Speaker's Corner: Mortgage fraud case raises questions about insurance exemptions

I have been out of the title insurance business for some time, but as First American Financial Corp.’s chief title underwriter and then as president of LandAmerica Financial Group, Inc.’s Canadian venture, I spent considerable time drafting policies and getting them accepted by Canadian financial institutions in the 1990s. Roughly 20 years on, I am surprised there has not been more Ontario Court of Appeal consideration of the language of the policies.

Although the Court of Appeal did have occasion to consider double recovery in Krawchuk v. Scherbak in 2011, reported title insurance matters deal mostly with issues such as building or zoning compliance, solicitor discipline hearings, and business interest spats.

The recent Ontario Court of Appeal mortgage fraud decision in Re Gray has reminded me of questions I wondered about when I first read what are known as the “suffered, created or assumed” and knowledge exclusions.

In Gray, an acquaintance used a Royal Bank of Canada employee as a straw man. The acquaintance, John Roberts, convinced Evan Gray to take title to a residence with him and co-sign a mortgage to RBC. Although Gray received $2,500 for his participation, the court found his discharge from bankruptcy should release him from his debt to the Canada Mortgage and Housing Corp. on the basis that he hadn’t made the misrepresentations to the bank at origination. There had been plenty of misrepresentations made to the bank, but the court found they were all from Roberts and his co-conspirators rather than Gray. The court also found Gray had not been wilfully blind and that even though he worked for the bank, his action, or lack thereof, was in his capacity as a borrower and not in his capacity as a fiduciary or employee.

The Ontario Court of Appeal dismissed CMHC’s appeal. CMHC had insured RBC’s $516,370.13 mortgage on the fraudulently inflated purchase price of $529,000 and was the assignee of the RBC debt.

Title insurers have the right to subrogate and it may be that the invalidity or unenforceability against title of the mortgage was insured, but it is my understanding that a title insurer was not involved. In any event, the mortgage in this case was valid and enforced against the title. The source of the bank and CMHC’s loss was a valuation fraud.

As someone who used to sit at the top of the underwriting escalation ladder used by most title insurers, I know that had RBC required title insurance on this mortgage the underwriters would have discovered at least some of the following important facts: Gray had no plans to live in the house; the mortgage broker had previously been on title with Kavita Naik, one of the vendors; Naik planned to live in the house after closing; the mortgage broker had provided the valuation; Gray had never even seen the house; one solicitor was acting for both the vendor and the purchaser; and Gray was getting money to take title with Roberts and sign the mortgage. The red flags on this file were so numerous that any title insurance underwriter would have made every inquiry imaginable to ferret out the story on this mortgage. It is what they have training to do.

The case led me to wonder about the exclusions I mentioned earlier. Title insurance policies exclude losses “suffered, created or assumed” by the owner or lender. Could a title insurer have denied coverage on the basis that the bank employee had been the straw man? On the facts of this case, I don’t think so. The courts found Gray so unaware of what was going on that he was not caught by s. 178(1) of the Bankruptcy and Insolvency Act that would have prevented release of the mortgage debt due to fraud, false pretences or fraudulent misrepresentation. It’s hard to imagine, then, that the bank could have “suffered, created or assumed” the loss when even its employee was found not to have taken part in the scheme or to have been wilfully blind to it. But what about the knowledge exclusion?

Title policies define knowledge as actual knowledge and specifically exclude constructive knowledge or notice that may be imputed. Here, an RBC employee actually knew quite a lot about the facts surrounding the fraud (such as the fact he wasn’t going to live in the home), but the court did not seem to believe he had an overall sense of what was happening. Absent any special endorsement someone may have negotiated, would the knowledge exclusion allow a title insurer to deny coverage when a corporate client’s employee knew many of the facts of the fraud but claimed not to be aware of the overall scheme? What if he knew of the scheme? Could that knowledge have been only in his capacity as a borrower and not as a fiduciary to his insured employer?

It is too bad there was no title insurance for this mortgage. From a public policy point of view, I wonder if this is the type of risk CMHC should be taking on. What expertise does it have to manage this type of risk? Perhaps it is time for CMHC to revisit entering the title insurance business. I suspect a title insurer’s underwriters would have stopped the deal, but had it closed, it would have been interesting to have the Court of Appeal comment on the exclusions and any endorsement that may have limited them.

Tim Hyde is founder and chief executive officer of real estate advisory service HouseVault.

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