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It occasionally happens that property in foreclosure will suffer a casualty, such as a fire. Depending upon when the casualty takes place in relation to the foreclosure process and how a mortgagee reacts to it, the mortgagee may find that it has acquired nearly worthless property while both extinguishing the mortgagor's liability and waiving its right to insurance proceeds.
In the typical foreclosure scenario, the mortgagor defaults on payments and the mortgagee commences foreclosure by advertisement. The mortgagee bids in the full amount of the outstanding debt at the sale, there being no other bidders. The mortgagee gets a sheriff's deed to the property and then waits out the redemption period. If the mortgagor does not redeem, the mortgagee markets the house to recover its losses.
A casualty can occur in one of three periods during foreclosure: before sale, after sale but before the redemption period expires, or after the redemption period expires. The rights and obligations of the mortgagor and mortgagee differ significantly depending in which period the casualty occurs. Generally, the rights of the parties to an insurance policy are fixed as of the date of the casualty. It is when the loss takes place before the sale that the mortgagee must exercise the greatest caution.
Most mortgages require a mortgagor to maintain insurance on the property, naming the mortgagee as a named insured and/or loss payee, in an amount not less than the balance due on the mortgage. Most mortgages also provide that, in the event of foreclosure and sale of the property, the mortgagor assigns his interest in any insurance policy to the mortgagee. Thus, if a loss occurs after a foreclosure sale, the mortgagee has the right to collect the insurance proceeds, both by virtue of being a named insured under the insurance policy and by virtue of its status as assignee of the mortgagor's interest in the policy.
However, legal title does not vest at once on the date of the sheriff's sale but only at the expiration of the redemption period. Because of this, the mortgagee may be obligated to apply the insurance proceeds to redemption of the property if the redemption period has not expired. If the insurance proceeds exceed the amount necessary to redeem, the mortgagee should retain so much of the proceeds as is necessary to redeem (and file a redemption receipt) and pay the difference, if any, to the mortgagor. If the insurance proceeds are not sufficient to redeem in full, the mortgagee should be able to require the mortgagor to come up with the difference before applying the proceeds to redemption. If the mortgagor does not redeem, then both the property and the insurance proceeds should belong to the mortgagee.
When the loss takes place after the redemption period expires, the mortgagee owns the property free and clear of the mortgagor's interest. After an initial adverse opinion, the Michigan Court of Appeals has held that the foreclosure sale is not a sufficient transfer to allow an insurance company to claim that a policy of insurance obtained prior to the foreclosure has been terminated by a clause prohibiting transfer of the property. Thus, the mortgagee makes claim for the proceeds, rebuilds the property, and markets the property to recoup the debt.
Bidding the full amount of its debt at a sheriff's sale has the legal effect of extinguishing the debt; the mortgagee obtains title to the property (by virtue of the sheriff's deed) in exchange for the debt. The mortgage itself is extinguished by the sale. Because the full amount of the debt was bid at the sale, there is no longer any debt for which the mortgagor can be liable. By the same token, since the mortgagee's claim against the insurance proceeds is merely security for repayment of the debt, if the debt has been satisfied, the mortgagee no longer has a right to insurance proceeds.
What happens when this law is applied to a pre-foreclosure loss? If the mortgagee fails to take into account the diminution in value of the property because of the loss and bids in the full amount of its debt, the mortgagee may acquire property worth substantially less than the amount of the debt while at the same time extinguishing the debt. Even the "assignment of insurance" clause in most mortgages is of no avail because such assignment is intended to be security for a debt, and the debt no longer exists.
This rule was first announced in Smith v. General Mortgage Corp., but was held to have prospective effect only, and the court in that case set aside the sale to fulfill the expectations of the parties. Subsequent decisions have refused to set aside sales when the mortgagee knew of the loss prior to the sale and proceeded to bid in the full amount of the debt.
To illustrate the possibilities, assume a mortgage indebtedness of $40,000 on property worth $60,000. The mortgagor defaults and the mortgagee commences foreclosure. Shortly before sale the house burns to the ground, reducing the value of the property to $30,000. If the mortgagee does not take the loss into account when bidding, it will bid $40,000 for property worth only $30,000, thereby incurring a loss when the property is resold. Under the rule announced in Smith v. General Mortgage Corp., the mortgagee will not be able to recover the loss from either the mortgagor or the insurance proceeds.
A mortgagee's better course of action is to adjust the bid downward to the fair market value of the property after the loss, thereby causing a deficiency. Under the scenario proposed above, the mortgagee would bid in not more than $30,000 at the sheriff's sale, representing the fair market value of the property after the loss. Ten thousand dollars of the debt remains after the sale, so the mortgagor retains personal liability for the deficiency, and the mortgagee has first claim to the insurance proceeds, up to the amount of the deficiency.
An even better course of action is to delay the sheriff's sale until the loss has been adjusted and the insurance proceeds applied either to reduction of the debt or rebuilding of the property. If the proceeds are applied to reduce the debt, the proceeds may be sufficient to both reinstate the loan and pay down a substantial portion of the principal, in which case there is no longer need for foreclosure. If the proceeds are applied to rebuilding the property, it should restore the property at least to its fair market value prior to the loss, thereby greatly increasing the amount to be realized at a sheriff's sale and subsequent resale.
Suppose the casualty takes place before the sale and the mortgagee doesn't become aware of it until after the sale&endash;can the sale be set aside? The answer depends in large part upon when the casualty takes place in relation to the sale and what steps the mortgagee takes to inform itself of the condition of the property.
If the loss takes place immediately prior to the sale such that the mortgagee did not have a reasonable opportunity to discover the loss, the mortgagee has a good chance of convincing a court to set aside the sheriff's sale. In Federal Land Bank of St. Paul v. Edwards, the Supreme Court of Michigan allowed a mortgagee to set aside a sheriff's sale and restore the mortgage (and thus claim insurance proceeds) when the buildings on the property were destroyed by fire the day before the sale unbeknownst to the mortgagee.
On the other hand, if the sale occurs sufficiently in advance of the sale that the mortgagee should have inspected the property and discovered the casualty, a court will probably not set aside a sale.
FHA/VA guidelines require a monthly inspection of property. Through bad timing, it is possible for a loss to take place immediately after an inspection and a sale to take place nearly one month later but before the next scheduled inspection. It is difficult to say what a court would do in that situation. A prudent mortgagee will, upon receipt of a sale date from the foreclosure attorney, notify its inspection company to make its next inspection of the property as near to the sale date as possible.
What if the casualty loss is completely within the property such that it is not obvious from the typical "windshield" inspection of the property? Mortgagees have no right of possession to the property until foreclosure of the mortgage and expiration of the redemption period, and thus have no right to enter inside the house. If the casualty truly is not discoverable by an outside inspection prior to the sale, a court might set the sale aside under the authority of the Edwards case, since the mortgagee was under a mistake of fact as to the condition of the property.
A casualty loss on property in foreclosure should raise a red flag to a mortgagee, because of the potential for significant loss if the foreclosure sale is not handled appropriately. While any casualty reduces the mortgagee's chances of full recovery, the exercise of caution will serve to minimize the loss.