Real Estate Non-Imputation Endorsements: A Primer For Capital Partners

A curious character in the modern real estate transaction is the “non-imputation endorsement.” Its name reveals little of its nature. Despite its expense—generally 15% to 20% of the cost of the basic premium—it remains misunderstood.

Commonly thought to protect a capital partner’s investment from everything its sponsor knows about a property, the endorsement offers this protection only in part. So, what problem does it solve? Is it worth the price?

Title Insurance

In short, title insurance protects an insured against “loss or damage” suffered on account of, among other things “any defect in or lien or encumbrance on the Title.” That is, if there’s a lien on the property, the title company will pay it off on the insured’s behalf. Moreover, a title company’s coverage will include the costs to defend against the lien—not an immaterial consideration.

Of course, a title company then seeks to discover any such defects and exclude them from coverage. In that way, by shifting risk title insurance provides a critical discovery function.

All this said, title insurance will not cover an insured for: its own acts,¹ unrecorded matters that only the insured knows,² and failure to qualify as a bona fide purchaser (more on this to come). If someone has permitted the lien, it is their own cost to bear.

For a capital partner, this raises the question, Will it be held to account for what its sponsor partner knew or did? In precise terms, will the sponsor’s knowledge and acts be imputed to the venture?

Practical Scenarios

To evidence the problem, consider the following scenarios.

• Equity Recapitalization: The sponsor owns a project with an existing capital partner, but will deed the property to a new venture in which it remains the sponsor with a new capital partner. In other words, the existing capital partner is bought out and fresh equity is injected.

The sponsor unintentionally paved over an easement area where it was not permitted to do so. The venture’s new title policy doesn’t identify the encroachment. When a utility line under the paving breaks, the cost to fix is now much larger due to the encroachment. The venture seeks to make a claim.

However, the title company asserts the defense that an insured cannot obtain coverage for its own acts: the sponsor is the party who built the improvements in the first place.

• Sponsor Contribution: The sponsor has sourced a new deal and closed on the land before securing a capital partner. The sponsor is caretaker for the land and now is raising equity for development.

Unfortunately, when conducting its acquisition, the sponsor became aware of a difficult neighbor who opposed new development and claimed ownership of a boundary area necessary for drainage. To avoid the neighbor’s ire in the zoning process, one of the sponsor’s principals arranges for a quitclaim deed to the disputed portion of the land, which goes unrecorded. After forming the venture, the issue is discovered and it becomes clear the site plan would need to be redesigned. The venture makes a claim seeking compensation under its policy.

But, the title company denies coverage to the venture on the basis that the venture knew about the quitclaim deed, imputing the knowledge of the sponsor to the venture on the basis that it has common owners.

• Sponsor Diligence: The sponsor is under contract to purchase land for development. The sponsor has conducted its own diligence and is permitted to enter onto the property under the purchase contract. The sponsor is now raising equity and the venture will receive the deed. 

Plausibly, the seller is having a difficult time paying operating expenses for the property.  In fact, the seller is looking to exit its position precisely because it is approaching insolvency. A contractor on site to fix a nuisance isn’t paid and the seller tells an executive of the sponsor, who reports up the chain. The sponsor group does not disclose the issue to the capital partner, who then underwrites and closes the deal without consideration of the lien. When the contractor seeks repayment, the venture makes a claim.

The title company asserts the defense that the insured venture knew of the mechanic’s lien since one of its direct owners knew about the issue and did not disclose it to the title company.

How can a capital partner protect its equity in these scenarios?

Deed Protections: Bona Fide Purchasers and Seller Warranties

 Before digging into title coverage, an important consideration is that state law may already protect the venture from unknown problems. Several states protect “bona fide purchasers” from unrecorded defects dating prior to their deeds.

In California, for example, so long as a deed was conveyed “in good faith and for a valuable consideration,” a buyer is protected from prior unrecorded conveyances for which it had no notice. The conveyance is not void per se but, rather, rendered ineffective against the new buyer. The rule incentivizes recording and provides a stable basis by which buyers can purchase real estate without assuming unknown obligations.

Moreover, market standard deeds include at least some basic warranties from a seller. A California Grant Deed warrants that the seller did not previously convey the property and that the seller has not encumbered the property, except as disclosed.

In each of the forgoing scenarios, the venture took title by deed, and the transaction was at arm’s-length. So the venture may have the legal basis to claim that any of the foregoing unrecorded defects are ineffective against the venture. Likewise, the venture would have a claim against the seller.

But consider that whether the venture is properly a “bona fide purchase” is a legal conclusion—and, thus, subject to the costs of litigation to reach such conclusion—as well as whether the seller has any assets to back its liabilities.

The venture may need to come out-of-pocket to vindicate itself, with nothing but a judgment lien to show for it.

Title Insurance Protection: Non-Imputation Coverage

 By purchasing non-imputation coverage, a title company will agree not to assert the exclusions concerning insured own’s acts, own knowledge, and status as a bona fide purchaser against the capital partner up to the capital partner’s percentage interest in the venture.

For transactions where a venture is formed with a capital partner, and the venture takes a deed, the endorsement will typically be an ALTA 15.1-06.³ This endorsement must name the parties staying in the deal.

To support the endorsement, the title company will conduct financial and organizational underwriting and require an indemnity from the sponsor or its creditworthy backer. This is no small task and one that the sponsor must be persuaded to satisfy.  Capital partners should require the sponsor to provide underwriting materials in the purchase and sale agreement or as a condition to entering into a joint venture agreement.

But, given this discussion, including the value of “bona fide purchaser” status, what can a non-imputation endorsement actually be said to offer?  

1. Incentivizes Disclosure: Like title insurance itself, the very act of underwriting risks itself reveals latent risks by clearly apportioning liability. The Title Company assumes risk for what the sponsor knows and shifts that risk squarely on the sponsor’s shoulders. As much as it is an insurance product, it is also a disclosure mechanism.
2. Circumvents Legal Argument: In any number of scenarios, a capital partner might seek to prove that the knowledge of its sponsor should not be imputed to it by law or that its sponsor’s acts should not be binding. But, as with proving itself to be a bona fide purchaser, such a determination will be expensive and uncertain of success. By eliminating the exclusions, a capital partner can avoid litigation and its pyrrhic victories: legally right but nonetheless out-of-the-money.
3. Covers Transaction Costs: The capital partner can rely on the title insurer to take on the costs of litigation, which is helpful whether or not the capital partner ultimately has the law on its side.

Considerations for Purchase

Purchasing a non-imputation endorsement is deal-specific. Recalling the given deal structures, consider the following:

• Equity Recapitalization: Strongest case for purchase. The sponsor group’s knowledge may be well developed, and it has had full rights to act at the property. Consider, however, whether the endorsement must cover any passive investors remaining in the deal.
• Sponsor Contribution: Likely beneficial to purchase. The sponsor group may have come across issues during its stewardship of the property, but this is less likely. The sponsor had full authority to encumber and covey the property, but unrecorded matters may be addressed by “bona fide purchaser” statutes. Consider if the endorsement is appropriately priced.
• Sponsor Diligence: Weakest case for purchase. The sponsor had only limited rights to encumber the property. Its knowledge of unrecorded matters is unlikely. Indeed, unrecorded matters are likely addressed sufficiently by the benefits of becoming a “bona fide purchaser.”

In each of these scenarios, thought must be given to the relationship of the sponsor and capital partner and the sponsor’s activity on the property. All this said, a capital’s partner’s risk preference will ultimately determine whether a non-imputation endorsement provides true value.

¹ “Created, suffered, assumed, or agreed to by the Insured Claimant”

² “Not Known to the Company, not recorded in the Public Records at the Date of Policy, but Known to the Insured Claimant and not disclosed in writing to the Company by the Insured Claimant prior to the date the Insured Claimant became an Insured under this policy”

³ “The Company agrees that it will not assert the provisions of Exclusions from Coverage 3(a), (b), or (e) to deny liability for loss or damage otherwise insured against under the terms of the policy solely by reason of the action or inaction or Knowledge, as of Date of Policy, of [identified knowledge party] whether or not imputed to the Additional Insured by operation of law, to the extent of the percentage interest in the Insured acquired by Additional Insured as a purchaser for value without Knowledge of the asserted defect, lien, encumbrance, adverse claim, or other matter insured against by the policy”