Stites & Harbison, PLLC

On December 21, 2007, the Tennessee Court of Appeals issued an opinion voiding a mortgage lender's property damage insurance claim because it failed to notify the carrier that foreclosure proceedings had been commenced.  The Court  held that mortgage lenders have a duty to notify an insurer when foreclosure proceedings are "commenced" in order to comply with standard mortgage clauses in insurance policies.    U.S. Bank v. Tennessee Farmers Mutual Insurance Co., 2007 Tenn. App. LEXIS 788 (Tenn. Ct. App., December 21, 2007).  Foreclosure is already a risky, albeit necessary, undertaking for secured lenders, and with the issuance of the U.S. Bank opinion, those risks have increased. 

In U.S. Bank, the Court reviewed both the language of the insurance policy issued by the insurer and T.C.A. § 56-7-804, and determined that both the language of the insurance policy and T.C.A. § 56-7-804 required the lender to notify the insurer of the commencement of foreclosure proceedings because such proceedings present an increased risk that the real property will be damaged or destroyed by the homeowner due to financial troubles, thereby increasing the risk to the insurer.  The Court first focused on the "standard mortgage clause" language in the policy.  These clauses typically require the mortgagee to notify the insurer of any known increases in hazard to the insured property.  Until the U.S. Bank opinion, there is no reported case law holding that the commencement of foreclosure proceedings falls within this zone of increased risk.

Case Facts and Trial Court Disposition

On February 12, 1999, Jessica Robbins ("Homeowner") purchased a home located in Gibson County, Tennessee (the "Property").  The loan was secured by a deed of trust in favor of U.S. Bank, N.A., and U.S. Bank was listed as the mortgagee on the insurance policy issued by Tennessee Farmers Mutual Insurance Company ("Tennessee Farmers").  Approximately eighteen months later, Homeowner married and changed her name.  At about the same time, Homeowner began to miss her scheduled monthly payments to U.S. Bank.  Her financial condition continued to decline over the next two years, culminating in the commencement of foreclosure proceedings pursuant to the deed of trust.

Prior to the foreclosure sale, the Homeowner and her husband filed for protection under Chapter 13 of the United States Bankruptcy Code.  The commencement of the bankruptcy case stayed the foreclosure sale, and the foreclosure attorney closed his file.  Six months later, during the pendency of the bankruptcy case, the Property was destroyed by fire.  The fire was allegedly caused by the Homeowner's husband while he was making methamphetamine.

On September 30, 2003, U.S. Bank filed a claim with the insurer under the insurance policy for the fire loss.  The insurer declined to pay the claim, and on April 8, 2004, U.S. Bank filed a lawsuit against the insurer for, among other things, breach of contract and bad faith refusal to pay the submitted claim.  The insurer's answer denied these claims and asserted counterclaims against U.S. Bank alleging that the lawsuit was frivolous and filed in bad faith. The parties subsequently filed cross-motions for summary judgment, and the trial court denied Tennessee Farmers' motion but granted U.S. Bank's motion. In granting U.S. Bank's motion, the trial court found that T.C.A. § 56-7-804 did not include foreclosures or the commencement of foreclosures from the requirement to notify Tennessee Farmers of an increased risk of hazard. Tennessee Farmers appealed the trial court's ruling arguing that both the standard mortgage clause in the insurance policy and T.C.A. § 56-7-804 include commencement of foreclosure proceedings as known hazards that require the mortgagee notification.

The Opinion

In determining that the mortgagee had a duty to notify the insurer of the commencement of foreclosure proceedings, the Court examined both the policy language and T.C.A. § 56-7-804.  The Court determined that the policy language created a contract between the parties whereby the mortgagee would continue to have coverage for loss even during foreclosure as long as notification was given to the insurer once this process was commenced.  The Court focused on the "standard mortgage clause" contained in the policy and determined that the clause created a separate contract between the insurer and the mortgagee, and in doing so construed the notice requirement in the clause to be unambiguous with regard to the mortgagee's duty to notify the insurer of "any … increase in hazard of which [the mortgagee] has knowledge." 

The Court next examined whether known increases in hazard included commencement of foreclosure.  First, the Court construed the term "increase in hazard" to be synonymous with an "increased risk of loss," a common term in the insurance industry.  With this determination made, the Court then analyzed whether commencement of foreclosure proceedings falls within the zone of those events increasing the risk of loss.  In concluding that foreclosure commencement does fall within this zone, the Court reviewed various jurisdictions that examined this issue.  Most of the cited cases were very old, dating back to the Great Depression. 

The Court found that the likelihood of foreclosure increases the risk to the insurer because the homeowner is tempted to destroy the property in order to realize the insurance proceeds and pay off the mortgagee's lien.  According to the Court, it is this moral hazard, i.e., the homeowner's temptation to destroy the property, that triggers the increased risk of commencing foreclosure.  Notice is crucial to the insurer in order to permit the insurer the ability to re-examine the policy risk and make its own assessment.   The Court determined that the contract's benefit to the mortgagee was that it could keep coverage in place despite foreclosure, but the mortgagee carried the burden of providing notice to the insurer of the commencement of the foreclosure in order to permit the insurer the time to re-evaluate the policy and make sure that "the premium rate is commensurate with the level of risk the insurer … agreed to assume."

Additionally, the Court determined that T.C.A. § 56-7-804 contains similar language to the policy language relating to the continuation of coverage during foreclosure proceedings.  It also determined that T.C.A. § 56-7-804 also contains similar duties to notify the insurance company of "increased hazards."  The Court stated that the analysis of T.C.A. § 56-7-804 is the same as the analysis for the policy itself.  Therefore, because the commencement of foreclosure proceedings falls within the zone of increased hazards, the mortgagee has a statutory duty to notify the insurer in order to enjoy the benefits of the statute's protection against an insurer's voiding of a policy due to foreclosure.

The Impact

Under the U.S. Bank decision, a mortgagee now has an affirmative duty to notify an insurer of the commencement of foreclosure proceedings in order to avoid having the casualty coverage voided.  The Court's opinion did not limit this duty to those policies with notice language.  Instead, the Court construed T.C.A. § 56-7-804 to include notification as a requirement for mortgagees.  Now a mortgagee must notify the insurer of the commencement of foreclosures regardless of the policy language. 

Additionally, the U.S. Bank decision has opened a Pandora's Box with respect to incidents that could be construed as an "increase in hazard" thereby requiring notice to the insured.  Prior to this opinion, Tennessee did not recognize commencement of foreclosures as an increase in hazard requiring notice.  While the U.S. Bank decision is limited to commencement of foreclosure, it does not definitively limit the notice requirement to this type of financial risk.  It is clear that the mortgagee must provide notice at the commencement of foreclosure.  However, there are additional unresolved issues.  First, what constitutes the "commencement of foreclosure?"  Is it the initial default by the homeowner under the mortgage or when the matter is referred to an attorney for foreclosure?  Does commencement occur when the title update is performed or when the foreclosure notice is published?  This decision does not indicate when commencement occurs.

Second, this decision raises the issue of further expansion of the term "increase in hazard" to potentially include default by the homeowner.  If one applies the Court's reasoning, i.e., that commencement of foreclosure increases the risk to the insurer because the homeowner may be tempted to intentionally destroy the property due to financial distress, then it is logical to assume that the next step would be to require notice to the insurer when the homeowner misses a payment to the mortgagee.  Would it also include non-monetary defaults under the mortgage?  Would notice be required to be given to the insurer if the homeowner files for bankruptcy protection?  Would delinquent property taxes also be considered to fall within this zone? 

Finally, this decision also raises questions about whether the mortgagee has a duty to notify the insurer of non-financial risks the mortgagee knows about, i.e., the physical condition of the property.  For example, would the mortgagee have a duty to notify the insurer of any detrimental or dangerous physical conditions to the property that were revealed by an appraisal?  If the homeowner has a thirty-year mortgage, and the original appraisal indicated that the electrical wiring in the property at that time was already thirty years old, would the mortgagee have a duty to notify the insurer later?  What are the limits for the zone of increased hazards?

It is likely that these questions will be raised and addressed in the future.  However, mortgagees should give notice to insurers as early as possible once the mortgagee is moving toward foreclosure.(1)   If the mortgagee is aware of any other fact that it believes may increase the hazard, it should consider notifying the insurer of that fact as well.
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(1)Under Tennessee's Financial Privacy Act, the mortgagee may be limited in the disclosure of financial information to third parties.  While this issue is outside of the scope of the U.S. Bank decision, mortgagees should consult with counsel about this issue.