Daily Development for Monday, March 29, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin

Note there are two cases here - both pertinent to the same basic issue.

INSURANCE; “ALL RISK:” Requirement in mortgage instrument that mortgagor acquire “all risk” policy does not obligate mortgagor to acquire all of the coverage available under an “all risk” policy at the time of the mortgage, but only to acquire insurance generally regarded as the equivalent of the “all risk” policy as traded in the marketplace at the time for acquisition of the insurance coverage.

Omni Berkshire Corp. V. Wells Fargo Bank, N.A., 02 Civ. 7378 ( S. D. N.Y.  2/25/04)

In 1998, Plaintiffs borrower $250 million under a mortgage loan arrangement secured by five hotels.  The borrower know that the loan was to be securitized.  Wells Fargo acted as the servicing agent for the securitization pool.  The mortgage required “all risk” insurance coverage, and the mortgagor acquired such coverage at a cost of about $360,000 for the year.  The policies included coverage for terrorism.  (Of course, “all risk” policies theoretically cover everything excepts excluded events, but in this case the policies expressly mentioned terrorism as a covered risk.)

After the events of 9/11/2001, insurance companies dropped terrorism from the policies and excluded damages from terrorism as a covered risk under “all risk” policies.  Although, in the immediate aftermath of 9/11, terrorism insurance was either unavailable or available only at astronomical prices, by the time of the dispute here terrorism insurance was commonly available under separate policies.  The lender had agreed to require only $60 million in coverage (the loan was well secured and cross collateralized by hotels in different locations) and the borrower had available to it a separate policy in that amount for an annual premium of about $316,000.  This compared with a cost of about $500,000 for standard “all risk” coverage that the borrower was also required to obtain (but which no longer included terrorism coverage.)

Although, by the time of the dispute, the federal government had weighed in with the Terrorism Risk Insurance Act (TRA), this didn’t solve the problem for several reasons.  First, the

Act requires that terrorism insurance be available, but doesn’t control the price.  Second the Act requires and facilitates  insurance only for Acts of international terrorism, and doesn’t apply to insurance against domestic terrorism.

The lender argued that the requirement for “all risk” insurance meant that the borrower was required to obtain insurance for the risks covered by such policies at the time of the mortgage covenant.

The borrower responded that the generic term “all risk insurance” means in the trade a specific “standard coverage” policy that differs from time to time, and frequently varies as to the risks that are covered.  The borrower noted that recently insurers have removed other types of risks from coverage, including mold and (even prior to 1998) Y2K problems.  Because this policy form had already been altered by insurers in the recent past, the borrower argued, the lender should have been aware that the specific coverage of an “all risk” policy is a moving target, and the lender should have been satisfied with what the market identified as the “standard risks.”

The court, on this point, agreed with the borrower, and held that “all risk” coverage requirements did not refer to the types of risks covered at time of agreement.

Comment 1: The editor is already on record as concurring with the lender’s position here.  The problem the editor has with the borrower’s position is that it assumes that for the life of the twenty year mortgage there will in fact be an “all risk” policy or the equivalent that the parties can use as the intended standard.  In fact, experience indicates that fashions come and go in the insurance world, and there may in fact be no functional equivalent to this policy for the entire term of the mortgage.  In fact, the parties should be held to have known that.  Consequently, for better or worse, the reference to an “all risk” policy ought to be regarded as identifying a distinct set of coverages, for better or worse.

The result of the editor’s analysis would be that more language would be necessary in long term contracts to identify clearly what the parties’ insurance expectations exactly are.  The editor sees no harm in this.  In fact, greater bargaining in this area is probably desirable, particularly in this era of risks coming home to roost.

The editor, however, is willing to concede that if there were evidence that those “in the trade” commonly viewed the meaning of this term as “all risk insurance, as commonly defined by the insurance industry from time to time,” then the editor’s argument, whatever its intrinsic merit, would bow to grim reality.  If that’s what the trade probably means, and there’s no other evidence, then that’s how we should construe this language.

Comment 2: As the second report of this case indicates (under the heading: “Insurance; Required Coverage; Terrorism,”) there are other ways to skin this cat.  The court went on to conclude that the additional clause giving the lender the power to require additional insurance coverage where reasonable did authorize the lender to require the coverage available here.

INSURANCE; REQUIRED COVERAGE; TERRORISM: Insurance requirements clause in mortgage that compels borrower to acquire “all risk” insurance and such other insurance as “lender reasonably may request” justifies lender in requiring some level of terrorism insurance even when “all risk” polices are amended to exclude such insurance.”

Omni Berkshire Corp. v. Wells Fargo Bank, N.A., 02 Civ. 7378 ( S. D. N.Y.  2/25/04)

This is a continuation of the discussion commenced under the heading: “Insurance; ‘All Risk:’ “

Wells Fargo Bank was the servicer of this securitized mortgage pool.  It indicated that it serviced 3632 loans (presumably commercial loans).  Of these, 2309 had terrorism insurance.  It noted that where it represented its own interests in the loan, Wells Fargo reviewed the need for terrorism insurance on a case by case basis.  But where it represented the interests of securitized mortgage pools, Wells Fargo had a blanket policy of requiring terrorism insurance.

Despite this testimony, Wells Fargo in this case had substantially retreated from its initial position and, as of the time of trial, was requiring terrorism insurance of only about 20% of the total amount of the loan.  Note that there were five properties involved, and, even if one of them was hit directly by a terrorist attack and suffered a catastrophic loss, this likely would be only about 20% of the total security.  The borrower also noted that the loan was heavily oversecured, so that even a total loss of one property might not lead to a major loan to value problem.

The borrower argued that Wells Fargo’s requirement was demonstrably unreasonable because it was part of a blanket policy, and did not take into account the high loan to value ratio in this matter, or the fact that the added cost of terrorism insurance led to a requirement that was more than half again the cost of the “all risk” insurance that it was already required to buy.

Instead of biting on the gambit argument that this decision was not made thoughtfully, the court analyzed the question of whether the outcome of the decision, however reached, could be defended as reasonable.  It noted that the properties in question here were large hotels, and that such hotels have in the recent past either been the target of terrorist attacks directly (the Marriott attack in Jakarta) or have been collaterally damaged in the course of attacks on landmark buildings in the area of the hotel.  In fact, two hotels were destroyed or substantially damaged in the 9/11 attack on the World Trade Center.  The court further noted that many other hotel chains had acquired terrorism insurance, although it didn’t indicate whether these purchases were in response to pressure from lenders.

Finally, the court noted that the $300,000 annual cost for terrorist insurance was “reasonable,” noting that it had cost much more in the months immediately following 9/11.

Comment 1: Clearly whether the cost of the additional insurance is “reasonable” is all in the eye of the beholder.  Although clearly 9/11 triggered huge increases in terrorism insurance, which now have subsided a bit, it should be kept in mind that we had already seen major terrorist attacks in America, most recently the destruction of a major federal office building in Oklahoma City.  Insurers had not deleted terrorism coverage from “all risk” policies as a consequence of that attack.  One wonders whether the new premiums for special terrorism coverage are truly a response to an enhanced sense of risk of loss, or rather to an enhanced awareness of slipping profits.

Nevertheless, the editor concurs that it does seem reasonable for a lender to be concerned about terrorism coverage.  If the “all risk” policy now excludes it, and didn’t do so when the mortgage clause was first written, the lender appears to have a very good argument that it is doing nothing more than renewing the coverage that the borrower originally agreed to provide.

Comment 2: The court cites with some apparent relish the comments in the record of an insurance broker who argued that the borrower was better off just acceding to the coverage demands, thus obtaining coverage of its own risk as well as those of the lender, than it would be by blowing several hundred thousand on attorney’s fees.

Far be it from the editor ever to argue that paying attorney’s fees is not a worthwhile use of money.  But it should be further noted that, once the precedent is set here, the borrower will be stuck obtaining this insurance when the lender requires, even if the costs go up while the perception of risk goes down.  Although it appears that the court took the cost of insurance into account in evaluating whether the requirement was reasonable, the evidence it considered as to reasonableness was simply the market, and not the absolute cost of the insurance to the borrower.

If someone offers me a really good deal on a 2004 BMW for 20% off the market price, it still may not be “reasonable” to expect me to take advantage of this really good price when I’m perfectly satisfied with my 86 Chevy.


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