Minnesota Court of Appeals Decision Expands Insurance Coverage for Commercial Lenders

12/19/2014 / Connor McNellis

Commerce Bank v. West Bend Mutual Insurance Co., 853 N.W.2d 836 (Minn. App. 2014)

This recent Court of Appeals decision expands insurance coverage for commercial lenders in Minnesota by ruling that vacancy cannot void a lender’s coverage under a “standard” mortgage clause. Commercial property casualty insurance policies do not insure against losses stemming from vandalism, sprinkler leakage, glass breakage, water damage, theft or attempted theft if the property has been vacant for more than 60 days. Vacancy (defined specifically in the policy) means less than 31% use and occupancy. As a result of this decision, these vacancy clauses that void coverage apply only to owners, and not their lenders. 
On September 22, 2014, the court decided the case of Commerce Bank v. West Bend Mutual Insurance Co. The issue was whether a mortgagee, under a “standard” mortgage clause, can obtain insurance coverage for losses sustained due to vacancy at a property. A standard mortgage clause allows the mortgagee to recover even if acts or neglect of the insured would void coverage as to the insured. This is distinct from “open” mortgage clauses, which only allow lenders to recover insurance proceeds if the owner would also have a right to recover. The court held that a mortgagee is entitled to insurance coverage even when the vacancy provision excluding coverage applies, the lender had ongoing knowledge of the vacancy, and the lender took no steps to protect or secure the property. The ruling shifts the costs of property management and risk mitigation, in many cases, away from lenders and onto their insurers.
The circumstances that gave rise to the decision were that a lender issued a loan secured by a mortgage on a commercial property in 2008. The borrower/owner of the property was unable to keep it at least 31% occupied, causing the vacancy provision of the insurance contract to apply.  At some point before 2010, the property was vandalized and the borrower filed a claim for property damage resulting from the vandalism. The insurer denied the claim because of the vacancy clause. By 2010, the loan was in default, but the lender did not immediately foreclose.
In September 2011, long after the loan was in default, the property was vandalized again and incurred significant damage. The lender finally obtained title by way of a deed in lieu of foreclosure in January 2012.  It then submitted a claim under its “standard” mortgage clause, and again, the insurer denied the claim reasoning that the vacancy provision barred coverage.
The court characterized the ongoing vacancy as the result of “acts or neglect” by the owner. It then reasoned that because a standard mortgage clause guarantees a lender’s right to recover even if acts or neglect of the owner void the owner’s coverage, the lender is entitled to insurance coverage for the loss. Although, the court did not make it clear that neglect was required, the court seems to assume that vacancy is neglect. The court’s analysis fails to consider several important aspects of insurance law.
Insurance often provides valuable social benefits, as the requirements of insurance policies often motivate their insureds to take steps that reduce risk. For example, many property insurance policies require a working fire suppression system in the property, which obviously reduces the risk by fire. Insurers also craft language in their policies to avoid actuarial problems such as moral hazard, adverse selection, and correlated risks. The court’s decision would appear to frustrate these purposes.
The effect of the decision could be that a lender now has less of an incentive to take action if its security is suffering from long-term vacancy. If a lender knows it is not insured for losses that may result from the vacancy, arguably it has incentive to seek to foreclose at the earliest practicable time, put the property to a higher and better use, or take adequate measures to secure and protect vacant property. Because insurance is now available for potential losses due to vacancy, a lender may not take steps to avoid risks of loss associated with vacant property. This is what is termed “moral hazard,” which describes situations where a party has perverse incentives due to the existence of insurance coverage.   
The court’s decision runs contrary to the law in other states that have considered this issue. For commercial lenders, the court’s ruling may affect decisions such as how much to pay for property management services, when to foreclose, how much cost and effort to expend mitigating risk, and when and how to seek insurance proceeds. The Minnesota Supreme Court has decided to hear the case, but for now, the Court of Appeals decision is the law in Minnesota.  It could take many months to over a year before the Supreme Court issues its decision.