Issues Concerning Mortgagee's Casualty Insurance Interests

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

Of Counsel: Lewis, Rice & Fingersh
Kansas City, Missouri

I. Concepts of good faith and fair dealing in the distribution of insurance proceeds between the mortgagor and mortgagee following a casualty loss.

Despite continuing inroads on freedom of contract in the law of real estate, courts generally have upheld mortgage provisions governing the application of insurance proceeds in the event of a casualty loss. The mortgagee may reserve the right to apply the insurance recovery to the outstanding debt at its sole option. [FN1] This continues to the be the case even though the covenant of good faith and fair dealing is a generally recognized element of real estate contracts in most states. [FN2]

The reasoning underlying the majority rule is that the insurance proceeds necessarily replace the lender's security interest in the property. (Wheeler v. Insurance Co., 101 U.S. 439, 442 (1879); Hoosier Plastics v. Westfield Savings & Loan Ass'n, 433 N.E.2d 24, 27 (1982); Pearson v. First Nat'l Bank of Martinsville, 408 N.E.2d 166, 169 (1980).) As one court suggested, if the mortgagee were forced to apply the proceeds toward rebuilding, it would in effect be extending additional credit in the form of a construction loan to the mortgagor and be exposed to additional risk and uncertainty it did not bargain for under the original mortgage. General G.M.C. Sales, Inc. v. Passarella, 195 N.J. Super. 614, 623, 481 A.2d 307, 312. Ostensibly, the mortgagor is benefited by having the balance of the debt reduced.

I.A. Cases Imposing a Duty to Allocate Proceeds to Mortgagor:

Some courts and state legislatures have reacted to the harsh consequences that can result from a mortgagee's rigid application of its insurance right. Schoolcraft v. Ross, 146 Cal. Rptr. 57, 81 Cal. App. 3d 75 (1978) is illustrative. The Schoolcrafts purchased a home from Ross, giving her a note secured by a deed of trust. Fire destroyed the house, and Ross refused to release the insurance proceeds for rebuilding, citing her option under the deed of trust to apply the proceeds to the outstanding debt. Unable to pay rent on an apartment and pay the mortgage payment, the Schoolcrafts defaulted and Ross took back the property through foreclosure. The court upheld the trial court's $4,500 damage award to mortgagees, which amounted roughly to the equity they lost in foreclosure, plus attorney's fees.

In resolving Schoolcraft, the court enunciated the threshold rule that in every contract there is an implied covenant of good faith and fair dealing; that is, that neither party will do anything that injures the right of the other to enjoy the benefit of his bargain. 81 Cal. App. 3d at 59. Schoolcrafts had bargained for the use of the loaned funds and Ross had received the right to specific repayment terms secured in her deed of trust. She did not have the unilateral right to cut off the loaned funds absent a showing that her security was impaired. Id. at 59-60. Although applying the insurance proceeds to the indebtedness was not contrary to the explicit terms of the agreement, "[t]he covenant in this case does not mean good faith in the abstract, but, instead, refers to the purpose of the particular contract." Id. at 60. Here, the purpose of the particular contract was to provide a long-term loan with adequate security in the property. Since the value of the property was sufficient to secure her interest in the mortgage and note, she had no claim to the proceeds. Id.

In short, the explicit language of the insurance covenant was subject to the control of the implied covenant of good faith and fair dealing that was also in the contract, limiting the discretion of the lender to apply proceeds to the loan when the property could be rebuilt without an impact on lender's security interest.

A later California case relied upon Schoolcraft, and considerably extended it. In Kreshek v. Sperling, 207 Cal. Rptr. 30 (Cal. Ct. App. 1984), the mortgagees held a $400,000 purchase money note secured by a deed of trust against the property. A portion of the property was destroyed by fire, resulting in approximately $421,000 in damages. At the time of the fire, some $320,000 remained owing on the mortgage. The trial court awarded the mortgagee the insurance proceeds to the extent of the indebtedness. The appellate court reversed the award, allowing the mortgagor to retain the insurance proceeds even though he did not intend to rebuild. Citing Schoolcraft, the court looked at the value of the property after the loss, $2,000,000, and reasoned that mortgagees were not entitled to the proceeds under the deed of trust because their security had not been impaired. They rejected mortgagees' argument that Schoolcraft was distinguishable because there the mortgagors intended to rebuild the property, whereas in the instant case there was no intent to rebuild.

In Kreshek, the mortgagors received a windfall by retention of the insurance proceeds when they did not replace the destroyed portion of the building. The court's statement that the mortgagees were not in a worse position than they would have been had the property not been damaged is not entirely true, of course. In absolute terms, their security was impaired by allowing the mortgagor to retain the insurance proceeds without rebuilding. Although the "coverage" of the secured loan may have seemed ample to the court, the same market volatility that drove the property value up to $2 million may later have driven the property down, and the mortgagees now had a thinner "cushion" to protect them in the downward drop. We should also keep in mind that California purchase money mortgagees are absolutely prohibited from a deficiency judgment. The significance of the protection of the mortgagee's security interest is magnified in such cases.

The California Legislature may have considered these concerns when it enacted legislation designed to retain the holding in Schoolcraft but to abrogate Kreshek. Cal. Civ. Code § 2924.7 and Section 3 of Stats. 1988, c. 179. Section 2924.7(b) provides that the mortgagee may control the disbursement of the proceeds of a casualty loss regardless of whether its security interest has been impaired.

In a novel bit of statute writing, the legislature then included instructions as to the interpretation of the statute that appears to amend the language: It stated that the courts are to interpret the statute in accordance with the legislative intent that lenders should be precluded from diverting insurance monies from rebuilding:

"The Legislature hereby declares that this act is not intended to abrogate the holding in the case of Schoolcraft v. Ross [citation omitted] insofar as it provides that a lender may not prohibit the use of insurance proceeds for the restoration of the secured property absent a showing that the lender's security interest in the property has been impaired."

Section 3 of Stats. 1988, c. 179.

In Ford v. Manufacturers Hanover Mortg. Corp., 831 F.2d 1520 (9th Cir. 1987), a federal court, prior to enactment of the statute, found that under California law a mortgagee has no good faith duty to permit the mortgagor to rebuild when the mortgagee is in default at the time of loss. The court explained that the good faith duty existed in Schoolcraft because of the reasonable expectations of the parties when the deed was executed. Id. at 151. The mortgagor could not rely on Schoolcraft when he had violated the intent of the agreement, i.e., failed to keep the mortgage current. The court further rejected Kreshek as irrelevant, noting that the purpose of the deed would be defeated if Ford were allowed to use the insurance proceeds to deprive the mortgagee of its preexisting contractual right to foreclose. Id. at 152. Although the statutory language expressly rejects Kreshek and embraces Schoolcraft, it says nothing about this case. It is unclear whether the legislature's failure to cite Ford represents a decision not to address specifically federal interpretations of state law, a decision to confirm the interpretation of the federal court, or simple oversight.

A lower New Jersey appeals court adopted the Schoolcraft rationale in Starkman v. Sigmond, 446 A.2d 1249 (N.J. Super. Ct. Ch. Div. 1982). The court held that where a mortgagor seeks to rebuild, a mortgagee may apply the insurance proceeds to reduce the debt only if its security interest would be impaired even with the rebuilding. Otherwise, the mortgagor may use the proceeds to rebuild. 446 A.2d 1249. In Starkman, the mortgagors' property was completely destroyed by fire one month after purchase. The now vacant land was appraised at $10,000 higher than the remaining indebtedness on the mortgage and note. Mortgagors argued that the mortgagees were receiving the benefit of their bargain, i.e., continuous monthly payments, and that their security was not impaired because the value of the property exceeded the remaining indebtedness. Mortgagees countered that the insurance policy was an independent agreement between the insurer and mortgagee which vested their rights to the proceeds at the time of the fire. Further, they argued that to allow mortgagees to retain the insurance proceeds would result in a windfall since the amount of the proceeds plus the value of the lot exceeded the purchase price by $56,000. Id. at 606.

The court adopted the reasoning that the purpose of insurance is to maintain the security for the debt, and if the property is restored, the security is therefore not impaired. It further noted the prevailing high interest rates and scarcity of construction financing, and considered the disadvantageous position in which the mortgagors would be placed should the proceeds be paid over to the mortgagee in satisfaction of the debt. Id. at 610.

The Schoolcraft/Starkman view has some appeal in light of the reality of financing in the modern real estate market. The mortgagor generally pays the insurance premiums on the property, of course, and thus has some equitable claim to benefit from the proceeds. Though the mortgagor receives some benefit from the reduction in the debt, it may be difficult, if not impossible, for him to obtain additional financing to rebuild if he is still making the same payment to the first mortgagee, albeit on a reduced debt. [FN3] The mortgagor is affected both by cash flow problems and by the fact that the new loan will be secured by a junior interest. Many mortgagors may find it difficult to maintain both the mortgage payments and rent on other premises while they rebuild.

The authors of the current draft of the Restatement of Property (Third) - Security (Mortgages), have taken a strong position favoring the Schoolcraft/Starkman reasoning, citing these cases as representative of a "noticeable trend" which includes, essentially, only the cases cited here and a few very old or inapplicable cases. Reporters note to comment d, page 98, Tenative Draft No. 3. The Restatement position is discussed at greater length below under the discussion of "Unconscionability." The Restatement authors apparently view both good faith and fair dealing and unconscionability to be concepts equally applicable to the situation.

I.B. Cases Refusing to Require the Mortgagee to Allocate Proceeds:

Notwithstanding the above arguments, the majority of courts in other states have been slow to apply the implied covenant of good faith and fair dealing to balance the competing interests of mortgagor and mortgagee on this question.

Two years after Starkman, supra, a New Jersey appellate court specifically refused to apply the reasoning in that case. General G.M.C. Sales, Inc. v. Passarella, 195 N.J. Super. 614, 481 A.2d 307 (1984). Citing Starkman with disapproval, the court rearticulated the pre-Starkman rule in New Jersey that, absent an express agreement or legislation, the mortgagee has the absolute right to apply the insurance proceeds to the debt after a loss. The court held that to force application of the proceeds to rebuilding would shift the risk to the mortgagee by converting its secured interest into a construction loan.

The court chose to emphasize efficiency concerns over concerns about fairness, noting that adoption of a new rule such as that in Schoolcraft or Starkman would spark dispute and litigation over the sufficiency of repairs, as opposed to the ease and certainty of a rule permitting the mortgagee the unilateral right to decide the disposition of the insurance proceeds.

The Supreme Court of Texas rejected out-of-hand the concept that every contract implicitly requires good faith and fair dealing. English v. Fischer, 660 S.W.2d 521, 522 (Tex. 1983). In reversing the lower court's award of insurance proceeds to the mortgagor following a fire, the court held that the terms of the mortgage were unambiguous and that to examine every case to decide what "might seem 'fair and in good faith'" would "abolish our system of government according to settled rules of law." Id.

Many of the cases that have applied the concept of good faith and fair dealing in other contexts actually have done little more than carry out the probable intent of the parties. This well established objective of contract law is also appropriate in real estate contracts. It is unlikely that English, or any other case, really represents a movement by the courts away from the concept that contract language should be interpreted generally to reflect fairly the probable expectations of both parties. In short, the majority of the cases do not interpret the mortgage contract as providing any limit on the mortgagee's discretion to allocate insurance proceeds to reduce principal.

A comparison of English and Schoolcraft/Starkman may give us one basis for differentiating those cases in which an implied duty to allocate proceeds might be found in the future. In Schoolcraft and Starkman the mortgage gave the mortgagee the option either to apply the proceeds toward rebuilding or to apply them to the loan. In English, the mortgage specifically set out that the benefits of the policy would inure to the mortgagee. Schoolcraft can be explained on the ground that whenever a party has a choice of performances, the principles of good faith and fair dealing ought to apply to prohibit the party from choosing a performance to the detriment of the other when the alternative performance would serve his own interests equally well. Arguably, a party is more likely to expect that the other party will behave fairly and reasonably in adopting an option than it would expect a party to refuse to take advantage of an opportunity unequivocally conferred upon it by the contract.

In fact, practitioners wary of the implied duty of good faith and fair dealing in general may wish to consider avoiding establishing optional courses for their parties in the instruments. A better approach is simply to identify one course of conduct that the lender and borrower will abide. If one of the parties is uncomfortable with that course of conduct when the situation arises, such as when there is an insured loss, let that party negotiate at that time for a departure from the established course. To outline both courses as mortgagee options in the mortgage instrument is to suggest that some decision making process must occur, and it is logical for a court to conclude that the mortgagee agrees to make its choice "reasonably." Unfortunately, what the mortgagee may view as reasonable may not be reasonable in the eyes of the court.

The recommendation to consider avoiding optional clauses is simply a suggestion to assist in avoiding problems in the future. There is no question that many cases involving optional insurance clauses have refused to disturb the mortgagee's choice to allocate the proceeds to repay the debt, even after Schoolcraft. Pearson v. First Nat. Bank, 408 N.E. 2d 166 (Ind. App. 1980), for instance, expressly rejects the reasoning of Schoolcraft in permitting an allocation of proceeds to the debt. A later Indiana case, First Fed. Sav. & Loan Ass'n v. Stone, 467 N.E. 2d 1226 (Ind. App. 1984), also permits application to the mortgage, even where the mortgagee had first notified the insurer that it could apply the proceeds to rebuild and then later withdrew that permission without notifying the mortgagor. The mortgagor and the mechanic's lienholder were unable to get the proceeds applied to reconstruction even under these circumstances. Also see Anchor Mortg. Services, Inc. v. Poole, 738 S.W.2d 68 (Tex. App. 1987).

I.C. Special Issues of Mortgagee Conduct:

I.C.1. Mortgagee conduct in dealing with mortgagor following an insured calamity.

A recent Arkansas case has held that once the mortgagee has agreed to apply the insurance proceeds to rebuild, it cannot withhold its performance in bad faith. United Bilt Homes v. Sampson, 832 S.W.2d 502 (Ark. 1992). In United Bilt, mortgagor hired a contractor with mortgagee's knowledge and approval to repair the damaged premises. Following completion of the work, mortgagee refused to pay the contractor, maintaining that the work was unsatisfactory. Because of this refusal to approve the repairs, the contractor remained unpaid and sued Sampson for the cost of the work. The court found that the repairs had been done in a workmanlike manner and suggested that mortgagee had withheld payment to force mortgagor and the contractor to perform work beyond that which had been contracted for. It found that mortgagee had tortiously interfered with the contract, justifying an award of punitive damages as well as requiring the insurance proceeds remaining in escrow to be paid over for the repairs as originally agreed. [FN4]

In First Federal Savings & Loan v. Cheton & Rabe, 567 N.E.2d 298 (Ohio Ct. App. 1989), the mortgagor requested the mortgagees to declare a moratorium on mortgage payments pending the receipt of insurance proceeds after a fire loss. Both mortgagees refused, and mortgagor failed to make any more payments. After the note became ninety days delinquent, the junior mortgagee declared mortgagor in default and invoked a two-percent penalty interest rate granted by the acceleration clause in the mortgage. Some three months later, the senior mortgagee filed foreclosure proceedings naming the mortgagor and the other mortgagee as defendants. Junior subsequently cross-claimed for foreclosure against. Ultimately, the insurer paid both lenders the amount of their mortgages with the balance to mortgagor.

Mortgagor maintained that the junior mortgagee had acted in bad faith by accelerating the note and invoking the interest-penalty clause when it knew that the property was insured. It characterized the mortgagee's behavior as "callous" under the circumstances. But, "refusal of [mortgagor's] request as 'callous' has no bearing on an arm's-length commercial transaction." Id. at 303.

The mortgagor sought to cast the mortgagee's behavior as opportunistic since it would profit by the imposition of the two-percent increase in the default rate when in reality the mortgagee had the certainty of the insurance proceeds to rely upon. [FN5] This approach, however, ignores the reality that first, insurance recovery was not a foregone conclusion, and that second, the Federal Home Loan Bank required the junior mortgagee to accelerate loans which were delinquent ninety days. 567 N.E.2d at 304. The imposition of the interest penalty was a result of mortgagor's failure to abide by the terms of the note, not a bad faith act on the part of the mortgagee to profit at the mortgagor's expense.

I.D. Possibility of Future Restrictions on the Enforcement of Mortgage Terms Regarding Application of Insurance Proceeds:

1. Contract Duty of Good Faith and Fair Dealing:

As Schoolcraft and certain other cases indicate, and as many practitioners have learned in painful ways, courts in the last decade have deepened and widened that category of contract interpretation known as the "implied duty of good faith and fair dealing." Properly interpreted, this concept probably constitutes no more than a restatement of the well established principle that contracts should be construed to carry out the probable intentions of the parties. Of course, not everyone would always agree whether given contract terms truly express contractual intent, and in virtually every contract there will be some possible developments which the parties have either not anticipated or fully addressed in the contract language. Consequently, where there is room for interpretation, courts have been willing to impose an interpretive "gloss" that requires the parties to treat one another fairly and reasonably in carrying out their contract relationship.

For instance, if the parties have stipulated that the mortgagee may, in its sole discretion, elect whether to allocate casualty insurance proceeds to rebuild or to reduce the mortgage debt, some might conclude that the contracting parties determined that in every instance the mortgagee had absolute discretion. Others, however, might say that the language demonstrates that the parties intended that the mortgagee have the right to make the decision, but that both sides anticipated that the mortgagee would make the decision only in such a way as to preserve the basic relationships established in the original mortgage contract.

If a court were to take the latter approach to the interpretation of an insurance allocation clause, it still might say that a mortgagee would be free to decide how to allocate insurance proceeds in instances in which the mortgagee had a legitimate concern about security coverage, even where the mortgagor might reasonably differ with the mortgagee about the extent of the coverage. But a court might also say that there is some point of coverage where a mortgagee would have no legitimate concern that it would have adequate security even if the proceeds were to be used to rebuild, rather than reduce the mortgage debt. This interpretation would support the parties' expressed intent that the mortgagee have "absolute discretion," but would still retain some judgmental discretion for the court in determining when the "absolute discretion" is being abused.

At the point where the mortgagee's security protection is not at issue, then, a court might look to whether the mortgagee's rejection of the mortgagor's request that insurance proceeds be used to rebuild is a decision that the mortgagor might not reasonably have anticipated the mortgagee would make at the time the mortgage contract was drafted. It would look at the kinds of factors Schoolcraft emphasized - the impact on the mortgagor's ability to obtain substitute financing to rebuild while still carrying the load of the first mortgage, the cost of refinancing the whole mortgage under the circumstances, the parties' anticipation that the original loan would establish a long term relationship, etc.

The correct interpetation of the probable intent of the parties may be colored by the court's view of whether the mortgagor, in particular, really understands the terms of the agreement. Therefore courts should play a more active role in interpreting them. Undoubtedly we would have seen more cases involving true "consumer instrument" arguments in this area were it not for the fact that the FNMA/FHLMC uniform instruments - the dominant mortgage form for first lien residential loans - give the mortgagor the ability to apply insurance proceeds to rebuild as a matter of contract right. The cases in which the issue has arisen, even when the loan is a residential loan, involve non-institutional transactions in which it is more arguable that the both parties had a fair chance to assert their interests in negotiation.

With respect to commercial mortgages, of course, experience teaches that there are in fact a number of choices available to mortgagors. Many mortgagees will consider reasonable provision for allocation of insurance proceeds. Thus, there is support for the notion that a mortgage containing a clause providing for an absolute right to application of proceeds is something that the mortgagee "bought" by giving up on other terms in order to attract mortgagors who had an option to go elsewhere and get different insurance provisions.

To the extent that the imposition of the implied covenant of good faith and fair dealing goes beyond simply identifying the contracting intent of the parties, the blanket application of the doctrine of the implied covenant may not be appropriate in the highly regulated area of mortgage lending. Unlike parties who, under the classic theory of contract are free to bargain, many institutional mortgagees, at least, must comply with the stringent body of regulatory law which governs financial institutions. It is also well to remember that "good faith and fair dealing" does not require a party to behave in a manner which is detrimental to its own interests.

Implying in all mortgages a covenant of good faith and fair dealing on the rebuilding issue, however, presents a problem of judicial efficiency as pointed out in Passarella, supra. Courts are naturally reluctant to abandon a bright-line rule in favor of one requiring a determination of the equities on a case-by-case basis.

Of course, if the mortgage agreement gave the mortgagee no discretion, and stated simply that the insurance proceeds would always be used to reduce the mortgage debt, it would be more difficult for the mortgagor to argue that it had a reasonable anticipation that the mortgagee would behave in any other way. It may be that fear of application of "good faith and fair dealing" concepts will lead parties to be much more severe in the drafting of their mortgage agreements, avoiding wherever possible a conferring of contractual discretion.

This "absolutist" approach still may create a problem for mortgagees. First, of course, it may be that there would be circumstances in which the mortgagee would be interested in keeping the mortgage alive but the mortgagor would be interested in having the proceeds used to retire the debt. Secondly, courts might view the application of insurance proceeds in certain circumstances as an event that might delimit other conduct of the mortgagee, such as assessment of the prepayment penalty, acceleration of the mortgage debt in the event of default, or seeking a deficiency following default.

The above scenarios exist under the prevailing "standard" view of the duty of good faith and fair dealing. There are cases that would extend the concept of good faith and fair dealing well beyond the realm of the "reasonable expectation" framework. Some such cases dictate a duty of moral contracting conduct that conceivably could restrict a party from exercising clearly delegated discretion in such a way as to cause injury to the other party without significant justification for the party exercising the discretion. The decided cases involving allocation of insurance proceeds do not go this far, but certainly there are other cases involving real estate contracts that do.

2. Tort Duty of Good Faith and Fair Dealing:

Circumstances might exist in which a mortgagee might have special fiduciary responsibilities to take actions designed to protect the interest of the mortgagor in special ways, even when the contract would confer express discretion or express rights on the mortgagee. Perhaps the best example of a situation that might arise in the context of casualty insurance proceeds would be a situation in which the mortgagee had already established itself as a mortgagee in possession. In such a case, clearly, the mortgagee has committed itself to a fiduciary duty to look after the property serving as security and to preserve the interests of the mortgagee and mortgagor in that property. It may not be able to allocate casualty insurance proceeds away from carrying out that objective, even when the mortgage agreement otherwise gives the mortgagee discrection to do so.

Other situations might also exist in which the mortgagee, for one reason or another, has so exercised control over the business affairs of the mortgagor as to impose a fiduciary duty on the mortgagee that would limit otherwise clearly delegated discretion or control the mortgagee's conduct even where there is no discretion under the contract.

3. Unconscionable Terms:

The current Tentative Draft of the Restatement Third on Real Estate Security Interests indicates that it might be possible, consistent with other provisions of the Restatement on Contracts, to view provisions that divert insurance proceeds away from rebuilding as unenforceable because unconscionable. The Reporters of the Restatement suggest a number of circumstances that might give rise to the possibility that the provision is unconscionable or where enforcement would breach the implied duty of good faith and fair dealing:

"In printed form mortgages it is common to find clauses which purport to give the mortgagee the right to casualty insurance and condemntation proceeds with no corresponding duty to permit use of the funds for restoration of the premises. While such a provision may be enforced, it may also be disregrded on the ground that it is an unconscionable term of the contract (see Restatemtn, Second, Contracts Sec. 208) or that enforcement woudl violate the mortgagee's duty of good faith and fair dealing (see Restatement, Second, Contracts, Sec. 205 ). Application of these principles depends on the facts of the case. See Illustration i.


8. The facts are the same as in Illustration 4, [insured casualty partially destroys security; application of insurance proceeds to rebuilding would restore value to point that loan to value ratio would equal that in existence just before casualtyt], except that a provision in the mortgge states that in the event insurance proceeds are paid out, the mortgagee at its election may either apply them toward the mortgage debt or toward restoration of the real estate. Whent Mortgagor requests that the funds be released for the purposes of restoration, Mortgagee refuses and advises Mortgagor that they will be applied toward the mortgage debt instead. /=Since restoration is reasonably feasible and will return the value of the real estate to its original amount, a court may be warranted in ordering Mortgagee to permit use of the funds for restoration on the grounds that refusal to do so is a breach of Mortgagee's duty of good faith and fair dealing or that the mortgage clause permitting Mortgagee to retain the funds is an unconscionable contract term. Additional facts which will tend to support this result include: (1) Mortgagee drafted the mortgage; (2) Mortgagor was unaware, at the time the mortgge was entered into, of the provision allowing the mortgagee to retain the funds; (2) [sic] Mortgagee is in the mortgage lending business; (3) the real estate is Mortgagor's residence; and (4) Mortgagor will be able to finance restoration of the real estate only by borroing other funds at an interest rate significantly higher than the rate on the present mortgage debt." Tentative Draft No. 3, Restatement of the Law of Property (Third) - Security (Mortgages) Sec. 4.7, Comment e.

It is important to note that in the view of the Restatement Reporters, the issue of unconscionability could arise even in commercial contracts in which the parties were fully aware of the language of the mortgage agreement. If the agreement is to be construed as expressing an intent that insurance proceeds could be allocated in a way to cause severe injury to the mortgagor, even when the mortgagee suffers little or no risk to security, then a court might no be able to apply concepts of good faith and fair dealing, but still could have the option of viewing the provision as unconscionable. At least arguably, the more absolute and draconian the contract language, the more likely a court would be to conclude that the provision could not result from a free and fair bargain, and thus is presumptively unconscionable.

Many would argue that mortgages in general are not "freely bargained," in that the mortgagor lacks either the sophistication or motivation to bargain strong about default terms, while the mortgagee has great incentive to stress those terms and demand a high level of protection. The whole concept of the equity of redemption reflects a sense of the common law that mortgagors are unable to protect themselves in bargaining over the terms of realization upon default in a security agreement.

There is a particularly strong argument in this regard with respect to consumer mortgages. Lenders now use a uniform mortgage form. Borrowers have virtually no opportunity to vary its terms. To the extent that the contract operates unfairly to the mortgagor, one could make a very strong argument that the contract is "unconscionable." (It almost certainly is a contract of adhesion.) The FNMA/FHLMC uniform mortgage instruments, however, have provided virtually from the start that insurance proceeds can be used to rebuild where the lender's security interest can be protected. Therefore, the issue simply has not arisen much in the context of institutional home lenders.

Non-institutional lenders, such as sellers taking purchase money mortgages, have a far greater reason to be concerned about maximizing their flexibility, and also far lesser ability to dominate the bargaining. It is more difficult to view as unconscionable stiff provisions for allocation of insurance proceeds when the provision appear in mortgage provisions between an individual buyer and an individual seller/financier.

When we move from residential to commercial mortgages, the difficulty with applying the concept of unconscionability is the reality, as described in the preceding section, that many mortgagees do permit mortgagors to include terms that provide for allocation of insurance proceeds to rebuilding in many cases. Consequently, borrowers clearly have a choice as to how this clause reads, and should not be heard to complain that the provision was forced upon them.

4. Conclusions

The author is persuaded by his own experience in practice to the effect that lenders are willing to negotiate over allocation of proceeds both in mortgage negotiations and at the time of loss. Consequently, this is an area of concern that is amenable to free and fair bargaining, and the best way to honor such bargaining as a vital element to our system of private exchange is to enforce the results. Where there is an apparent "windfall," resulting from an insured loss on a property which provides solid coverage, the mortgagee most likely will be responsive to the mortgagor's reasonable requests to use proceeds to rebuild. But where the mortgagee is not responsive, the courts should be prepared to accept the fact that the mortgagor exposed himself to that possibility when he signed the mortgage. To change the rules in the middle of the game is to drive from the game some of the most important players.

II: Mortgagee's Responsibility to Obtain Insurance:

Absent an agreement to the contrary, a mortgagee is under no obligation to insure the mortgaged premises. Beckford v. Empire Mutual Ins. Group, 525 N.Y.S.2d 260, 263 (A.D. 2 Dept. 1988). In Beckford, the insurance company cancelled, reinstated, and subsequently cancelled the mortgagor's policy. The mortgagee failed to notice the differences in the second cancellation, leaving the property uninsured when a fire occurred. The mortgage documents placed the duty on the mortgagor to maintain insurance for the benefit of the mortgagee, and it was reasonable for the mortgagee to assume that the mortgagor had notice of the cancellation. Id. Bare acceptance of the escrow payments was not sufficient consideration to support an agreement to provide insurance or to shift the performance of the duty to procure insurance onto the mortgagee. Id. A clause giving the mortgagee the option to pay premiums in the event mortgagor fails to perform its duty under the contract does not create an affirmative duty on the part of the mortgagee. It provides an elective remedy, and does not obligate the mortgagee to assume the duty of the mortgagor to maintain insurance. Id.

Some authorities hold, however, that where a mortgagee makes an oral agreement contemporaneous with or subsequent to the mortgage agreement, wherein it agrees to procure the insurance with the funds placed in escrow, the giving of the mortgage may be sufficient consideration to support the agreement. 3 Couch on Insurance 2d, Agents of Insured, § 25:86, p. 433; Hudson v. Ellsworth, 56 Wash. 243, 105 P. 463 (1909). In order to be binding, it must be part of the transaction, and, if it occurs later, the mortgage is insufficient consideration and the mortgagee's promise gratuitous and therefore unenforceable. Id.

Under a recent Indiana case, a contemporaneous or subsequent oral agreement regarding application of proceeds was enforceable through estoppel despite the mortgage's explicit language placing the burden upon the mortgagee. Tincher v. Greencastle Federal Savings Bank, 580 N.E.2d 268 (Ind. Ct. App. 1991).

In Tincher, the mortgage documents specifically stated that mortgagor would "insure and keep insured [the property] . . . for the benefit of the Mortgagee." Id. at 270. At closing, Tincher advanced the premium for the first year's insurance, and agreed with the mortgagee that thereafter the mortgagee would pay the insurance premiums from an escrow account accumulated from monthly payments by Tincher. This arrangement continued for fifteen years until the property was substantially damaged by fire, when both Tincher and the mortgagee discovered that the insurance had been cancelled almost a year earlier.

The court declined to impose a blanket duty on the part of a mortgagee to insure the premises simply because there was an escrow account. The mortgage agreement did not create a contractual duty on the part of the lender to maintain insurance, but rather, granted it the right to procure insurance for its benefit should the mortgagor fail to do so.

Here, however, the mortgagee's promise to maintain insurance out of the escrow account created a second, oral contract separate from the mortgage. This additional contract facilitated the exercise of mortgagor's duty to insure the premises, rather than contradicting or supplementing the mortgage. Under the doctrine of promissory estoppel, the mortgagor could maintain an action for breach of contract for failing to insure the premises. The Tincher court left open the possibility that on remand an action could also sound in tort against the lender if it was found that he had assumed a duty and had then failed to discharge it with skill and care. Id. at 273.

In Gulfco Finance Co. v. King,542 So. 2d 801 (La. Ct. App. 1989), rev'd 552 So. 2d 1199 (1989), the Louisiana Supreme Court reversed a lower appellate court's ruling and absolved a mortgagee of responsbility to procure insurance and to evaluate the solvency of insurance cariers. The lower court had reasoned that the mortgagee had become the agent of the mortgagor for the purpose of fulfilling the mandatory provision requiring the security be insured, and had thereby assumed the duty of procuring insurance on mortgagors' behalf, shifting the burden of "providing for adequate coverage" to the mortgagee. 542 So. 2d at 802-3. Consequently, the lower court had deemed the debt extinguished. The Supreme Court reinstated the debt, holding that the insurer's insolvency does not necessarily demonstrate mortgagee's negligence:

"a mortgagee does not guarantee that the insurance company will be financially able to pay claims when filed." 552 So. 2d at 1200. (59 C.J.S. Mortgages §328, p. 449.)

III. The impact of foreclosure on loss recovery: Some anomalous results.

The mortgage clause in the property insurance policy is divided into two basic categories: the open, or loss-payable clause, and the standard, or union mortgage clause [FN6] Under the first, open clause, the mortgagee's interest in the property is protected only to the mortgagor's interest. As a practical matter, the mortgagee can only recover if the mortgagor can recover. If there is a loss before foreclosure the mortgagee will have an insurance claim only to the extent of a deficiency because, theoretically, the property is actually worth the bid at the trustee's sale. [FN7] On the other hand, if the loss occurs subsequent to foreclosure, the mortgagee is precluded from recovery because his interest under the open mortgage clause is insured only as mortgagee and not as owner.

Under the standard, or union mortgage clause, the mortgagee's interest survives foreclosure because an independent contract between the mortgagee and the insurance company has been created and its rights to the insurance proceeds are not invalidated by any act or neglect of the mortgagor. When a loss occurs after foreclosure, the mortgagee's right to recovery is not barred by the change in ownership. [FN8]

What appears to be a simple principle at first glance can produce some unusual results. The Texas appellate court in Fireman's Fund Ins. Co. v. Jackson Hill Marina, Inc., 704 S.W.2d 131 (1986) interpreted a policy to: 1) bar recovery to the mortgagor because of a change in ownership; and, 2) to allow the mortgagee to recover to the extent of the amount outstanding on the debt following foreclosure. Although the court is unclear as to the type of policy clause, it would appear to be applying the standard mortgage clause which normally allows coverage to the mortgagee following foreclosure.

The result in Jackson Hill Marina would be logical under the open mortgage clause if the loss had occurred prior to the foreclosure. The mortgagee would have extinguished a portion of its debt through foreclosure and would have had a claim against the insurance proceeds to the extent that its security had been impaired, based on the mortgagor's insurable interest in the property prior to foreclosure. Here, however, the loss occurred after the foreclosure.

Where the insurer is covered for losses following the foreclosure, one would assume that its coverage is as owner, and not as lender. The court here, however, did not allow the mortgagee to recover the actual amount of the loss, but rather only that amount which remained outstanding from the mortgagor's debt even though the mortgagor had no insurable interest on the date of the loss. This raises the question: If the mortgagee's interest is converted from a secured interest in money to an actual interest in real property, why should it not be allowed to recover for the actual damage to the property after he has acquired ownership? Unlike a loss-foreclosure situation, the mortgagee would not receive double recovery because the property in its undamaged state was equal to the amount bid at foreclosure, and the loss was an actual diminution in value subsequent to foreclosure. (See Federal Nat'l Mortgage Ass'n v. Great American Ins. Co., 157 Ind. App. 347, 300 N.E.2d 117 (1973).)

A more consistent, but unfortunate, application of the loss-foreclosure rule occurred in Margaretten & Co., Inc. v. Illinois Farmers Ins. Co., 526 N.W.2d 389 (Minn. Ct. App. 1995). The property was damaged by fire and the insurance company denied the claim by mortgagors because it determined that they had caused the fire. Id. at 390. The mortgagor subsequently defaulted and the mortgagee was precluded from recovery under the policy because the full credit bid at the foreclosure sale extinguished the debt. The court commented that this result could have been avoided if the mortgagee had given a partial assignment of the mortgage to the insurance company, which would have given the insurer a claim against the mortgagor for the amount of the insurance payment. Id.

An Alabama Supreme Court opinion clearly articulates the reasoning behind preclusion of recovery in such a case, explaining that in a loss-before-foreclosure situation the mortgagee has an election between two remedies: he can either recover the insurance proceeds and extinguish the debt leaving the property to the mortgagor, or take the property and extinguish the debt. Chrysler First Financial. Serv. Corp. v. Bolling, 608 So. 2d 734, 737 (Ala. 1992). Because the rule requires an election of remedies, the mortgagee must have notice of the loss prior to the sale in order to make an informed choice. In Chrysler First Financial, a fire occurred just prior to the sale, and neither party discovered the loss until afterward. The court concluded that there was a mutual mistake of fact and set aside the foreclosure sale, returning the parties to the status quo.

A federal court applying California law refused to reform a deed of trust based on a mistake of fact with regard to the condition of the property before foreclosure. In Universal Mortgage Co., Inc. v. Prudential Ins. Co., 799 F.2d 458 (9th Cir. 1986), the mortgagee failed to gain entry to the premises prior to the foreclosure sale and did not discover until after a full-credit bid that the inside of the property had sustained an insured loss. After reselling the property at a loss, the mortgagee sought to recover the difference from the insurer.

The court denied reformation because a mistake of fact is not an appropriate remedy to avoid a contract that would not have been entered into at all except for the mistake. Recovery by Universal was barred because, regardless of whether a loss occurs after the sale or before the sale, "[a]ctual or constructive knowledge of property damage prior to a full credit bid is irrelevant because . . . once made, [the debt secured by the policy is extinguished.]" Id. at 460.

The California Court of Appeals, however, in reviewing a similar issue of law, noted that the decision in Universal Mortgage Co. "takes a step other courts have been unwilling to take." Walker v. Fire Ins. Exchange, 269 Cal. Rptr. 831, 835 n. 2 (1990).

In Walker, the mortgagee was aware before foreclosure that there was damage to the property and notified the insurer of its intent to foreclose and proceed with a claim. The mortgagee took back the property at the foreclosure sale and again notified the insurer, who issued a new policy face sheet naming the mortgagees as owners. The insurance company investigated the damage to the property and received an estimate of approximately $193,000 to make the needed repairs. The insurer then denied the claim, based on the fact that the debt had been extinguished by the mortgagee's purchase of the insured premises at the trustees' sale for the total amount due and owing. Id. at 833.

Here, the general rule that a mortgagee is barred from recovery of the insurance proceeds in a loss-foreclosure situation is excepted not because it lacked knowledge of the loss, but because it lacked knowledge of the insurance policy covenant precluding recovery. During the pre-foreclosure transactions, the insurer failed to provide the mortgagee with the endorsement upon which it relied in part in denying coverage. The mortgagees claimed breach of the duty of good faith and fair dealing on the part of the insurer. The Court of Appeals found that the rule precluding recovery by the mortgagee after a full credit bid is not enforceable unless the insured mortgagee had reasonable notice of the "peril" of making a full credit bid. Id. at 834.

Some mortgagees have been allowed to recover insurance proceeds in pre-foreclosure loss situations under various reasoning. Estate of Brindisi, 564 N.Y.S.2d 985 (N.Y. App. Div. 1991) (mortgagee can be "made whole" for fire occurring between initiation of foreclosure and sale by bidding the value of the damaged property and moving for a deficiency judgment against the fire insurance proceeds); Smith v. General Mortgage Corp., 252 N.W.2d 551 (Mich. Ct. App. 1977) (in a case of first impression, principles of equity dissuaded the court from following the majority rule and the mortgagee was awarded a portion of the insurance proceeds despite its full credit bid at foreclosure to avoid unjust enrichment to the mortgagors). Also, see: Farmers Savings Bank, Joice v. Gerhart, 372 N.W.2d 238 (Iowa 1985) (Bank entitled to new foreclosure sale where it bid in the debt believing that it was entitled to retain insurance proceeds from pre-foreclosure loss without applying such amounts to reduce debt);

Under the open mortgage clause, the distinction between loss-foreclosure and foreclosure-loss is unimportant because the mortgagee's interest is extinguished by the foreclosure in either event. However, under the standard mortgage clause the mortgagee should be able to recover when the loss follows the foreclosure because its interest is not disturbed by a change in ownership. [FN9] In advising mortgagee-clients who are considering foreclosure, it is well to review the insurance policies before taking action in order to avoid waiving potential rights to insurance proceeds.

IV. Other events affecting disposition of proceeds:

A mortgagee can recover only the amount owing on the mortgage, and once the underlying debt is satisfied, his insurable interest terminates. In Pantano v. Maryland Plaza Partnership, 507 N.W.2d 484 (Neb. 1993), mortgagee commenced foreclosure proceedings against certain property and purchased an insurance policy to protect its interest as mortgagee. Following commencement of the foreclosure but prior to the trustee's sale, the property was damaged by fire and mortgagee collected $155,000 insurance proceeds. The mortgagee then purchased the property at the trustee's sale, leaving a balance due and owing on the note.

The mortgagee sued for the deficiency, and the insurer intervened to recover the proceeds paid over to the mortgagee as mortgagees. Under Nebraska's "fair value" anti-deficiency statute, the court found that the fair market value of the property (even in damaged condition) was at least equal to the indebtedness. Therefore, the mortgagee was not entitled to a deficiency judgment since the greater of either the purchase price at the trustee's sale or the fair market value of the property must be subtracted from the total indebtedness before a deficiency judgment could be had. Id. at 489.

Because the fair market value of the property exceeded the amount of indebtedness in its damaged state, the debt had been satisfied and the mortgagee did not have a claim to the insurance proceeds since its secured interest had been satisfied by equity in the property. Id. "The rights of the insurer do not decrease simply because its insured, a trust deed beneficiary, is paid in equity rather than cash." Id. Because the mortgagee was not entitled to a deficiency judgment, the insurer had no right of subrogation. Hence, Fireman's Fund was entitled to recover from the mortgagee the amount paid over and above the mortgagee's equity in the property. Id.

In In re Natale, 174 B.R. 362 (Bankr. R.I. 1994), a mortgagee retained its right to insurance proceeds even where the mortgagor had failed to name him as loss payee on the policy. The mortgagor, who was in bankruptcy, collected the policy proceeds after a casualty loss and included it in the bankruptcy estate. The mortgage agreement contained a paragraph which required that the mortgagee be named as loss payee under the policy, creating a contractual as well as an equitable claim on behalf of the mortgagee. The debtor/mortgagors were entitled to hold the funds subject to the lien, rendering the proceeds the property of the mortgagee and not the property of the debtor's estate in bankruptcy. Id. at 364. See Jones v. GE Capital Mortgage Co., 179 B.R. 450 (E.D. Penn. 1995).

V. Conclusion:

Although parties contract about catastrophic losses, and although insurance policies provide insurance for them, in many cases borrowers are unable to project clearly what their situation will be when losses occur. They often are far more concerned with the "live" sections of their loan agreements - interest rate, mortgage constant, and even such matters as default notice, because they have a better vision of how these matters will arise. Casualty loss can arise from an almost infinite number of causes and affect a business in many unanticipated ways. In major loan transactions, parties lawyers are able to play the "what if" game with their clients and often bring a focus on insurance terms. But many mortgages, even commercial mortgages, reflect very little thought in this area. It is perhaps for this reason that some courts have been reluctant to leave the parties with the result of the contractual agreement.

There is an unmistakeable, although regrettable, trend in many jurisdictions toward greater judicial involvement in commercial contracts through the implied covenant of good faith and fair dealing. Thus, even in states where the case law now favors the mortgagee, there is every reason to believe that future "hard cases" will result in some reinterpretation of the parties' rights in this area. If the propposed language of the new Restatement holds up through the final drafts, we can expect to see greater judicial activism in reworking the parties' understanding respecting insurance proceeds.

Redrafting the insurance language to provide for absolute application of proceeds to reduce the debt will blunt, but will not completely divert, the movement toward reinterpretation. Courts will still argue that the provision itself is unconscionable as applied or else that the overall relationship of the parties dictates a result other than that compelled by the insurance clause.

Parties who are very certain that they want the right to apply insurance proceeds in a particular way would be wise to establish a "paper history," even in the contract itself, that supports the contractual allocation. This approach would be similar to that taken by many lawyers in dictating liquidated damages clauses. Set forth precisely why the parties believe that allocation of insurance proceeds as provided in the contract fairly reflects the bargaining expectations of the parties. If one cannot do this, then perhaps one's contract does not reflect the bargaining expectation of at least one of the parties, and this is precisely the case in which a court is likely to intervene later when "the chips are down" because the casualty has occurred.

1. See, e.g., General G.M.C. Sales, Inc. v. Passarella, 195 N.J. Super. 614, 481 A.2d 307 (1984), aff'd 499 A.2d 1017 (N.J. 1985); Loving v. Ponderosa Systems, Inc., 479 N.E.2d 531 (Ind. 1985); Giberson v. First Federal Sav. & Loan Ass'n, 329 N.W.2d 9 (Iowa 1973); First Federal Sav. & Loan Ass'n v. Stone,467 N.E.2d 1226 (Ind. App. 1984); Hartford Fire Ins. Co. v. Bleedorn, 235 Mo. App. 286, 132 S.W.2d 1066 (1940); State ex rel. Squire v. Royal Ins. Co., 58 Ohio App. 199, 16 N.E.2d 342 (1938).

2. U.C.C. 1-203; and Restatement of Contracts Second 205, "Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement."

3. See Osborne, Nelson and Whitman, Real Estate Finance Law (3d ed. 1979), 4.15.

4. But see First Federal Savings & Loan Ass'n v. Stone, 467 N.E.2d 1226, n.1, supra , wherein the failure of the mortgagee to notify the mortgagor of its intent to apply the insurance proceeds to the debt rather than rebuilding did not preclude such application even though the mortgagors had expended the funds toward rebuilding in reliance on receipt of the proceeds.

5. For another discussion of good faith and fair dealing and the concept of opportunism, see E. Allan Farnsworth, Contracts 7.17, n. 3 (2d ed. 1990).

6. Note, Foreclosure, Loss and the Proper Distribution of Insurance Proceeds Under Open and Standard Mortgage Clauses: Some Observations, 7 Val. U. L. Rev. 485 (1973).

7. Id. at 485-6; Whitestone Savings & Loan Ass'n v. Allstate Ins. Co., 28 N.Y.2d 332; 270 N.E.2d 694, 321 N.Y.S.2d 862 (1971); Arkansas Teacher Retirement System v. Coronado Properties, Ltd., 33 Ark. App. 17, 801 S.W.2d 50 (1990); and Caruso v. Great Western Savings, 229 Cal. App. 3d 667, 280 Cal. Rptr. 322 (1991).

8. Id.; Nationwide Mutual Fire Ins. Co. v. Wilborn, 291 Ala. 193, 279 So. 2d 460 (1973); and Guardian Savings & Loan Ass'n v. Reserve Ins. Co., 2 Ill. App. 3d 77, 276 N.E.2d 109 (1971).

9. See n. 8, supra.