How Should a Mortgage Company Use Insurance Proceeds Arising Out of Storm Damage? To Pay Delinquent Interest/Principal, or to Repair the Property?

Wilmington Savings Fund Society, FSB v. Daw, ___ N.J. Super. ___ (App. Div. 2021). Judge Sabatino issued this opinion for the Appellate Division today, in a case that arises out of Superstorm Sandy. It consumes 36 pages and is well worth reading in full. But the first few pages of the opinion explain very well what the case is about, what the governing principles are, and the panel’s ultimate ruling that the case is being remanded for further development of the record. As a result, this remainder of this post is a (shameless but convenient) quotation of those pages of the Appellate Division’s opinion:

“When a mortgaged residence is damaged by a storm and the homeowners’ property or flood insurer pays benefits for the storm damages, how should the mortgage company determine whether to use those insurance funds to pay down the delinquent mortgage principal and interest, or, alternatively, use the funds to repair the property, as provided by the loan agreement? More specifically, if the loan agreement states the lender may choose to apply the funds to the outstanding debt if either repairs are ‘economically infeasible’ or if such expenditures would impair the lender’s security interest, does the lender have an obligation to the borrower to make that decision promptly and in good faith?

“In the present case, the lender’s assignee held the storm insurance proceeds for over three years before ultimately applying them to the homeowners’ outstanding debt. During that lengthy interval, an estimated sum of $40,000 in mortgage interest accrued. Negotiations to modify the terms of the loan failed when the assignee demanded that two thirds of the insurance funds be applied to the debt upfront as a condition of the loan modification, which the homeowners contend would have left them with insufficient funds to complete all the repairs and disqualify them for a state grant that they had conditionally received.

“Relying on two unpublished federal district court cases and other authorities, the homeowners contend the assignee acted unfairly by purposely stalling the process to drive up the interest owed on the mortgage, while allegedly never intending to apply the insurance funds to repairs. Therefore, they contend the insurance funds should have been applied to the mortgage principal and interest earlier, and the amount of the final judgment of foreclosure should be reduced accordingly. The assignee counters that it acted in good faith and made generous efforts to propose a loan modification that was requested by the delinquent borrowers in an effort to enable them to keep their home. The assignee contends the mortgage interest during the three-year interval was appropriately charged until a final decision was made about the use of the insurance proceeds.

“Consistent with principles of fairness and reasonableness expressed in the Restatement (Third) of Property (Mortgages) (1997), we hold the mortgage lender (or its assignee) in such situations owes the borrower an implied covenant of good faith and fair dealing in determining the disposition of the property or insurance funds.

“Once the lender is provided with adequate information to determine how the insurance funds should be used—such as the estimated costs of repairs and market values—the lender is obligated to clearly advise the borrower within a reasonable period of time as to whether the requested use of insurance monies for repairs is economically infeasible or will impair its security in the property. The time to notify the borrower of the disposition may be extended if the parties mutually undertake good-faith negotiations to modify the loan terms. If the lender unreasonably delays making a decision to approve the proposed use of the insurance funds for repairs, the court has the equitable power to abate the mortgage interest that has accumulated in the meantime. Additionally, the lender must place the insurance funds in an interest-bearing, segregated account until the proper use of those funds is resolved.

“Having announced these governing principles, we remand this matter to the trial court to develop the record more fully and evaluate whether the lender ‘s assignee breached the implied covenant and, if so, to fashion an appropriate remedy such as a reduction of the amount of the final judgment of foreclosure.”