Lenders and Insurance: Are Your Bases Covered? A Checklist for Confirming Lenders' Rights in Borrowers' Insurance Proceeds

The economic impacts of the COVID-19 pandemic, particularly the impacts arising from federal, state and local shelter-in-place restrictions, have caused numerous affected parties to submit claims under their insurance policies. These claims assert losses covered by a variety of insuring clauses, from business interruption to pollution to civil authority clauses. While it remains to be seen whether insurers will pay on such claims, voluntarily or not, lenders who have an interest in their borrowers' insurance proceeds should be ready to enforce their rights at the appropriate time. To do so, they must understand the extent of their rights – whether there is a security interest in insurance proceeds, a contractual right to a specific designation on the borrower's insurance policy, or both – and how to enforce those rights.

What follows is a checklist that lenders may use to confirm the existence and enforceability of their interests in borrowers' insurance proceeds.

Step 1: Review the loan documents

As a preliminary matter, lenders should check their loan documents to determine the existence and scope of the security interests and contractual rights with respect to insurance proceeds.  Lenders should examine the applicable documents to answer some basic questions relating to insurance.

•  What types of policies/coverages were borrowers obligated to obtain, and what do such policies and coverages include?  The types of required insurance will vary according to the type of loan and the nature of the borrower's business, but typically include commercial general liability, property, pollution or business interruption policies.  Lenders should also review the non-recourse provisions and related guarantees to determine whether there are carve-outs that might affect rights to insurance proceeds.  Finally, lenders should identify which state's law applies to the insurance proceeds.  Each of these issues may affect whether and how the lenders might recover proceeds.
•  What rights do lenders have to a specific status?  Lenders are often entitled to be named additional insureds, loss payees, lender's loss payees, or mortgagees on the borrowers' insurance policies.
  • Important distinctions may apply depending on which status a lender holds.  For example, despite the similar names, loss payee status carries fewer rights than lender's loss payee status.  Loss payee status, on the one hand, entitles the lender to insurance proceeds, but only to the extent that the insured is eligible to recover, and sometimes only as a joint payee with borrower.  Lender's loss payee status, on the other hand, entitles the lender to recover insurance proceeds even in some cases when the insured is not eligible to recover because of, for example, the insured's non-compliance or misconduct.  Mortgagee status carries a similar degree of protection.  Under a standard mortgagee clause in an insurance policy, a mortgagee is eligible to recover insurance proceeds in spite of misconduct or non-compliance on the part of the insured.
•  What additional rights or powers were the lenders entitled to hold?  Loan documents sometimes provide lenders with a power of attorney giving them control of the handling of claims if borrower is in default.  Additionally, loan documents typically require that lenders be given notice from the insurer if the policy has not been renewed or is about to be cancelled.  Furthermore, the loan documents may include reporting obligations that require borrower to provide lender with specific information concerning potentially insured losses.
•  What are the borrower's reporting requirements?  Lenders should verify the reporting requirements in the loan documents with respect to insurance policies and insurance claims, and verify who controls the settlement of claims. 
•  With respect to security interests, how is the security interest defined?  Lenders with a security interest in insurance proceeds should identify whether they have a specific secured interest in insurance policies and proceeds, or a general secured interest in certain identified collateral and the proceeds thereof.  Additionally, if applicable, lenders should note whether the insured collateral includes real property.  Lenders should also analyze which state's law applies to the conveyance of the secured interest, as loan documents may be inconsistent as to choice of law provisions.  These issues will impact the necessary steps for lenders to enforce their interests.

Step 2: Confirm borrowers' compliance and the status of the policies.

Having determined the extent of insurance protection required by the loan documents and their rights and powers with respect thereto, lenders should next confirm that borrowers complied with their obligations and have properly maintained the applicable policies.

•  Were appropriate endorsements obtained to confirm lenders' status?   Lenders should verify that all requirements of the insurer have been met with respect to lenders' status.  An endorsement is required to designate the lender as an additional insured, loss payee, lender's loss payee or mortgagee on the insurance policy.  The insurer will typically make a copy of the endorsement available to each party at the time it was executed.  Lenders should check their files to confirm all necessary endorsements were obtained.  Lenders should avoid relying on certificates of insurance, which are generally for informational purposes only.  It is the endorsement that establishes the legal rights of the parties.
•  Are all policies currently in effect?  Lenders should verify, either through their borrowers or, if appropriate, directly with the insurers, that all required policies are current and remain in effect.  Lenders should also verify whether any policies are in danger of cancellation, either because the borrower is late on a premium payment or may not be able to make an imminent premium payment. 

Step 3: For secured interests, verify perfection of the security interest or lien.

Lenders with security interests in, or liens on, insurance proceeds should next verify that such interests have been properly perfected.

•  What law applies? The ability to perfect a security interest in personal property, such as insurance proceeds, is established by the applicable law. 
  •  Insurance policies and the UCC: Under the uniform version of § 9-109(d)(8) of the Uniform Commercial Code (UCC), lenders may not perfect a security interest in insurance proceeds through the filing of a UCC1 financing statement.  Accordingly, in states that have adopted the uniform version of the UCC, lenders must look to other statutes or the common law of the applicable state to determine whether they may obtain and perfect a lien, and what steps are required to do so.  For example, the common law in one state might require evidence of the insured's intent to assign proceeds to the lender, along with notice of the assignment to the insurer.  The common law of another state might also require that the insurer acknowledge the assignment.  Requirements vary from state to state, so lenders should consult counsel to verify the applicable requirements.
  • Perfecting the security interest in California: California does not follow the uniform version of the UCC with respect to the perfection of a security interest in insurance proceeds.  Instead, California allows lenders to perfect their security interest "by giving written notice of the security interest or claim to the insurer," under California Uniform Commercial Code § 9312(b)(4). 
  • Potential conflict of law issues: The determination of the applicable law can be complicated, particularly where the documents at issue, including the loan documents and the insurance policies, have conflicting choice of law provisions.  A full examination of this issue is beyond the scope of this alert, and lenders should consult counsel for assistance.  That said, to the extent the perfection requirements of the applicable insurer have been met, a lender may get the insurer's cooperation in enforcing its security interests even in the absence of a determination concerning applicable law.
• If a security interest in or lien on insurance proceeds is permitted in the applicable jurisdiction, have all steps been taken to perfect that interest?  Lenders should verify that the procedures required to perfect the security interest or lien in each jurisdiction have been followed.  For example, where California law applies, lenders should verify that written notice of lenders' interests was provided to the insurers.  In states that require the insurers' acknowledgement, lenders should verify such acknowledgements were obtained.  In addition to verifying legal requirements, lenders should verify whether the specific insurers involved have separate requirements that must be met to perfect their interests and confirm that such requirements have been met.
•  If not currently secured, should lenders consider obtaining a security interest in insurance proceeds at this time?  In light of the economic impacts of the coronavirus, many borrowers are requesting temporary relief from their repayment obligations, such as short-term payment deferral.  In such a case, lenders that are not currently secured should consider whether to request that any amendment to the loan documents include the grant of a security interest in insurance proceeds.  Note, lenders should be cognizant that the grant of such an interest might be deemed a preference under Section 547 of the Bankruptcy Code in the event the borrower filed for bankruptcy within 90 days thereafter.

Step 4: Confirm the status of claims.

Lenders should verify the existence and status of any and all claims submitted by borrowers, and establish protocols to ensure up-to-date status reports will be provided in the future.   As part of this step, and in order to ensure they have all relevant information before assessing their enforcement options, lenders should remind borrowers of any potentially relevant reporting obligations that may exist in the loan documents, such as when a borrower is confronted with a material change or seeks to assert an insurable loss.  Lenders should also verify whether the loan documents limit their rights to contact the insurers directly, and whether the insurance policy entitles lender to receive information directly from the insurer.  To the extent direct contact with insurers is permitted, it can be a valuable source of information.  However, we recommend that lender not contact the insurance carrier directly unless the borrower and/or insurance carrier have failed to provide required information.

Step 5: Assess enforcement options.

Lenders should verify what enforcement options are available under the circumstances.  Do the loan documents call for insurance proceeds to be deposited in an account under lender's control (e.g. through a Deposit Account Control Agreement)?  If so, lenders should evaluate whether to apply those funds to the loan balance.  Typically, unless a loan is in default, insurance proceeds must be made available for repair – in the case of a casualty loss – or rent replacement – in the case of business interruption insurance.  Lenders must also take note of requirements concerning how their interests may be enforced.  Are any notices required by the loan documents before the commencement of legal action?  Are lenders required to marshal or exhaust other collateral before looking to insurance proceeds for repayment?  Not only must lenders comply with contractual requirements, but lenders considering legal action should also account for court closures and delays due to COVID-19 restrictions.

Lenders with security interests in insurance proceeds must take into account the COVID-19 restrictions as well.  In states where foreclosure of a lien or security interest is a recognized remedy, lenders should verify whether foreclosure, either judicial or non-judicial, is feasible in light of applicable government restrictions.  Are local courts allowing judicial foreclosure actions to be filed?  Can non-judicial foreclosure sale procedures be "commercially reasonable" under the UCC or similar state law when a shelter-in-place order is in effect?  Where enforcement can only be done through a judgment, are the applicable courts allowing such actions to be filed and, if so, what unusual delays should lenders expect as a result of COVID-19 restrictions?  These considerations will vary by jurisdiction, as some local ordinances are stricter than others.

Finally, for loans that are secured by real property in California, lenders must be cognizant of enforcement issues presented by California's anti-deficiency statute and the one-action rule, which limit lenders' enforcement rights.  Given the complexity of these statutes, lenders should consult with counsel before taking steps to enforce their rights.

Conclusion

Faced with numerous borrower requests for relief, lenders must arm themselves with a detailed understanding of the assets and resources that may be available to satisfy their loans, including insurance proceeds.  Lenders should take action now to determine the scope of, and prepare to enforce, their interests.  This checklist provides a starting point for lenders who wish to do so, and Allen Matkins attorneys are available to advise lenders as they determine their rights and assess their options.