Court Limits Home Lender Rights to Quake Payouts

In a precedent-setting decision that will cheer thousands of homeowners, a state appeals court has ruled that insurance payouts on voluntary earthquake damage policies belong to the homeowners, not their mortgage-holders.

The 2nd Court of Appeal in Los Angeles made the ruling in favor of a Northridge woman against First Federal Bank of California. The court held that “when a lender does not require in its contract that the borrower obtain earthquake insurance on the property securing the loan, it has no right under the contract to receive or control the insurance proceeds as a result of earthquake damage to the property.”

In the aftermath of the Northridge quake, many homeowners were shocked to discover that insurance companies made out benefit checks to them and their mortgage-holders, jointly. In many cases, the payouts came from policies purchased with the homeowners’ own foresight--policies the lenders had not even known about until the checks arrived.

The lenders in turn sometimes refused to endorse the checks--making them worthless--unless they could dictate what use was made of the money, such as specific repairs.

But in its June 29 ruling, the three-judge panel declared that as long as it was the homeowner’s decision to buy quake insurance, the homeowner was entitled to decide how to spend the benefits.

Insurance companies frequently add the lender’s name to quake benefit checks because homeowners usually obtain earthquake coverage by adding it to their fire insurance policy. Under state law, lenders are co-beneficiaries of fire insurance payouts, so the quake insurance payments from the same policy are made the same way, the attorneys involved said.

Lawyers for both homeowners and lenders said the ruling should help clarify ambiguous and outdated California case law concerning who controls insurance proceeds.

The appeals court moved quickly to deal with the issue when it appeared on the calendar in June, the attorneys said. The ruling was among the 20% or so each year that the court deems important enough to publish, making the decision binding on lower courts in its district.

The ruling will have an impact well beyond Northridge quake cases in which lenders and homeowners are still battling over insurance checks, attorneys said. Although about 95% of quake insurance claims have been settled--for $11.7 billion--the ruling may open the door for homeowners to seek reimbursement for some repairs their lenders forced them to make, the attorneys said.

“This is a case that will have major effects for decades,” said attorney Richard Close, a San Fernando Valley homeowner activist. “And it will have an effect on victims of future earthquakes.”

Beth Young, an attorney for First Federal, agreed that the ruling would have “far-reaching implications, not just for homeowners but for banks and lenders throughout California.”

Although the state Department of Insurance has not yet studied the ruling in depth, it will apply not only to California firms, but to insurance companies based elsewhere that are authorized to operate in the state, said Candysse Miller, a spokeswoman for the department.

“This has been an issue the department has been monitoring very closely,” Miller said. “Especially after the earthquake, we were receiving a lot of complaints from people about this, trying to settle a lot of them on a case-by-case basis.”

Banks and other lenders contended that as part-owners--often majority owners--of the damaged properties, they had the right to insist that the money be spent on repairing the homes--their collateral.

“Why should the bank take the loss” on the value of a home, Dominick Albano of the California Bankers Assn. said when the suit was first filed against First Federal by Phyllis Ziello. “It isn’t her money, per se, because the bank is still legally co-owner of the house until it’s paid off.”

The verdict is “a step backward,” Chris Chenowith, another spokesmen for the bank association, said Wednesday. It gives policyholders an incentive “to take the cash and to leave the bank and the community with this worthless piece of property,” he said.

The lawsuit grew out of the travails of Ziello, a 72-year-old Northridge woman who had moved to the San Fernando Valley from the Westside to be near her son and one of her daughters.

A widow subsisting on a trust fund that relied heavily on income property, Ziello’s fortunes had waned along with the state’s real estate market well before the earthquake, according to her attorney, Geoffrey Bryan.

She had fallen behind on her mortgage payments, and was already in danger of losing her $512,000 home to foreclosure when the temblor hit.

The quake caused an estimated $100,000 in damage to the property, and Safeco Insurance made out a check for $62,101, payable to Ziello and First Federal.

When Ziello decided she did not want to immediately sink the insurance money into repairs, First Federal refused to endorse the check.

“Mrs. Ziello wanted the right to manage the money herself. She critically needed that earthquake money right then,” and the freedom to spend it as she needed, Bryan said.

Ziello said Wednesday that she pleaded with bank executives to “please just give me a little breathing room,” because she needed to get her life back in order.

But the bank held fast and eventually foreclosed on her house because she had stopped making payments.

Ziello sued, challenging the bank’s authority over the insurance payment and demanding that her house be returned. A Los Angeles Superior Court judge granted a summary judgment to the bank, leading to the appeals court action that brought a partial victory for Ziello, although she still has not regained ownership of her home.

The appeals court ordered her case returned to trial in Superior Court, where both sides will have a chance to argue the specifics of the litigation.

“It’s not over yet,” said Young, the bank’s attorney.

Many homeowners who shared Ziello’s experience of fighting insurance companies and banks while trying to rebuild shattered homes and shaken lives, however, say Ziello has already won the greater case.

Said attorney and homeowner Close: “For anyone who owns property in California, this is a major victory.”