In the coming months, lenders that have extended loans to businesses that are struggling as a result of the COVID-19 pandemic may consider modifying existing loan arrangements rather than seeking legal remedies against defaulting borrowers. While this may be beneficial to their business and their relationship with their borrowers, they should be aware that certain modifications may cause a mortgage or other security instrument to lose its priority as to the collateral, severely and negatively impacting the lender’s ability to recover in the event that the borrower ultimately defaults or files for bankruptcy protection. For this reason, lenders considering loan modifications should investigate the potential benefits of adding title insurance coverage at the borrower's expense.
Material vs. Nonmaterial Changes
Generally, “nonmaterial” changes to a loan will not affect the validity, enforceability or priority of the mortgage. However, a “material” modification of loan terms may, under Pennsylvania law, be deemed a termination of the original agreement and replacement with a new agreement. The legal term for this deemed termination and replacement is a “novation.” A modification that is “prejudicial” to junior lienholders may constitute a novation, which may cause the lender to lose its priority as to its collateral if the modification is treated as a new loan issued at the time of the modification. Any liens or other encumbrances perfected prior to the date of the novation, but after the date of the original mortgage, may have priority over all or a portion of the lender’s mortgage, despite the fact that it was recorded before the junior lienholder’s mortgage. If the collateral is subject to junior liens, and the junior lienholders are not willing to consent to the modification, the lender runs the risk that the loan modification will cause its loan to lose its priority as to junior lienholders.
Title Insurance
A lender’s existing loan policy of title insurance will generally not insure the continuing validity, enforceability or priority of the insured mortgage after the date of the original policy and, therefore, will not protect against loss of validity, enforceability or priority brought on by a modification. The lender’s title insurer can provide coverage to protect against the risks of loan modification through the issuance of endorsements to the existing policy, the cost of which may be borne by the borrower. Insurable risks include the invalidity or unenforceability of the lien of the mortgage and the lack of priority of the lien of the mortgage over other liens or encumbrances.
Unfortunately, there is a great deal of confusion as to when it makes sense to incur the additional costs associated with title insurance for the loan modification. Pennsylvania courts have not provided clear guidance on this question. Thus, borrowers and lenders alike may be hesitant to incur this additional expense. However, it is more important than ever that lenders understand the risks associated with a loan modification and that they acquire the appropriate title insurance product when it is advisable to do so.
As an initial matter, a lender, after performing its preliminary due diligence and determining that a modification is the preferred course of action, should always order a title “bring down” search and update all other searches performed during the initial due diligence. These updated searches will help identify any other interests that may exist as to the collateral.
Next, the lender should discuss the need for additional title insurance coverage with its counsel and its title insurer. These professionals can help the lender understand the risks associated with the modification and whether the borrower should be required to incur the additional expense of added insurance.
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