may have to build it appropriately
    • either way, you’ll still need to get that environmental study BEFORE you take possession or take title

Keith: " love how you talk in bullets . . . let’s just assume that you’ve taken possession or obtained title  . . . . foreclosure or a deed in lieu . . . . Question #2: what’s next on the list?

Bill Weinberg: "you’re the dog that just caught the car – so:

  • Do you know how to operate and maintain the green building features?
  • A green building may contain some high-tech features with which the typical maintenance or janitorial crew may not be familiar.
    • Do you know how to operate the solar panels or the rain water re-use system?
    • How about the geothermal heating and cooling system?
    • Does the janitorial staff know how to clean a waterless urinal?
  • Do you have the warranties for the specialized fixtures and equipment?
  • Don’t lose the value of the innovative features by neglecting to seek expert assistance.

If you have any comments, questions or war stories, please comment below.

More from Bill Weinberg shortly . . . .