As a matter of first impression, the Seventh Circuit recently issued an opinion interpreting a “created or suffered” exclusion in a title insurance policy with a mechanic’s lien endorsement. See 695 F.3d 725 (7th Cir. 2012). In interpreting the exclusion, the court held that a title insurance company breached its duty to defend a construction lender under a mechanic’s lien endorsement to a title insurance policy.

In this case, the lender agreed to lend $95.5 million to finance the construction of an ethanol production plant. The lender was to disburse the loan in installments. To protect its mortgage, the lender purchased title insurance. The title insurance company was required to perform a title search after the lender made each loan disbursement. The lender paid an extra premium for a mechanic’s lien endorsement which insured against “enforcement or attempted enforcement” of a mechanic’s lien claim having priority over or sharing on a parity with the mortgage. The mechanic’s lien endorsement also required the title insurance company to defend the lender “in litigation in which any third party asserts a claim…alleging a defect, lien or encumbrance or other matter insured against by this policy.”

After $87 million of the loan had been disbursed, a dispute arose between the owner and the general contractor, which resulted in the general contractor filing a $6 million mechanic’s lien against the property. Suspecting a lien had been filed, the lender requested that the title insurance company perform a title search. The title insurance company updated the title search and disclosed the existence of the general contractor’s lien and, at that point, made an express exception from coverage.

After the lender filed suit to recover the $95.5 million due under the loan and to foreclose on its mortgage, the general contractor asserted a counterclaim against the lender, claiming that it was entitled to enforce its lien against the entire property and claiming priority over the lender’s lien. Although the title insurance company initially acknowledged the contractor was seeking a judgment determining that its lien was prior to and superior to the lender’s mortgage, it denied the lender’s request for defense and indemnification. After settling with the contractor, the lender then sued the title insurance company for breaching its duty to defend and indemnify under the title insurance policy and the mechanic’s lien endorsement.

In conducting its analysis, the Seventh Circuit noted that many title insurance policies insure only against mechanic’s liens arising before the endorsement date and for which labor or materials have already been furnished. However, the endorsement at issue in this case covered any claim “arising from construction contracted for and/or commenced on the land prior to, at, or subsequent to the effective date.” The court held that under the terms of the policy and endorsement, the title insurance company was required to defend against any enforcement or attempted enforcement of a claim asserting priority over or parity with the mortgage, regardless of the merits of the attempted enforcement. Although the contractor had little chance of success of prevailing on its counterclaim under Indiana law, the insurer still had a duty to defend the lender since the counterclaim was an attempt to enforce a claim of priority over a mortgage.

Of notable interest, the title insurance company also argued that coverage was excluded under the policy since it excluded from coverage claims “created, suffered, assumed or agreed to or by the Insured claimant.” As explained by the court, the “created or suffered” exclusion is standard in title insurance contracts and “apparently, one of the most litigated clauses in the field.” The title insurance company argued that the lender “created, suffered, assumed, or agreed to the lien” when the lender decided not to disburse the remaining $8.5 million in funds under the loan. Although the court recognized that First American Title Ins. Co. v. Action Acquisitions, LLC, 187 F.3d 1107 (Ariz. 2008) may support this argument, the “overwhelming weight of authority is to the contrary.” Rather, the “‘created or suffered’ language is intended to protect the insurer from liability for matters caused by the insured’s own intentional misconduct, breach of duty, or otherwise inequitable dealings.” Noting that neither Indiana nor the Seventh Circuit had ever defined the “created or suffered exclusion”, the court predicted that Indiana would adopt the majority view that the exception only applies when the insured was guilty of intentional misconduct, breach of duty, or otherwise inequitable dealings and does not apply when the insured is innocent of any conduct causing the loss or was simply negligent in bringing about the loss. Here, there was no allegation or evidence that the lender engaged in deliberate, dishonest, or illegal dealings.

The court also rejected the title insurance company’s claim that the lender breached a duty to the title insurance company to distribute the entirety of the loan proceeds. Id. at 733- 734. In distinguishing Brown v. St. Paul Title Ins. Corp., 634 F.2d 1103 (8th Cir. 1980) and Bankers Trust Co. v. Transamerica Title Ins. Co., 594 F.2d 231 (10th Cir. 1979), both of which involved title insurance policies and mechanic’s lien endorsements similar to the one at issue, the court noted a “critical” factual difference in those cases. There, the insured lenders had each “agreed to make adequate funds available to pay the developers and their contractors.” The court found it significant that in those cases, the title insurers assumed the responsibility for securing the lien waivers and actually disbursing the loan funds to the various contractors. These agreements with the title insurance companies clearly contemplated that the lenders would make adequate funds available to the title insurance company to satisfy claims. However, in this title insurance policy, there was nothing that required the lender to disburse the entirety of the funds. Because there was not a disbursement agreement with the title insurance company, the lender did not have a duty to disburse all of the funds. Therefore, the claim did not fall within the “created or suffered” exclusion as defined and interpreted by the court.