Daily Development for Wednesday, February 25, 2004 by: Patrick A. Randolph, Jr. Elmer F. Pierson Professor of Law UMKC School of Law Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu MORTGAGES; INSURANCE; PROCEEDS: Where builder's loss insurance proceeds are used to restore project damaged during course of construction, excess proceeds belong to contractor, and cannot be applied to mortgage debt notwithstanding language in the mortgage giving mortgagee option to apply insurance proceeds to satisfy indebtedness. . RGS Contractors, Inc. v. GC Builders, Inc., 348 F.3d 897 (10th Cir. 2003). Contractor and Owner entered into a construction contract to build an apartment project. Contractor maintained a builder's risk insurance policy, in which Contractor was "named insured" under the policy and Mortgagee was listed as "additional insured." The policy, according to the court, contained a "standard mortgage clause" that identified the mortgagee as an insured "as its interests may appear." Prior to substantial completion, a portion of the Project was damaged by fire. Insurance Company paid more than was required to rebuild the Project, including ten percent profit and ten percent overhead. All the parties agreed to use the proceeds to rebuild the Project. Contractor and Owner entered into a Memorandum of Understanding concerning how to apply the excess proceeds, and the money was placed in escrow, pending the outcome of binding arbitration. Arbitrator granted the funds to Contractor, but mortgagee refused to distribute the funds to the contractor. A year after reconstruction was completed, Owner defaulted on the loan. The district court held that the proceeds were subject to Mortgagee's perfected security interest and Mortgagee was not bound by the arbitration award because it was not a party to the arbitration and it was not in privity with the Owner. The Court of Appeals reversed, holding that under the mortgage, Mortgagee had an interest in the proceeds at the time of payment and, according to the Note, had the option of satisfying the interest by paying down the Note or releasing the proceeds to repair the Project. Once the Mortgagee had agreed to repair, the proceeds were released from the lien of the Mortgagee's security interest, and Mortgagee's remaining interest was in the completion of the Project to pre-fire specifications. The court noted that this result obtained because of the special nature of the insurance policy here. It was insurance taken out by the Contractor, and the surplus resulted, apparently, from the fact that the insurance proceeds included a 10 percent profit and ten percent overhead allowance. Comment: Although the court asserts that the policy contained a "standard" mortgagee's clause, the editor does not believe that such a clause insures the mortgagee "as its interests may appear," but rather states imply that the mortgagee is an additional insured and provides certain other anti-cancellation benefits and also provides, as it apparently did here, that the mortgagee is the loss payee. If, as the court suggests, a surplus resulted from the insurer's paying monies attributable to the two ten percent "overage" charges - for profit and overhead - then it make sense that this money should go to the builder, as the arbitrator apparently concluded. The mortgage gave the mortgagee the right to apply the proceeds of insurance to satisfaction of the debt, but the builder did not sign the mortgage, and these insurance proceeds never passed to the mortgagor. The case seems correct, but should be narrowly construed. The court goes on at some length about the fact that the lender was fully protected in its security interest by the rebuilding of the improvements, and that it would be unfair for the mortgagee to get both restoration of its security and the application of the excess to its debt. "Unfair," of course, often is in the eye of the beholder. If the owner, rather than the builder, had been the primary insured, and a surplus resulted because of saving in construction costs following the insurer's payment, for instance, the editor believes that the mortgage language would compel that such monies be paid over to the mortgagee. Despite certain rhetoric in this case, the editor doubts that the Tenth Circuit would feel differently. 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