In Fidelity National v. Osborn III Partners LLC, the Arizona Supreme Court recently decided the question of whether mechanics’ liens filed by a general contractor are a construction lender’s “own darn fault” if the liens result in part from the lender discontinuing advances of loan proceeds to be used to pay the mechanics’ lien claimant. We’ve gathered members of our commercial finance and construction teams to help explain what the decision means for lenders, borrowers, owners, developers, and contractors.
Summary of the Opinion
The standard ALTA form of title insurance policy excludes from its coverage any defects, liens or encumbrances that were created, assumed or agreed by the insured. As the Arizona Supreme Court notes, this exclusion – “Exclusion 3(a)” – is meant to exclude coverage for matters that are the insured’s “own darn fault.”
In Osborn III, the construction lender, Mortgages Limited (“ML”), entered into a loan agreement with a developer to provide a loan for the construction of a condominium project, secured by a first deed of trust on the project. Two years later, in mid-2008, the developer defaulted by failing to make an interest payment, and ML ceased funding the loan. As a result, the general contractor for the project – Summit Builders (“Summit”) – was not paid in full and recorded a mechanics’ lien against the project. That same summer, ML went into bankruptcy, and the bankruptcy court created several LLCs - including Osborn III Loan LLC (“Osborn”) - to hold ML’s existing loans. As successor-in-interest to the lender, Osborn became the insured party on the title policy. Summit sued to enforce its mechanics’ lien at the end of December 2008.
The title policy expressly provided for coverage if the lender’s deed of trust did not have priority over mechanics’ liens arising from work related to the project that was commenced before the policy date, even though work had indeed already begun prior to the loan closing. Although the Court did not specify the source of this coverage, filings with the Arizona Court of Appeals cite Covered Risk 11 (a) of the title policy, which protects against loss caused by lack of priority of the deed of trust caused by a mechanics’ lien for work that commenced on or before the date the deed of trust is recorded. Perhaps with that understanding, the lender settled Summit’s claims and sought coverage under its title policy.
Fidelity denied the lender’s claim, however, arguing that the lender triggered Exclusion 3(a) because the lender’s decision to withhold project funding “created” the mechanics’ liens.
Rejecting two frameworks established by federal courts, Arizona’s Supreme Court held that its prior opinion in a homeowner’s title insurance claim matter provided appropriate guidance in disputes as to the application of title policy Exclusion 3(a) in the context of construction lending in its recent Osborn III opinion. Accordingly, Arizona courts will rely on a causation framework to determine if the insured “created” or “suffered” a defect, encumbrance, or adverse claim - such as a mechanics’ lien - excluded from insurance coverage by Exclusion 3(a).
The Osborn III Court relied on its prior opinion in First American Title Insurance Co. v. Action Acquisitions, LLC, in which the Court held the created-risk exclusion in the purchaser’s homeowner’s title policy applied to its loss of title when the purchaser paid a grossly inadequate price for the home at a sheriff’s sale, which led to the sale being set aside. As in Action Acquisitions, the Fidelity National Court found the language of the title policy exclusion to be unambiguous, meaning that Exclusion 3(a) is applicable if the insured’s actions caused or allowed the defect. Significantly, this analysis does not consider the insured’s intent in creating the defect or whether the insured engaged in misconduct - such as a contractual breach - related to the defect.
The rejected federal frameworks would have imposed other factors into the analysis into application of Exclusion 3(a). However, the Osborn III Court opted instead for a causation framework, similar to a proximate cause analysis in tort law, which relies on examining the sequence of events: The insurer has the burden of proving that the insured’s actions actually caused a defect, encumbrance, or adverse claim so as to trigger Exclusion 3(a).
What does Osborn III mean for Lenders and Borrowers?
This decision will have ongoing relevance for construction lenders. Although the title policy in Osborn III was issued nearly 17 years ago, Exclusion 3(a) and Covered Risk 11(a) remain essentially the same despite ALTA’s recent revisions to its form policies.
The Osborn III Court was clear: Timing is key when it comes to Exclusion 3(a). The current economic climate is prompting construction lenders to look closer at the default provisions in their loan documents, and although construction lenders are always concerned with ensuring loan advances are used to pay contractors, Exclusion 3(a) provides one further reason.
What does Osborn III mean for the Construction Industry?
Osborn III is a 2023 opinion about a 2008 dispute. And even more dramatically – the matter is still not resolved! The Supreme Court remanded to the trial court to evaluate three factual issues. This opinion is a timely reminder that in order to avoid decades (plural) of litigation, keep good records. For example, the Court could not determine on the record before it the key timeline of events (e.g., did Developer fail to pay Contractor because Lender withheld funding, or did Developer fail to pay Contractor before Lender withheld funds). A clear record will help facilitate resolution of disputes. This is important as nearly everyone is better off promptly resolving a dispute and getting back to their respective core businesses (e.g., construction or lending, not litigating).
