Resolving a dispute at the “intersection of bankruptcy and New York state [foreclosure] law,” Bankruptcy Judge Robert E. Grossman of Central Islip, N.Y., tells us that a lender who consents to a bankruptcy sale for less than the amount of the secured debt does not waive a claim against an insurer up to the amount of the lien.

Procedurally and factually, the case was complex. For the sake of understanding, here’s what counts:

The debtor owned a restaurant that burned to the ground. The debtor filed a chapter 11 petition and confirmed a plan to pay the mortgage holder up to the full amount of its lien, if all the stars aligned.

Six months after the fire, the insurer rescinded the policy and denied coverage to both the debtor and the lender. The debtor and the lender sued the insurer. With regard to the debtor, Judge Grossman separately ruled in favor of the insurer by finding that the debtor had made misrepresentations to the insurer, thus voiding the policy as to the debtor.

The lender and the insurer filed cross motions for summary judgment with regard to the insurer’s liability on the policy to the lender.

The dollars and cents worked out like this: By stipulation with the debtor, the lender had an allowed secured claim for about $2.5 million. Under the policy, the maximum coverage was about $2 million for the building and $300,000 for personal property.

Without objection from the insurer, the debtor and the lender stipulated to an order calling for an auction sale of the property. At auction, the property sold for $1.9 million. From the net sale proceeds, the lender expected to recover not more than $1.8 million. The insurer did not object to the sale. In other words, the sale would leave the lender maybe $700,000 short of recovering all of its allowed claim.

On the motions for summary judgment, the insurer contended: (1) It had no liability to the lender given the debtor’s misrepresentations; and (2) if the policy were still in force as to the lender, the lender’s agreement to sell the property for less than the debt extinguished the lender’s claim for a deficiency, giving the lender no claim against the policy to recover any of the $700,000.

The Standard Mortgage Clause

The lender was listed as an additional loss payee on the insurance policy. The policy contained what Judge Grossman called a “standard” mortgage clause.

Even if the insurer were to deny the insured’s claim, Judge Grossman said that the standard clause “creates a separate insurable contract between the insurer and the mortgagee such that a rescission as to the insured does not necessarily result in denial of coverage to the mortgagee” as long as the policy premium was paid.

Because the lender “holds a separate insurable interest in the Debtor’s property, not dependent upon continued coverage to the Debtor,” Judge Grossman held that “the rescission of the Policy as against the Debtor did not also rescind [the lender’s] rights to coverage.”

In short, the lender could recover from the insurer even if the debtor couldn’t.

Deficiency Claim Not Lost

The insurer made an analogy to New York foreclosure law to argue that the lender’s consent to a sale for less than the lien cancelled the lender’s right to recovery under the policy.

Specifically, state law provides that extinguishment of the debt before or after the loss precludes recovery under an insurance policy. Similarly, the failure of a lender to obtain a deficiency judgment following foreclosure waives any right to recover under a policy.

Judge Grossman stated the insurer’s theory like this:

[The insurer] argues that because the Property was sold by the Debtor with [the lender’s] consent in a bankruptcy sale for less than the amount of the [lender’s] debt, and [the lender] failed to obtain a deficiency judgment against the Debtor, [the lender] no longer has an insurable interest in the Property because under these facts the proceeds of the sale are deemed to be full satisfaction of the mortgage debt.

Succinctly, Judge Grossman said:

[S]tate court foreclosure and deficiency rules have no application in the context of a sale conducted under the auspices of a confirmed chapter 11 plan and court-ordered Stipulation setting the rights and obligations of the parties.

Looking at the sale stipulation and the chapter 11 plan, Judge Grossman said that the lender had an allowed secured claim for $2.5 million and that the lender was not required to give a satisfaction of the mortgage until the mortgage debt was paid in full. From the plan, the lender was entitled to payment from sale proceeds and from “any insurance payout.”

Judge Grossman rejected the insurer’s “argument that [the lender] has not retained an insurable interest and a right to benefits under the Policy.” He therefore held that the lender “still has an insurable interest as that term is contemplated in the Policy and retains the right to seek benefits from [the insurer] under the loss payable provisions of the Policy.”

Judge Grossman granted the lender’s motion for partial summary judgment by declaring that the lender retained a right to payment under the policy. Regarding the amount of the insurer’s liability, there were disputed issues of fact that Judge Grossman left for later determination.