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May 2016

What Happens When You Mix the Real Estate Crash Of 2008?

What happens when you mix the real estate crash of 2008, equitable subrogation claims, mechanics’ liens, title insurance, reservations of rights, clever (or not so clever) clients and attorneys, and a Morris agreement? You get the Arizona Court of Appeals decision in Fidelity Nat’l Title Ins Co. v. Centerpoint Mechanic Lien Claims, LLC, 238 Ariz. 135, 357 P.3d 170 (App. 2015) in which the court of appeals addressed the issue of whether a title insurance company is liable under United Services Automobile Ass'n v. Morris, 154 Ariz. 113, 741 P.2d 246 (1987), for damages agreed to by its insureds in a settlement agreement resolving third-party mechanics' lien claims against the insureds' interest in a real estate development.

But before the facts are discussed, an understanding of a Morris agreement is necessary. A Morris agreement in Arizona is known by other names in other states. Under Morris, when an insurer agrees to defend its insured against a third-party liability claim, but reserves the right to challenge coverage under the insured's policy, the insured may independently settle with the third-party claimant without violating the insured's duty of cooperation under the insurance contract. The insured generally assigns its rights against the insurer to the third party claimant, subject to the insurer's retained right to contest coverage.

I. Facts

The facts start in 2007 at the beginning of the real estate crash in Arizona. In mid-2007 and early 2008, Mortgages, Ltd., a private lender, agreed to loan a developer additional funds to build Centerpoint, a high-rise residential condominium development in Tempe, Arizona. Construction on the project had begun in December 2005, and a portion of the loan was used to pay off an earlier loan from Freemont Investment and Loan ("Freemont") secured by a deed of trust. The balance of the loan was used to fund construction. The loan was secured by a deed of trust against Centerpoint. A predecessor to Fidelity National Title Insurance Company ("Fidelity") issued a title insurance policy insuring priority of Mortgages, Ltd.'s deed of trust for a face amount of $165,200,000 (the "ML Policy"). This is the huge mistake that leads to this case, but kept attorneys employed for several years.

Two months later, Mortgages, Ltd. went into bankruptcy. Mortgages, Ltd.'s Centerpoint deed of trust interests were transferred to two investors—Centerpoint I Loan, LLC ("CPI") and Centerpoint II Loan, LLC ("CPII")—and eight individual fractional interest holders. ML Manager, LLC acted as manager of CPI and CPII, and as agent and attorney-in-fact for the fractional interest holders (all collectively referred to as “ML Investors").

Starting in April 2008, subcontractors and suppliers began to record mechanics' liens and notices of lis pendens against Centerpoint. The first of dozens of mechanics' lien foreclosure claims was filed in court in October 2008. The lawsuit asserted that the mechanics' liens had priority over Mortgages, Ltd.'s (subsequently ML Investors') security interest in Centerpoint.

ML Investors tendered the defense of the mechanics' lien claims to Fidelity, and in September 2009, Fidelity accepted the defense with a general reservation of rights. Retained defense counsel for ML Investors asserted that ML Investors, as Mortgages, Ltd.'s assignees, were entitled to be equitably subrogated to the priority position held by Freemont, whose loan Mortgages, Ltd.'s initial loan had paid off and whose deed of trust undisputedly had priority over the mechanics' liens. In April 2010, ML Investors purchased Centerpoint at a trustee’s sale for a credit bid of $8 million. In September 2010 in the lien foreclosures, the superior court denied summary judgment on equitable subrogation. The ruling determined the validity and amount of several mechanics' liens, but left the issue of priority for trial. After the summary judgment ruling, Fidelity reaffirmed its general reservation of rights under the ML Policy.

ML Investors contracted to sell Centerpoint for $30 million in September 2010. The sale failed to close in October, in part due to Fidelity's decision, in the wake of the summary judgment ruling, not to provide a title policy to the buyer that would insure priority over the mechanics' liens.

ML Investors also negotiated to settle the mechanics' lien claimants. After the summary judgment ruling, the claimants insisted on cash, rather than an assignment of ML Investors' title insurance claims. Beginning in October 2010 and continuing until the eventual sale of Centerpoint in January and February 2011, ML Investors informed Fidelity that they were seeking a potential Morris settlement directly with the mechanics' lien claimants.

A global agreement was reached in February 2011 to sell Centerpoint and settle the mechanics' lien claims. Concerned that Fidelity would deny coverage if ML Investors simply paid the liens (thus clearing title) or if ML Investors—rather than a third party—purchased the liens (under the merger doctrine), ML Investors created a new entity, Centerpoint Mechanic Lien Claims, LLC ("CMLC"), which was wholly owned and controlled by CPII, to acquire the mechanics' lien claims and, later, to pursue the claims against Fidelity. Under the global agreement, the buyer purchased Centerpoint for $30 million, and CMLC purchased the mechanics' liens for $13.65 million. All the entities with interests in Centerpoint agreed to subordinate to the buyer.

The global agreement provided that once CMLC had been substituted for the mechanics' lien claimants, CMLC and ML Investors would enter a stipulated judgment for $38 million and a declaration that the mechanics' liens had priority over ML Investors' interests in Centerpoint. CMLC would accept assignment of ML Investors' claims against Fidelity, would agree not to execute against ML Investors, and would pursue title insurance claims directly against Fidelity. Pursuant to the February 2011 agreement, CMLC substituted itself for the mechanics' lien claimants in the ongoing litigation. Fidelity intervened to challenge the settlement agreement. After a five-day hearing, the superior court ruled that (1) the settlement agreement was valid under Morris, (2) the agreement was neither fraudulent nor collusive, (3) Fidelity had received proper notice of the settlement, and (4) the settlement amount was reasonable. The court thus found the settlements of the claims against Fidelity's ML Policy ($24,583,799.38 plus $1,880,994.51 in mechanics' lien attorney's fees) "were reasonable, prudent, and fully supported by the evidence produced at the hearing" and entered judgment in favor of ML Investors and CMLC. The insurance coverage issue remained pending. Fidelity timely appealed. CMLC and ML Investors timely cross-appealed a denial of their request for attorneys fees.¹

Fidelity and Commonwealth sued CMLC in a companion case for intentional interference with contract, alleging that CMLC had intentionally interfered with the title insurance contracts by entering into the Morris-type agreement. The superior court dismissed the case on the basis that it found that the Insureds did not breach the insurance contracts by entering into the settlement agreement. Fidelity timely appealed that decision.

II. Analysis

On appeal, Fidelity argued that, as a matter of law, a title insurance policy holder may not enter a Morris agreement. Fidelity asserted that, unlike the third-party insurance claim at issue in Morris, the title policies provide insurance for a first-party property loss, meaning loss caused by alleged defects that, if established, could lessen the value of the insureds' property. The court side-stepped this interesting issue and assumed that even if Morris applied to title insurance claims, under the circumstances presented, the settlement agreement is not a compliant Morris agreement.

The court of appeals noted that the settlement agreement was not between the insureds and the third-party mechanics' lien claimants, but was rather an agreement between the insureds and an entity they controlled that had purchased the mechanics' lien claims. The insureds were not at risk of personal liability because of the settlement. This removed the risk a Morris agreement is designed to protect against, i.e., the insured’s risk of excessive personal liability. Additionally, the settlement agreement was for an amount significantly greater than the amount paid to purchase the mechanics' lien claims ($38 million compared to $13.65 million). And the settlement amount contained payments for which the insured was not liable. It included an amount for the attorneys’ fees of the mechanics’ lien claimants, but this amount was not paid to the mechanics’ lien claimants. The court apparently felt that the Morris agreement was not free from collusion and the amount was not reasonable. Accordingly, the court of appeals concluded that the settlement agreement between the insureds and the entity that purchased the mechanics' lien claims was not a compliant Morris agreement and reversed the superior court's ruling. This determination also caused the court to reverse the dismissal of Fidelity’s intentional interference claim against CLMC for interfering with the insurance contract with ML Investors.


¹ Other parties with loans and with title policy claims and another title insurer were also involved but are not discussed in this summary.


David L. O'Daniel