Can Lenders Take Insurance Claim Proceeds and Apply Them to the Loan?
- an insured's deed of trust requires the insured to name the lender as a loss payee on their property insurance policy;
- a loss occurs;
- the insurance company issues claim payments naming the lender and insured as co-payees; and
- the lender refuses to release the insurance proceeds to the insured in a timely manner.
Without the insurance money, many insureds do not have the resources to begin repairing property or resume business. Where the property damage is severe, insureds are often forced to incur substantial costs to rent other property, and cannot afford the rental costs on top of their mortgage. Things can quickly spiral out of control and the insured's mortgage can go into default.
In situations like this, do insureds have any recourse against their lenders?
Like insurance policies, deeds of trust are contracts that contain an implied covenant of good faith and fair dealing.1 Although most deeds of trust give lenders the right to be named on insurance checks earmarked for property damage, a lender's right “to apply insurance proceeds to the balance of a note secured by a deed of trust must be performed in good faith and with fair dealing. . . .”2
Courts have found that where the security is not impaired, the lender must release the insurance proceeds to the insured so that the insured may repair/rebuild their property. In the context of the rights of the parties to the insurance proceeds after an insured loss, when the insured demands the proceeds to repair the damage, and the deed of trust requires the insured to repair the damage, the covenant of good faith and fair dealing requires the lender to relinquish the proceeds to the insured for payment of the costs of repair, unless the lender needs the proceeds to protect its legitimate interests (i.e., where its security is otherwise impaired).
When the insured's loan is in good standing, impairment will normally involve a factual inquiry into whether the market value of the trust deed property still adequately secures the insured's indebtedness. This is because the purpose of a deed of trust is to provide the lender with sufficient recourse should the insured default on the loan.3
Courts have found that lenders that refuse to release insurance proceeds to fund repairs before the loan is in default can be found to have violated the implied covenant of good faith and fair dealing.4
In Pressler v. American Home Mortgage Servicing, the court denied a lender's summary judgment motion where the evidence demonstrated that:
Lender told the Presslers that they had to front 33% of the costs-a condition found nowhere in the Deed-and though such an arrangement could be reasonable depending on the parties' understandings and negotiations, nothing in the current record explains why it was here. See Pressler Decl. (dkt.22–1) ¶ 4. Then[…], after two years of a generally productive partnership to rebuild the house, Lender fell silent for four months after construction had ceased. Then, Lender conditioned its continuation of the funding on a new “pay as you go” scheme, which, like the 33% out of pocket condition, was not in the Deed.
It makes sense that a lender should not be able to withhold insurance proceeds from an insured to cause a default on the loan and take possession of the insured's property. This is because the parties (lender and insured) intended that the purchase price would be paid in the ordinary course of events, and that insureds would have the use of their property during the full period of the long-term loan.5
Insureds who (1) face property damage claims, are (2) not already in default on their loans at the time of the insurance claim payment, and (3) face lenders reluctant to release insurance proceeds, may pursue claims against their lenders for breach of the implied covenant of good faith and fair dealing.
1 Schoolcraft v. Ross, 81 Cal. App. 3d 75, 80 (Cal. App. 1978).
2 Id., at 77.
3 Ford v. Manufacturers Hanover Mortg. Corp., 831 F.2d 1520, 1525 (9th Cir. 1987).
4 See Pressler v. Am. Home Mortg. Servicing Inc., No. CV 11-6400 CRB, at *8 (N.D. Cal. Mar. 29, 2013).
5 Schoolcraft, at 81.