Daily Development for Friday, March 9, 2001

MORTGAGES; INSURANCE: California court construes ISO standard policy language to constitute "standard mortgage clause;"

therefore mortgagee is covered notwithstanding fact that mortgagee deliberately demolished improvements on property.

Home Savings of America v. Continental Ins., 1 C.D.O.S. 1903, No. B138138 (Cal. App., 2nd Dist. 3/6/01)

Mortgagors elected to develop a new townhouse development on property that included their mortgagor's home. Without the knowledge of the mortgagee holding a mortgage on their home, mortgagors transferred title of the property to a complex of business entities with their children as beneficial owners, moved out of the house, obtained various permits from land use authorities, and demolished the house in preparation for the building of the new development. After mortgagors laid a concrete foundation for part of the new construction on the site, they defaulted on the home mortgage and abandoned the project.

When the mortgagee came to the property, Surprise!!! No house.

Following foreclosure, the mortgagee was able to sell the property with just the concrete pad on it for $800,000 (this is California, after all). The mortgagee's secured debt was in excess of $1.05 million with accrued interest. Thus, the mortgagee was out about $250,000. (Note that it probably had no deficiency claim against the mortgagors, in light of the California antideficiency laws). The mortgagee resorted to a claim against the mortgagors' property insurer, arguing that the mortgagee was an additional insured on the property and was entitled to a claim based upon the protection extended for the "theft" of the residence. (Talk about your creative lawyering.) It worked!! At least on appeal here.

The trial court granted summary judgment for the insurer, but the California Court of Appeals reversed, addressing the various issues raised in the insurer's blunderbuss defense to the claim.

Perhaps the most significant analysis from the standpoint of national common law was the court's conclusion that the current standard form ISO homeowner's policy language involving mortgagees constitutes a "standard" mortgagee clause as that clause is commonly understood.

Consequently, the mortgagee is an additional insured, with special protection that immunizes it from defenses that might be available against the mortgagor.

The clause in the home mortgage here contained minor differences from the standard form language, but the court concluded that these differences were without substance in its conclusion that the language created a "standard mortgage clause" status for the mortgagee. The court notes that South Carolina, Mississippi and West Virginia case law already have found that this standard ISO language establishes the "standard mortgage clause" coverage.

Although the policy did not contain the standard mortgage language that states that the mortgagee is an additional insured and free of defenses that the insurer could raise against the insured mortgagor, the policy did state: "If a mortgagee is named in this policy, any loss payable under Building Coverage shall be paid to the mortgagee and you, as interests appear . . . If we deny your claim, that denial shall not apply to a valid claim of the mortgagee. . . ."

The insured argued that the policy was not in effect because of a condition in the policy that the mortgagors be residing there at the time of the loss. It noted that the "Building Coverage" portion of the policy states that the insured must *own* and reside in the property, and that the reference to "Building Coverage" is the one significant departure from the ISO form, which refers to "Parcel A and Parcel B" the principle residence and any outbuildings. The ISO language does not require that the insured own the property. But the policy contained specific language that stated that the mortgagee would not be barred from claiming coverage due to the fact a change in ownership or occupancy unless the mortgagee had notice of the fact and failed to notify the insurer. This appears to bring the analysis full circle, and the court concludes that the difference in language between the policy here and the ISO policy is a "distinction without a difference."

The insurer raised the defense that both California statute and the policy exclude coverage for wilful destruction of the property by the insured.

The court dealt with this quite easily, since it had already concluded that, under the standard mortgage clause treatment, the mortgagee is a separate insured, and the destruction of the premises occurred without its knowledge or consent. The matter of intentional destruction should be examined "from the perspective of the claimant."

The insurer finally argued that this was not an act of *destruction,* but rather an act of *improvement* of the property just one that hadn't been completed at the time of claim. It asserted that it was illogical to view a construction project approved by various local and state planning agencies as falling into the same category as criminal arson, for example.

It claimed that the policy contained an exclusion for "faulty construction," which, arguably the incomplete project turned out to be.

Without really too much analysis, the court simply responded "that's wrong." It saw a distinction between "faulty construction" and deliberate demolition of the entire premises. It analogized to cases involving wrongful conversion acts by the insured that nevertheless did not void a secured party's coverage.

The court noted that the fact that a mortgagee might have an action against the mortgagor for waste would not preclude its ability to recover on the insurance contract.

Comment 1: Note that, by California standards, the mortgagee might not have an action for waste here, since this may not have been the kind of "bad faith waste" that is actionable as a tort in California. Of course, the demolition may have been in violation of specific provisions of the mortgage agreement, but we know nothing of that from the opinion.

Comment 2: The fact that the demolition was, in fact, an intentional act by the insureds that they expected would increase the value of the property did not influence the appeals court here. But it may have some impact on appeal, particularly where the policy claim is based upon "theft." But, with only $250,000 at stake, we may not see any further appeal in this case.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1‑6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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