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Notice of Foreclosure To Insurance Company Not Required in Tennessee

The Tennessee Supreme Court issued an opinion on Jan. 29 in the case of U.S. Bank NA, as servicer for the Tennessee Housing Development Agency v. Tennessee Farmers Mutual Insurance Co., which addressed industry concerns relevant to notice to insurance companies upon the commencement of a foreclosure action in Tennessee.

The issue presented in this case was whether the commencement of foreclosure proceedings constituted an “increase in hazard” for notice purposes under a standard mortgagee clause in an insurance policy. The parties to this dispute were the bank that loaned funds to a homeowner for the purchase of a house and the insurance company that issued a personal fire and extended coverage insurance policy on the premises.

After the homeowner became delinquent on her payments, the bank began foreclosure proceedings by notifying the homeowner of its intent to foreclose on the house. No notification of the foreclosure was given to the insurance company, which insured the house against fire loss. Before the foreclosure process was complete, the homeowner filed for bankruptcy, which stayed the foreclosure proceedings. Thereafter, the house was destroyed by fire. The insurance company refused to pay the insurance proceeds to the bank on the theory that the commencement of foreclosure proceedings constituted an increase in hazard of which the bank was required to notify the insurance company under the policy.

The bank filed suit against the insurance company for breach of contract, bad faith refusal to pay an insurance claim and violation of the Tennessee Consumer Protection Act. The trial court granted partial summary judgment to the bank, concluding that the bank's failure to give the insurer notice of the foreclosure proceedings did not invalidate the insurance coverage. The Tennessee Court of Appeals reversed, finding that the bank's initiation of foreclosure proceedings amounted to an increase in hazard under the policy and the bank's failure to provide notice precluded coverage.

The Tennessee Supreme Court has now concluded that commencement of foreclosure proceedings does not constitute an increase in hazard under the terms of the insurance policy or the applicable statutory provisions, and therefore, no notice was required to be given to the insurance company. Accordingly, the judgment of the Court of Appeals was reversed.

The court began its analysis by initially describing the two types of insurance policy provisions designed to protect the mortgagee, the “simple/open clause” and “standard mortgagee clause”. A simple/open clause provides that the lienholder’s rights are no greater than the insured borrower’s rights. In other words, a simple/open clause merely identifies the person or entity entitled to collect the insurance proceeds in the event of a covered loss. The generally accepted view is that under a simple/open clause, the rights of the lienholder are wholly derivative and cannot exceed those of the insured. Thus the lienholder stands in the insured’s shoes and is subject to the same defenses that may be raised against the insured by the insurance company. Under this type of clause, the acts of the insured are highly relevant, as those acts directly affect the rights of both the borrower and the insured.

The second type of insurance policy provision designed to protect the mortgagee is known as the standard mortgagee clause. Courts have uniformly held that, under a standard mortgagee clause, coverage is provided for the lienholder regardless of the actions of the insured borrower. The primary function of the standard mortgagee clause is to furnish to the lienholder with a reliable security in a definite sum free from any interference on the part of the insured borrower, which would, to any extent, invalidate or make less adequate that security. Accordingly, most jurisdictions addressing the question recognize that a standard mortgagee clause creates a separate contract between the insurer and the lienholder, conferring greater protection to the lienholder than the insured has in the underlying policy. Tennessee adopted this position in Reeves v. Granite State.

As previously noted, the policy in question contained a standard mortgagee clause. Although no Tennessee case has squarely addressed the precise issue presented, the ruling in S. Ins. Co. v. Estes, was instructive to the court. In Estes, the insurance policy contained a clause stating that the policy would become void “if, with knowledge of the insured, foreclosure proceedings be commenced.”

There was a mortgage on the property, foreclosure was commenced, and the property was subsequently destroyed by fire due to no fault of the insured. Neither the existence of the mortgage nor the commencement of the foreclosure was disclosed to the insurer. The insurer sought to void the policy, but the court ruled that neither the existence of the undisclosed mortgage nor the commencement of foreclosure proceedings invalidated the mortgage coverage. The court reasoned that foreclosure proceedings are the remedy of the mortgage for nonpayment of the debt, and the remedy is an “incident of the mortgage … and … a result that is brought about by the existence of the mortgage."

The court’s review of cases from other jurisdictions revealed that courts have reached a similar conclusion on the issue of whether the commencement of foreclosure proceedings constitutes an “increase in hazard” for the purposes of a standard mortgagee clause. In cases involving the standard mortgagee clause requiring notice of an “increase in hazard,” courts have also found that the plain meaning of those words do not include an event such as a foreclosure proceeding, but rather, refer to the physical condition on the insured property posing a more hazardous risk to the property. However, courts have reached a different conclusion when the policy language specifically provides that foreclosure proceedings void the policy or require notification of the proceedings. In such cases, courts have held that the commencement of foreclosure proceedings does constitute an increase in hazard.

The mortgagee clause at issue in the present case contained no such language, and the court found that there were no facts in the record, which supported the conclusion that the mere commencement of foreclosure proceedings constituted an increase in hazard. Further, it was not willing to assume, absent proof, that a homeowner facing a foreclosure sale would set fire to his or her property for monetary gain. In essence, the insurer asked the court to write a new contract in accordance with its idea of what the policy should have said, and the court declined to do so. Aaron Squyres is a partner at Wilson & Associates PLLC and is the supervising attorney of the litigation division. Wilson & Associates provides its clients in Arkansas and Tennessee with turnkey bundled services in the real estate default legal market.