Lender’s Insurance Claim vs. Deficiency – A New Exception

This is a dangerous area about which we have necessarily commented over the years.  A recent case now covers a new exception to a rule that can otherwise trip up the lender. [Washington Mutual Bank v. Allstate Ins. Company, 48 A.D.3d 554, 852 N.Y.S.2d 201 (2d Dept. 2008.)]

Understanding what the new exception means leads first to a discussion of the underlying lender’s dilemma.

When there is a hazard loss (such as a fire) at mortgaged premises, both borrower and lender have a claim.  Typically the borrower submits the claim and the insurer is bound to issue the check to both borrower and lender.  Actually, the lender doles out the proceeds to assure that the repairs are made.  (If the borrower is in default, then insurance proceeds are to be paid solely to the lender.)  While there certainly are nuances to this, for the most part this is standard stuff with which mortgage servicers should be familiar.

But in the instance of a mortgage foreclosure action, if the loss (such as by fire) is incurred near the point of a foreclosure sale, a different principle intercedes.

When a foreclosure sale is conducted, and if the foreclosing lender does not elect to pursue a deficiency judgment, the proceeds of the sale, no matter how small, or the taking back by the lender of the property, no matter how little it may be worth, is deemed at law to be full satisfaction of the debt.  So if the lender is considered paid in full, it no longer has an insurable interest.

Accordingly, if an insurance loss has not yet been paid by the insurance company, and a lender proceeds to sale but does not obtain a deficiency judgment, there is no right to continue the claim against the insurance company. Viewed from the reverse, the insurer is no longer liable to pay anything – a most serious situation for lenders who may not be aware of the rule.  As a practical matter, this means that when an insured loss occurs, a lender either refrains from conducting a sale until the claims process runs its course, or it holds the sale but then pursues the deficiency judgment.  (In most instances, we recommend the latter path.)

What happens, though, if during the course of a foreclosure which suffers a hazard loss, the borrower files a petition in bankruptcy – which of course stays any further action by the lender? Where the lender gets an order lifting the stay and personal liability for the debt is discharged in bankruptcy, then pursuit of a deficiency would be meaningless and void.  And in the subject case the lender was enjoined from any action to collect a discharged debt.

In short, the lender could not have sought a deficiency and even if it could have, it would have been unenforceable.  Under this circumstance, even though the lender went to sale – and did not seek a deficiency – the insurance company was still liable.

Aside from an important distinction, the case is a reminder that when a hazard loss coincides with an impending foreclosure sale, the servicer is wise to convene with local counsel to assess the safe course of action available.

Mr. Bergman, author of the four-volume treatise, Bergman on New York Mortgage Foreclosures, LexisNexis Matthew Bender (rev. 2017), is a partner with Berkman, Henoch, Peterson, Peddy & Fenchel, P.C. in Garden City, New York. He is also a member of the USFN, The American College of Real Estate Lawyers, The American College of Mortgage Attorneys, an adviser to the New York Times on foreclosure issues and writes a regular servicing column for the New York Law Journal. He is AV rated by Martindale-Hubbell, his biography appears in Who’s Who In American Law and he has been for years listed in Best Lawyers In America and New York Super Lawyers.