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By: Donald R. Davidson, III of The Wolf Firm
(Reprinted with permission. CTA Newsletter, 1995 by California Trustee's Association, all rights reserved.)
Lenders fortunate to have earthquake insurance covering their loans in California may flinch at the latest insight from a California appellate court. The case stems from the January 17, 1994 Northridge earthquake that caused an estimated $5 billion in property damage and thousands of homeowner insurance claims.
In Ziello v. Superior Court (1995) 36 Cal. App. 4th 321 the Second District Court of Appeal held that a lender that did not require in its contract that the borrower obtain earthquake insurance nor direct the manner in which insurance proceeds could be applied had no legal right to receive the insurance proceeds paid as a result of earthquake damage to the residence.
First Federal Bank of California loaned to Ziello $358,400 to purchase a residence in Northridge, California. The loan was secured by a first trust deed that required the borrower to maintain fire and extended coverage insurance but did not require the borrower to maintain earthquake insurance. Ziello obtained the required fire and extended hazard coverage from Safeco Insurance Company and named the lender as the loss payee. Two months later, she purchased earthquake coverage and added it to the policy by separate endorsement.
Safeco adjusted the loss at $62,101.00 and issued a joint check to Ziello and First Federal. Ziello asked First Federal to endorse the check to her and when First Federal refused, claiming that the money should be applied to repair the property or reduce the loan, Ziello brought a declaratory judgment action seeking a declaration that she had the exclusive right to the proceeds. She also stopped making her monthly loan payments. The trial court ruled in favor of the lender and judgment was entered. The following day the foreclosure sale was held and First Federal bid less than the outstanding loan balance.
On appeal, the court found that the loan documents contained no special provision for the borrower to maintain earthquake insurance coverage. Significantly, there was no broad provision that all insurance proceeds be applied to repair the property or reduce the debt. Instead, the deed of trust only referenced the insurance required to protect the security, i.e., the fire and extended coverage insurance. Consequently, the court ruled that the lender was not entitled to receive the insurance proceeds from the special earthquake endorsement, relying upon a 59-year old case as precedent, Alexander v. Security First National Bank of Los Angeles (1936) 7 Cal.2d 718, [62 P.2d 735]. First Federal also argued that the assignment clause of the deed of trust that assigned to the lender all sums due or payable by judgment or settlement entitled it to the proceeds. However, the court found that payment on an insurance contract was neither a "judgment" nor a "settlement" and consequently the clause did not apply. The fact that First Federal was named as loss payee did not entitle it to the insurance proceeds because the borrower claimed that she never intended to name the lender as receiver of the funds and Safeco's unilateral act in naming the lender as the payee "...does not create either a contractual or equitable right in lender to receive or control the proceeds of that insurance." It should be noted, in general, that assignment to a lender as a loss payee does not make the lender an insured under a policy.
The troublesome question raised by this case is who should suffer the loss: the lender, whose $358,400 loan enabled Ziello to purchase the residence, or the borrower, whose $500 annual premium enabled her to obtain earthquake insurance protection? For whose benefit was the insurance obtained? A strong argument in favor of the lender arises merely from the disparity of the financial investments involved. The court also ignored the following trust deed requirement:
"All insurance policies and renewals shall be acceptable to lender and shall include a standard mortgage clause in favor of and in form acceptable to lender." There is no indication in the opinion of this case that Ziello ever submitted the earthquake endorsement for the lender's acceptance. Her failure to do so was a breach of her obligations under the loan and a tacit admission that she intended to assign to First Federal all insurance proceeds, whether required as part of the fire and extended coverage policy or not. The language of the deed of trust implies that the borrower may obtain insurance for additional risks (flood, earthquake, nuclear accident, etc.) and that the lender shall be named as loss payee, as it would under the standard mortgage clause.
Presumably, when the borrower obtained the coverage but failed to notify the insurer that there was a mistake, she intended the coverage to protect the lender. This act contradicts her self-serving declaration (made after the litigation had commenced) that she had "no intention of granting to [lender] any rights in the additional earthquake coverage that I added in August, 1988". The mistake should be borne by Ziello, not First Federal, as Ziello had control over the manner in which the coverage was obtained. The fact that she failed to obtain First Federal's acceptance is a breach of her obligations to the lender which should not be condoned by a court. Instead, the court sent the message that irresponsible borrowers may walk away from their obligations with cash in hand.
Lenders and their servicers may want to scrutinize their loan documents in light of Ziello to determine whether they require the borrower to procure earthquake insurance and, if not, whether there is a broad provision for the application of all insurance proceeds to repair the property or reduce the debt in the event of an earthquake loss. Lenders should not assume that their "standard documents" are sufficient, nor look to the fact that the borrower named them as loss payees or as additional insureds for protection. In fact, for lenders using the standard Fannie Mae-Freddie Mac Form #3005, the language used in the uniform Deed of Trust is virtually identical to the language of the deed of trust in the Ziello case. Although one commentator stated that Ziello should not have a major impact in the future (as lenders will be expected to review and revise their agreements to protect them from the holding in this case), Ziello is certain to have an immediate and major impact on lender losses arising from this disaster. Although it is impossible to estimate the number of loans that are affected, it could number in the thousands. If a Ziello problem exists, lenders may be tempted to obtain a specific agreement from their borrowers to modify their loans so that insurance proceeds will be applied to either repair the premises or reduce the debt. The problem with this approach is that a modification of the loan may cause the lender to lose priority. A better approach would be to specially designate the lender as loss payee under all insurance policies that borrower may obtain. If the loan refinanced a purchase money loan, a lender faced with a defaulting borrower could proceed with judicial foreclosure and request application of the insurance proceeds to cover the deficiency, as the anti-deficiency statute, CCP Section 580b, does not apply to non purchase money loans.
Although Ziello sends the wrong message it may be lost in the realities of a growing homeowner's insurance crisis in California. It is estimated that 75% of the companies that sell homeowner's insurance have pulled out of the California market, making it increasingly difficult for consumers to obtain earthquake coverage. There are a number of bills now pending before the California legislature that could affect some estimated 5.6 million homeowner's insurance policies including the 2.1 million that now include earthquake coverage. The passage of such legislation is urgently needed, as borrowers and lenders are in a state of "aftershock".
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