To further protect the value of the collateral supporting your loan, you confirm your borrower has adequate insurance and obtain an endorsement as “loss payee” on the policy.  What happens when the collateral is stolen or destroyed and your borrower misrepresents to the insurance company that there are no liens on the collateral?  The above facts are virtually identical to those in Westfield Ins. Co. v. Talmer Bancorp, 2013 WL 5812027 (6th Cir. 2013), a case where the Sixth Circuit  ruled that because the secured party was listed as “Loss Payee” rather than “Lender Loss Payee,” the secured party was barred from recovering any insurance proceeds.  This case highlights the small but very important distinction between “Loss Payee” and “Lender Loss Payee” endorsements.  While the terms differ by a single word, the designations make a critical difference in determining whether a secured party can recover insurance proceeds under the borrower’s insurance policy after a loss.  A secured party receives far greater protection when its rights are endorsed as “Lender’s Loss Payee”.

In the Westfield case, Milan 2000 Furnishings, Ltd. (“Milan”) obtained a business-property insurance policy from Westfield Insurance Co. (“Westfield”).  Peoples State Bank (“Peoples”) obtained a lien on Milan’s real property and a security interest in Milan’s inventory and required Milan to obtain insurance on the collateral.  Milan obtained the policy and named Peoples as a loss payee under the policy.

Subsequently, Milan submitted an insurance claim alleging that burglars had stolen inventory from its warehouse.  Westfield requested executed proof-of-loss (“POL”) statements for Milan for both the warehouse and the inventory.  Although Milan listed Peoples on the warehouse POL, it did not identify Peoples as a loss payee on the inventory.  In fact, Milan admitted to affirmatively indicating to Westfield that no party held a security interest in its inventory.  After conducting an investigation, Westfield issued a joint payment to Milan and Peoples to cover the property damage and a separate payment to solely Milan to cover the stolen inventory.

Bancorp, as successor-in-interest to Peoples, objected to Westfield’s failure to pay insurance proceeds to the bank to cover the lost inventory.  Westfield refused and sought a declaratory judgment that it did not owe Bancorp any insurance proceeds due to Milan’s fraud.  The District Court for the Eastern District of Michigan entered a consent judgment in favor of Westfield in the amount paid to Milan, and declared the insurance policy void.  On appeal, the Sixth Circuit affirmed that Bancorp, as a loss payee, was ineligible to share in insurance proceeds when the insurance policy was voided due to Milan’s fraudulent POL.  As the court explained, “Milan’s admitted fraud forecloses Bancorp’s right to recovery under Michigan law because, unlike mortgagees, the policy gives loss payees such as Peoples no independent right of recovery if the insured breaches the policy’s terms.  Instead, under the policy’s loss payable provisions, ‘the lienholder is simply an appointee to receive the insurance fund to the extent of its interest…’” In sum, Bancorp’s lesser status as a loss payee (as opposed to a lender loss payee) prevented it from recovering any insurance proceeds after the actions of the named insured voided the underlying policy.

The Westfield case and the antecedent cases cited by the Westfield court, illustrate the harsh results that can ensue when an insurance policy is voided and a secured creditor is listed as a “Loss Payee”, as opposed to “Lender’s Loss Payee”.  There are a number of reasons why insurance companies may have the right to void a borrower’s policy (e.g., fraud, failure to timely file a proof of loss and intentional destruction of personal or real property).  Despite the similarity between the two terms, a secured party who is a loss payee rather than a lender’s loss payee cannot enforce the insurance policy after the policy is voided due to any of the circumstances listed above.  Lenders should be mindful of the difference between the two endorsements and always insist on obtaining a Lender Loss Payable endorsement.  In addition, Lenders should carefully read the provisions of that endorsement as well as the enumerated circumstances that can give rise to the insurer’s ability to void the policy.