Lender Must Treat Mortgagee With Utmost Good Faith

Oct 28, 2021

FACTS

The lender’s assignee held the storm insurance proceeds for over three years before ultimately applying them to the homeowners’ outstanding debt. During that lengthy interval, an estimated sum of $40,000 in mortgage interest accrued. Negotiations to modify the terms of the loan failed when the assignee demanded that two thirds of the insurance funds be applied to the debt upfront as a condition of the loan modification, which the homeowners contend would have left them with insufficient funds to complete all the repairs and disqualify them for a state grant that they had conditionally received.

ANALYSIS

Once the lender is provided with adequate information to determine how the insurance funds should be used-such as the estimated costs of repairs and market values-the lender is obligated to clearly advise the borrower within a reasonable period of time as to whether the requested use of insurance monies for repairs is economically infeasible or will impair its security in the property. The time to notify the borrower of the disposition may be extended if the parties mutually undertake good-faith negotiations to modify the loan terms. If the lender unreasonably delays making a decision to approve the proposed use of the insurance funds for repairs, the court has the equitable power to abate the mortgage interest that has accumulated in the meantime. Additionally, the lender must place the insurance funds in an interest-bearing, segregated account until the proper use of those funds is resolved.

Superstorm Sandy and Its Aftermath

On October 29, 2012, Superstorm Sandy battered the Jersey Shore. As described by the Daws, the storm caused the ocean to break through the dunes near their Point Pleasant home and rush into the bay. The residence was flooded with over two feet of water, destroying much of the first floor and requiring it to be gutted. The disposition of the insurance proceeds was governed by several provisions within the mortgage. These provisions apparently are common or standard terms that have been discussed in other mortgage cases.

The Foreclosure Litigation and Other Events

As the loan remained in default, plaintiff filed a mortgage foreclosure complaint against the Daws in March 2016, which the Daws did not answer. Consequently, default judgment was entered against them in June 2016.

Despite the plaintiff’s filing of the foreclosure complaint, the Daws requested another loan modification to enable them to keep the house. Concurrently, the lender obtained in October 2016 a broker’s price opinion (“BPO”). The BPO stated that the house was “in average condition” and that “as-is,” in the next 90 to 120 days, the probable sale price of the house was $440,000, compared to $450, 000 if the proposed repairs were completed. The BPO estimated the “as-is” list price of the home was estimated as $459,900, compared to $469,900 if the property were repaired. The BPO stated it was “unknown” if the property needed emergency repairs, and only noted the property needed exterior repairs costing slightly over $6,000.

On March 3, 2017, the trial court issued an order granting in part and denying in part the Daws’ objection to the entry of final judgment. The court found the Daws had adequately identified a discrepancy in the amount due on the mortgage at time of foreclosure, because the $150,000 of insurance proceeds had not been deducted from the debt. Additionally, the judge noted that plaintiff had not approved the repairs, and therefore violated the contract by not carrying out either of the two specified options for the insurance proceeds.

Final Motion Practice

The Daws argued that plaintiff had unfairly held the $150,000 in insurance proceeds without a disposition of them for over three years. They calculated that if, hypothetically, plaintiff had promptly applied the insurance proceeds to the outstanding principal and interest when it received the funds in October 2015, the final balance due on the mortgage loan would have been about $40,000 less.

THE APPEAL

It is well settled that “an implied covenant of good faith and fair dealing” inheres in “every contract in New Jersey.” Sons of Thunder, Inc. v. Borden, Inc., 148 N.J. 396, 420 (1997); see also Restatement (Second) of Contracts § 205 (Am. Law Inst. 1981) (“Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.”). The implied covenant signifies that “neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.” Sons of Thunder, Inc., 148 N.J. at 420 (quoting Palisades Props., Inc. v. Brunetti, 44 N.J. 117, 130 (1965)).

These general principles sensibly extend to how a mortgage lender or its assignee exercises its control over insurance proceeds received after a borrower’s home has been damaged by a storm. The old adage, “Don’t throw good money after bad,” pertains. In some instances, it will be unreasonably expensive for certain repairs to be made with the insurance money, even if contrary to what the homeowner desires.

Lenders and their assignees must convey their decisions and reasons concerning the disposition of insurance proceeds to homeowners with clarity and consistency.

The insurance funds are viewed as substitute collateral and the mortgagee’s claim on them is sometimes described as an “equitable lien.” This means simply that the mortgagee is entitled to recover the funds to the extent necessary to compensate for the impairment of security that results from the loss or damage, with a maximum recovery equal to the balance owing on the mortgage debt. This result is required to avoid unfairness to the mortgagee through devaluation of the real estate as a consequence of the loss or damage. [Third Restatement § 4.7 cmt. a (1997)]

If repairs are objectively shown to be economically infeasible or would impair the lender’s security, then the insurance proceeds must be applied promptly to the mortgage balance, unless otherwise agreed upon by the parties.

It is appropriate for the insurance funds to be placed – if not applied to the mortgage debt – in an interest-bearing account until their disposition is finally determined. Such opportunity for the funds to grow, even at a modest interest rate, is preferable to the funds remaining dormant, because if the funds appreciate, that growth can be applied to either the resources available to finance repairs or to pay down the debt.

Rather than attempting on an incomplete record to apply the new standards the court announced in this opinion it elected to remand the issue of the disposition of the insurance funds to the trial court. Consistent with principles of fairness and reasonableness expressed in the Restatement (Third) of Property (Mortgages) (1997), the mortgage lender (or its assignee) in such situations owes the borrower an implied covenant of good faith and fair dealing in determining the disposition of the property or insurance funds.

ZALMA OPINION

People sometimes forget that the covenant of good faith and fair dealing applies to all contracts, not just insurance contracts. In this case the New Jersey court enshrined that duty on mortgage contracts with regard to the use of insurance proceeds held by the mortgagor instead of applying the funds to the repair or to reduce the mortgage debt. The mortgagor did neither and was chided by the court for holding money for too long without explaining the reasons to the mortgagee. There are no tort damages for the breach but there are contract damages that may be available to the mortgagee.

Barry Zalma, Esq., CFE, now limits his practice to service as an insurance consultant specializing in insurance coverage, insurance claims handling, insurance bad faith and insurance fraud almost equally for insurers and policyholders.

He also serves as an arbitrator or mediator for insurance related disputes. He practiced law in California for more than 44 years as an insurance coverage and claims handling lawyer and more than 54 years in the insurance business.

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He is available at http://www.zalma.com and zalma@zalma.com. Mr. Zalma is the first recipient of the first annual Claims Magazine/ACE Legend Award. Over the last 53 years Barry Zalma has dedicated his life to insurance, insurance claims and the need to defeat insurance fraud. He has created the following library of books and other materials to make it possible for insurers and their claims staff to become insurance claims professionals.

Go to training available at https://claimschool.com; articles at https://zalma.substack.com, the podcast Zalma On Insurance at https://anchor.fm/barry-zalma; Follow Mr. Zalma on Twitter at https://twitter.com/bzalma; Go to Barry Zalma videos at https://www.rumble.com/zalma ; Go to Barry Zalma on YouTube- https://www.youtube.com/channel/UCysiZklEtxZsSF9DfC0Expg; Go to the Insurance Claims Library – https://zalma.com/blog/insurance-claims-library/ The last two issues of ZIFL are available at https://zalma.com/zalmas-insurance-fraud-letter-2/ podcast now available at https://podcasts.apple.com/us/podcast/zalma-on-insurance/id1509583809?uo=4

Lender Must Treat Mortgagee With Utmost Good Faith