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2.8 Mishandling of Insurance Proceeds

Almost all mortgage loans require borrowers to maintain hazard insurance to protect the lender’s interest in the property. The typical security instrument language gives the lender133 broad discretion to determine what types of insurance are required (fire, flood, earthquake, wind, and so forth) and the amount of coverage.134 The lender is also authorized to change these requirements during the life of the loan. The lender (or servicer) must be named as a loss payee on the insurance policy.

After a covered loss occurs, the insurance company resolves the claim by issuing a check identifying both the borrower and the mortgage lender or servicer as payee.135 Because the lender or servicer is also a payee, it effectively controls disbursement of the proceeds to the borrower. As a result, borrowers have faced significant financial hardship when the servicer136 seeks to apply the funds to the loan balance rather than dedicating them to restoration of the property. In other cases, the servicers may insist on completion of the repair work prior to releasing the funds. This forces the borrower to pay for repairs up front out of pocket before receiving the insurance proceeds.137 In some instances servicers have been known to hold insurance proceeds indefinitely, neither applying them to restoration of the property nor crediting them to the loan balance.

The Fannie Mae standard security instrument provides that insurance proceeds will be applied to the restoration of the property so long as the restoration and repair138 are “economically feasible” and the lender’s “security is not lessened.” If the repairs do not satisfy both conditions, then the security instrument directs the lender to apply the insurance proceeds to the debt. The term “economically feasible” is not defined in the instrument, and there is no explanation of what it means to lessen the security. Most courts have interpreted the phrases to mean, respectively, whether the cost of repairs will exceed the insurance proceeds and whether the value of the repaired home will at least equal its value prior to the loss.139 Like many mortgage servicing issues, who bears the burden of demonstrating economic infeasibility or reduced security may depend on the procedural posture of the case.140 This issue is typically a question of fact that will preclude summary judgment.141

If the proceeds are to be used for restoration and repair, the mortgage servicer may disburse proceeds in a single payment or in a series of progress payments as the work is completed. A typical disbursement schedule might release one-third of the proceeds up front, the next one-third at 50% completion (and after inspection), and the last one-third at completion (and after inspection).142 Delays in distribution of funds can wreak havoc with rebuilding efforts, and may give rise to claims of breach of contract or breach of the covenant of good faith and fair dealing.143 Courts have held, however, that once the borrower defaults, the lender is under no further obligation to disburse insurance proceeds.144 Lenders generally may not keep insurance proceeds that exceed the outstanding loan balance and should not keep any funds attributable to the loss of personal property.145 The lender is not required to pay interest on undisbursed funds unless “applicable law” so requires.146

Another issue is when the servicer must apply the insurance proceeds if the repairs do not satisfy the stated conditions. No time frame is specified for when the property must be repaired or when the proceeds should be applied to the debt. Mortgage servicers have allowed insurance proceeds to languish for years in restricted escrow (or loss draft) accounts. Courts have implied a “reasonable time” to perform under this contract provision.147 In Vongohren v. Citimortgage, Inc., the court determined that once the loan investor had instructed the servicer to foreclose instead of pursuing repair, there was no need to delay in applying the insurance proceeds to the debt due under the loan.148

Claims that may be raised when the mortgage servicer mishandles insurance proceeds include:

  • • Breach of contract;
  • • Breach of the implied covenant of good faith and fair dealing;
  • • Conversion;
  • • Unjust enrichment;
  • • Negligent servicing;149 and
  • • Unfair and deceptive acts and practices (UDAP).

Footnotes

  • 133 {130} Though the standard security instrument refers to the “lender,” the mortgage servicer is generally responsible for ensuring compliance with the security instrument, including the insurance provisions.

  • 134 {131} See Single-Family Fannie Mae/Freddie Mac Uniform Instrument ¶ 5 (Jan. 2001).

  • 135 {132} For a description of variations in insurance policy mortgage clauses, see Costanzo v. Prop. & Cas. Ins. Co. of Hartford, 2014 WL 1151717 (D.N.M. Oct. 1, 2014).

  • 136 {133} Many servicers outsource the managing of covered losses and the handling of insurance proceeds to third-party vendors.

  • 137 {134} See Pressler v. Am. Home Mortg. Servicing, Inc., 2013 WL 1320462 (N.D. Cal. Apr. 1, 2013) (lender required borrowers to front one-third of costs, a condition the court noted is not required by the contract).

  • 138 {135} Courts have construed the terms “restoration” and “repair” narrowly at times. See Green Tree Servicing, L.L.C. v. Mann, 2008 WL 793632 (W.D. Ky. Mar. 24, 2008) (replacement of manufactured home did not constitute restoration or repair; therefore lender did not need to disburse insurance proceeds for that purpose); Cox v. Wightman, 2007 WL 708611 (W.D. La. Mar. 5, 2007) (insurance proceeds not required to be used for mold testing, as “testing” was not restoration and repair).

  • 139 {136} Vongohren v. Citimortgage, Inc., 2016 WL 739070 (D. Md. Feb. 25, 2016); Alvarez-Mejia v. Bellissimo Properties, L.L.C., 208 So. 3d 797 (Fla. Dist. Ct. App. 2016).

  • 140 {137} See Music v. Bank of Am., 2015 WL 8477614 (N.D. Cal. Dec. 9, 2015) (placing burden on borrower-plaintiff to show economic feasibility), aff’d, 2017 WL 4772555 (9th Cir. Oct. 23, 2017).

  • 141 {138} See Alvarez-Mejia v. Bellissimo Properties, L.L.C., 208 So. 3d 797 (Fla. Dist. Ct. App. 2016).

  • 142 {139} For current loans with loss proceeds in excess of $40,000, Fannie Mae requires installment distributions of up to $40,000 or 10% of unpaid principal balance, whichever is greater. Fannie Mae Single-Family Servicing Guide, at B-5-01 Insured Loss Events (July 15, 2020), available at www.fanniemae.com.

  • 143 {140} Pressler v. Am. Home Mortg. Servicing, Inc., 2013 WL 1320462 (N.D. Cal. Apr. 1, 2013) (denying breach of contract and breach of the covenant of good faith and fair dealing claims for predefault conduct).

  • 144 {141} Music v. Bank of Am., 2015 WL 8477614 (N.D. Cal. Dec. 9, 2015), aff’d, 2017 WL 4772555 (9th Cir. Oct. 23, 2017); Everidge v. Wells Fargo Bank, 2015 WL 5786738 (M.D. Ga. Sept. 29, 2015) (suggesting that paying over proceeds and delaying foreclosure constituted sufficient impairment of security to justify applying proceeds to debt), aff’d, 654 Fed. Appx. 479 (11th Cir. 2016); Pressler v. Am. Home Mortg. Servicing, Inc., 2013 WL 1320462 (N.D. Cal. Apr. 1, 2013). But see Fannie Mae Single-Family Servicing Guide, at B-5-01 Insured Loss Events (Apr. 12, 2017), available at www.fanniemae.com (requiring release of loss proceeds for repair and evaluation of the borrower for workout options).

  • 145 {142} See, e.g., Fannie Mae Single-Family Servicing Guide, at B-5-01 Insured Loss Events (July 15, 2020), available at www.fanniemae.com.

  • 146 {143} State law may require the payment of interest on insurance proceeds held by the servicer. See, e.g., Md. Code Ann., Com. Law § 12-109 (West); Or. Rev. Stat. §§ 86.205.3, 86.245; Utah Code Ann. § 7-17-2 (West); Vt. Stat. Ann. tit. 8, § 10404(b). But see Lippitt v. Nationstar Mortg., L.L.C., 2020 WL 3891676 (C.D. Cal. Apr. 16, 2020) (interest on insurance proceeds not required by applicable law).

    Some banks have argued that the payment of such interest is preempted; however, preemption principles should not apply to the bank’s contractual obligation to pay interest.

  • 147 {144} Vongohren v. Citimortgage, Inc., 2016 WL 739070 (D. Md. Feb. 25, 2016).

  • 148 {145} Id. at *8.

  • 149 See, e.g., Pickett v. Ditech Fin., L.L.C., 322 F. Supp. 3d 287, 293 (D.R.I. 2018) (servicer held insurance proceeds for months without inspecting repairs on property, then applied funds to loan when borrower defaulted; motion to dismiss negligence claim denied).