Are Section 50(e) Issues Covered Title Insurance Risks?

a. Business Difficulties Created by Insurance Department Bulletin (1) Is Section 50(e) a consumer Credit Protection Matter?

The Insurance Department has informally raised the issue of whether or not the Section 50(e) risks was excluded from coverage as a consumer credit law under Exclusion from Coverage No. 5 of the promulgated mortgagee policy of title insurance.

i. In the author’s opinion, it is unlikely that a Texas court would conclude that Section 50(e) is a consumer protection matter. Please consider the following sub-points:

• Homestead risks have traditionally been treated as covered claims; with the exception of cases where the Lender appears to have made an off record agreement with the borrower {which agreement was not disclosed to the title company} that the borrower would falsely designate homestead property as non-homestead property for the purpose of obtaining the loan.

• The T-2 Mortgagee Policy, when the T-42 Home Equity Endorsement is attached, specifically modifies the Consumer Credit Protection Law exclusion to include Subsections (a)(6) and (g) of Section 50, Article XVI, Texas Constitution as an exclusion.

• The T-42 Endorsement does not specifically change the definition to add Section 50(e) or Section 50(f); but it would be argued that it was not necessary for the T-42 to mention §50(e) and §50(f) in the home equity context.

• If Section 50(e) and Section 50(f) are not excluded by the specific and narrow definition in the new T-42 Endorsement; are Sections 50(e) and 50(f) excluded under the broader T-2 Mortgagee Policy definition? Note that the broad definition of Consumer Credit Protection Law applies to the T-2 Mortgagee Policy form when the T-42 Endorsement is not attached. The narrow definition for Consumer Credit Protection Law applies only when the T-42 Endorsement is attached to the T-2 Mortgagee Policy in the case of a home equity {i.e. Section (a)(6) loan}. Would a court consider it material or relevant that the standard T-2 exclusion was not amended?

• If an underwriter has issued specific underwriting guidelines appearing to address coverage of the Section 50(e) and Section 50(f) matters, will a court permit the insurer to invoke a broad exclusion {and deny coverage} when specific underwriting requirements have been imposed?

• It seems incongruous to take a position that: (i) the refinance risk was a covered title matter prior to 1-1-98 due to favorable case law and the legal supportability of the partial invalidity clause theory; and, (ii) after 1-1-98 that the same risk is now not covered due to the fact that the law now seems to dictate that the lien would be totally invalid and not just partially invalid.

• Another business/legal consideration is whether or not the consumer Credit Protection Law exclusion would be deemed to be ambiguous under a certain set of facts. Of course, it is black letter law that ambiguity is construed against the insurance company.

ii. At some point in time, if there is a temporary restraining order issued against the lender {restraining foreclosure of the insured deed of trust based on section 50(e) of the Texas Constitution}, the lender will tender defense to the title insurance company.

• At this point, should the title insurance company decline to defend on the basis that the Consumer Credit law exclusion applies?

• If the insurer declines to defend, the insurer loses control of the litigation between the lender and borrower. If the insurer does not defend the lawsuit, the insurer’s experience in defending homestead type claims is not available to the court making the decision. If the lender’s defense counsel is not seasoned, bad case precedent may result.

• If the insurer accepts the tender of defense under a reservation of rights, the insurer runs the risk of incurring: (i) litigation expense; and, (ii) a potential policy limits loss if the court determines that the lender’s lien was invalid in the litigation between the lender and the borrower. A second lawsuit would be necessary between the insurer and the lender to determine the applicability of the Consumer Credit law exclusion. This results in a multiplicity of litigation with the potential for inconsistent results.

• If the insurer accepts the tender of defense without a reservation of rights, it is likely that the insurer has waived the applicability of the Consumer Credit law exclusion.

(2) Lending Community Reaction to Commissioner’s Bulletin

Several discussion drafts of the Commissioner’s Bulletin {in which the issue of the Consumer Credit Exclusion applicability to refinance transactions is mentioned} were circulated among members of the lending and title insurance industries. The comments of Robin Gillespie, Vice President and Regional Counsel of Fannie Mae, which were filed with the Texas Department of Insurance, are illustrative of the problems created by the earlier Texas Department of Insurance draft:

“We are writing to express concern regarding the February 9, 1998 draft bulletin being considered for publication regarding title insurance on liens securing certain refinance loans that include additional advances for closing costs under Section 50(e) of the Texas Constitution. We believe, based on the legislative history, that Section 50(e) was adopted to confirm and support continuation of the historic lending practice of including closing costs in refinance loans secured by a borrower’s homestead. We are worried that the bulletin may actually undercut this objective, to the detriment of consumers and the mortgage lending industry, without advancing the interests of the title industry.

Although the proposed bulletin does not state that Section 50(e) is a consumer law provision, it implies that it is such a provision and that, therefore, any title policy insuring a refinance loan would exclude coverage for lien validity in the event the additional advances for costs were found not to satisfy the “reasonable costs necessary” criterion of Section 50(e).

We believe that the bulletin is not necessary because, as the bulletin points out, if in fact Section 50(e) is a consumer law provision, then Item 5 of the Exclusions From Coverage in the Texas Mortgagee Title Policy will be effective, without any further act, to exclude coverage if the lien proves invalid due to unreasonable or unnecessary costs having been financed.

Also, as the proposed bulletin states, there is no promulgated endorsement for waiving Item 5. Thus, it appears that if Section 50(e) is a consumer law provision, then coverage will be subject to the Item 5 exclusion.

Further, we fear that if the bulletin is issued it would actually harm both consumers and the mortgage industry, without adding substantive protection for title insurers against any new type of risk. The bulletin may create confusion by implicitly suggesting that there is no coverage at all available for refinance liens that include advances for costs–even if those costs are of the type and amount that have been traditionally insured. That well could have a chilling effect on the willingness of lenders to advance closing costs as they have done historically and as consumers have come to expect; alternatively, lenders might choose to pay the costs themselves and charge a higher rate of interest–another bad result for consumers.

Additionally, there is a real risk that secondary market investors will be unwilling to purchase refinance loans if they perceive that they lack adequate title insurance coverage. These effects would be particularly unfortunate now, when unusually low rates have generated high consumer demand and a “refi boom” that is contributing significantly to housing affordability in Texas.

Moreover, we believe it is most likely that Section 50(e) will be held by the courts to be merely an affirmation and express authorization of the historic practice of advancing and securing closing costs in connection with a refinance loan, as opposed to being a consumer protection law. Although it has been commonplace for many years for lenders to finance closing costs in connection with refinance loans, and for title insurers to issue coverage on the financed amounts, up until this point there has not been definitive legal authority supporting the validity of the lien securing the financed costs. Surely Section 50(e) was meant to ensure that past lending and title insurance practice regarding refinance loans can continue in the future, not to change the practice in a manner adverse to consumers. It is incongruous, and we believe the practice in a manner adverse to consumers. It is incongruous, and we believe unintended, that a provision of law intended to validate a practice that benefits consumers should be turned instead against them.

We understand that the legislative history surrounding Section 50(e) supports this interpretation. As we understand it, during the course of hearings on home equity loans, a concern was raised that refinance loans

securing closing cost advances might be construed as “cash out” equity loans. We understand Section 50(e) was proposed in response to that concern–both to confirm prior refinance practice and to ensure its viability in the future. By approving Section 50(e), surely voters did not intend to promote a change in lending practice that would result in less title insurance coverage being available than was unavailable for their benefit in the past.

If Section 50(e) is looked at as a means of preserving the status quo regarding refinance lending practices and as a means of distinguishing refinance loans securing closing costs from home equity loans, then in that context it is clear that the “reasonable costs necessary” clause in Section 50(e) is included simply to describe the permitted use of the additional secured advances that are made to the borrower. Again, this appears to us to be an effort to codify past practice, in which lenders and title insurers have made case-by-case determinations on the nature and amount of closing costs that would be financed on a secured basis without risk that any consumer law protection could apply.

To summarize, we believe that, in light of the uncertainties involved and general apprehension in the mortgage lending industry occasioned by the recent Constitutional Amendment, the issuance of the bulletin would have a detrimental effect on the mortgage industry and consumers. It would make it more difficult for Texas homeowners to refinance their mortgages, while not adding any substantive protection for title insurers against any new type of risk.

H. TITLE INSURANCE COVERAGES AND UNDERWRITING APPROACHES RELATING TO