"UCC MEZZANINE INSURANCE:
THE COST-EFFECTIVE ANSWER TO AN OPINION OF BORROWER’S COUNSEL"

By James D. Prendergast
Senior Vice President, General Counsel

The premise of this article is that the use of an opinion of borrower’s counsel as to the perfection and priority of the lender’s security interest in the pledged equity collateral securing a real estate mezzanine loan, and as to the “protected purchaser” status of the lender as a “Purchaser” of the equity collateral, makes little sense under any rational cost-benefit analysis. In lieu of such a legal opinion, UCC Mezzanine Insurance offered by Fortune 500® land title companies is much more cost effective -- and a claim will not otherwise lead to the bankruptcy of the opinion-giving law firm.

Law firms have, on occasion, given “priority” and “protected purchaser” opinions, so the issue is not that sophisticated law firms cannot provide such an opinion. The issue is whether the opinion is from a sophisticated law firm and; if so, whether giving the opinion makes economic sense. The issue of sophistication is the easier to dispose of. The Special Report of the TriBar Opinion Committee, UCC Security Interest Opinions – Revised Article 91 has made the observation that:

“While this Report provides a detailed discussion of Article 9, opinion preparers who do not regularly work with Article 9 should consider whether to involve a lawyer familiar with Article 9 in the preparation of a security interest opinion.2”

Given this general discussion, if we connect the dots to the TriBar Report, clearly the report is advising that, in its opinion, an attorney who ventures into the area of providing a security interest opinion under Article 9 is assuming the mantle of a specialist in the Uniform Commercial Code, or at least to Article 9 and related sections of other Articles, such as Article 1 on scope and choice-of-law, Article 3 on instruments and Article 8 on securities, protected purchaser status, and the relationship of Article 8 to the issue of perfection and priority of security interests in investment property.

So let us assume that the law firm representing the borrower has a sophisticated commercial law practice and is legally capable of providing the U.C.C. Article 8 and Article 9 protected purchaser and perfected security interest opinions; the question is whether it is smart and cost effective to do so.3

But competence in matters related to the U.C.C. of the state in which the opinion giver is licensed, is only part of the issue. Most real estate mezzanine loan transactions involve Delaware limited liability companies and certificated securities located on a closing table in New York. If we assume that counsel for the borrower is neither a New York or Delaware lawyer, the opinion given concerns a broader issue than just competence with the U.C.C. in his or here state of law license. Notwithstanding the enforcement of local rules of professional conduct, an overarching concern of, for example, a California lawyer giving an opinion on Delaware law -- even an opinion limited as to scope as discussed in the TriBar Report -- is the issue of legal malpractice and the standard of care employed in judging the competence of the foreign law U.C.C. priority and protected purchaser opinion. It may not be malpractice per se for a California lawyer to provide a U.C.C. priority and protected purchaser opinion under Delaware law. However, unless the opinion recipient is willing to accept a competence limitation on the opinion (and even assuming the enforceability of such a limitation), the opinion giver does become a guarantor of the correctness of the opinion to the extent of its scope. As stated by the Court in a relatively recent New York action: “When, as here, counsel is retained in a matter involving foreign law, it is counsel’s responsibility … to know, or learn, the law of the foreign jurisdiction.”4 And the malpractice exposure must be further considered in light of the end of the 10-year buyer’s market for malpractice insurance.5

Let us also assume that the qualifications to the UCC secured transaction and protected purchaser closing opinion are substantially the same as the exclusions to the comparable UCC insurance policy. This assumption is generally true. As stated in the Tribar Report: “The opinion preparers, therefore, are permitted to rely on assumptions, whether stated or not, concerning the secured party’s lack of notice of an adverse claim.”6 UCC insurance policies have a similar exclusion for matters “suffered, assumed, or agreed to” by the insured as well as matters known to the insured and not known to the insurance company that could affect coverage under the policy. That all being said, there are many factual matters, not covered by a closing legal opinion that are covered by your typical UCC insurance policy, such as filing office error, mis-indexing by the filing office, financing statements filed in the GAP between the date of the initial UCC filing office search and the date of the filing of the secured party’s financing statement, forgery, etc. Nevertheless, for the sake of brevity and to focus on the significant financial exposure to the opinion preparer, let us assume comparable qualifications to the legal opinion and UCC insurance even though such a conclusion does disservice to the UCC insurance coverage.

Then let us assume that the opinion giver is a sophisticated New York law firm with a Delaware office with competent Delaware lawyers, so we don’t have a malpractice per se problem; the question is again whether it is smart for the law firm to provide the opinion. Donald W. Glazer, former Chair of the Legal Opinion Committee of the Section of Business Law, and Jonathan C. Lipson, Professor of Law at Temple University have written a thoughtful article addressing cost-benefit evaluation of a law firm providing a closing opinion to a commercial transaction such as a real estate mezzanine loan transaction which is, after all, a personal property secured transaction.7 The authors titled their article “Courting the Suicide King,” a title that says it all!

The first factual underpinning of the article’s conclusion of the courting of suicide is that a lawyer being sued for their legal opinions is no longer a theoretical possibility. As stated in the article: “Lawyers today too often are seen as deep pockets when a deal goes bad and the acrid aroma of financial fraud fills the air.”8 Given the reality of CFS, Enron and Dean Foods,9 law firms should no longer be cavalier about being sued on their opinions. Although the probability that an opinion will result in litigation may be small, given the size of commercial transactions (especially real estate mezzanine loan transactions, often in the billions of dollars), law firms are betting the solvency of the firm in providing the legal opinion.

The cost-benefit analysis, as discussed by Glazer and Lipton, needs to take into consideration not only the transaction value exposure but also the cost of defense. The authors conclude that there are a number of obstacles to an effective cost-benefit analysis, which are:

• The absence of reliable statistics because of the paucity of reported judicial decisions involving third-party opinions;
  
• The lack of public information about settlements and defense costs (although we understand anecdotally that settlements can be in the high eight figures or even more);
• The inability to translate into dollar terms the impact a suit can have on a firm's practice and the productivity of the lawyers who worked on the challenged opinion; and
• Most importantly, the inability to place a value on the continuing existence of a law firm as an institution when a suit jeopardizes its future.10

Therefore, a traditional cost-benefit analysis cannot isolate the true cost of providing the opinion. Adding to the difficulty, as pointed out by the authors, is the fact that most lawyers consider the consequences of not providing the opinion as dire, including the loss of the client, and the risk minimal. The probability of lightning does not stop people, including lawyers, from playing golf. However, if the lightning (i.e., an action for malpractice) were to hit notwithstanding the low probability, the very existence of the law firm would be in serious jeopardy. This is a “bet the farm” issue.

The authors then discuss two traditional methods of addressing the problem of catastrophic loss. The first is insurance, and the authors state that there is no available coverage for liability arising out of closing opinions and, even if there were, the premium could be substantial (more on the insurance option below) The second alternative is procedural such as arbitration, following the investment banker model. But, as again stated by the authors, “[e]ven a procedure in which disputes are resolved by experts will not protect an opinion giver from having to pay potentially ruinous damages if it did make a mistake and, in fact, was negligent.”11

What the authors then suggest, as the solution to third party liability on closing opinions well in excess of what even the largest law firm can afford, is a cap on recovery under the legal opinion. The amount of the cap, as suggested by the authors, would be an amount sufficiently large to assure that the law firm takes its responsibilities in giving the opinion seriously, and would not apply to recklessness or willful misconduct, but would not be so large as to jeopardize the continued existence of the law firm. They conclude by making the observation that “Transactions involving opinions are not one-off events, and over the long run forcing law firms to risk their futures each time they give an opinion is in nobody's interest.”12

The authors conclude their article with a discussion of a simple card game called “Suicide King.” In this game the player makes an initial ante of $5 million. The deck is shuffled and a card is drawn. You lose if it is the King of Hearts – the Suicide King. If you do not draw the Suicide King, the house pays you 5 percent of the pot. Out of your winnings, initially at $250,000, you pay yourself 40 percent initially $100,000, and leave the balance on the table. As the game progresses, both your winnings and the pot increase. But sooner or later you will eventually lose.13 The same can be said for secured transaction closing opinions: the legal fees are nice while they last, but sooner or later the law firm will lose. The authors’ solution is to cap exposure. My solution to the exposure to law firms of closing opinions in real estate mezzanine financing is UCC insurance, a much better solution than the legal opinion, with or without a cap.

First of all, I would not use the lightning and golf analogy. Rather, I would use fire insurance as the analogy. Although the probability of a fire at your home is extremely low, the result is catastrophic. Given the catastrophic nature of the risk, insurance is a good idea notwithstanding the low probability of occurrence; the only question is the premium amount. The authors, when discussing legal opinion insurance, argue that even if available the premium for such insurance would be prohibitive. That is not the case with UCC insurance. UCC insurance is less expensive than comparable land title insurance for comparable insured amounts and the reasonableness of the cost to scope of coverage was one of the reasons why Moody’s Investors Service, in its report titled “US CMBS and CRE CDO: Moody’s Approach to Rating Commercial Real Estate Mezzanine Loans,” suggests obtaining UCC insurance for a neutral rating position. However, given its relative low premium cost, UCC insurance becomes a reasonable alternative, not as a risk management tool to mitigate the exposure to the law firm providing the priority secured creditor/protected purchaser legal opinion as suggested by the authors, but rather as an alternative to the law firm betting its existence through issuing the opinion. I would also argue that given its relatively low cost and comparable coverage, a UCC insurance policy is a better buy than a legal opinion.

The conclusion to this point is that the real-estate mezzanine borrower should offer a UCC insurance policy to the lender rather than the opinion of its legal counsel on the priority secured creditor and protected purchaser status of the lender because: 1) it provides greater coverage than a typical legal opinion because the UCC insurance policy covers many factual and other matters not covered by a legal opinion; 2) UCC insurance is usually cheaper than the legal opinion, and will always be cheaper if the legal opinion is separately priced; and 3) the borrower would like to see its law firm survive, so why force it into a “bet the farm” position of providing the real estate mezzanine legal opinion?

But the lender should also want UCC insurance rather than the legal opinion. The first reason is the strength of the insurance provider. For a real estate mezzanine transaction in the hundreds of millions (or billions) of dollars, the law firm as sole insurer could never really answer on a claim. The law firm lacks reserves to fund claims that are statutorily required of insurance companies. Further, the law firm takes the sole risk of a claim for the coinsurance and reinsurance structures available to the UCC insurance company, which is not available to law firms to spread the risk of legal opinions.

But even if the provider of the legal opinion has the financial resources to stand behind its opinion, the lender’s recourse against the opinion provider is constrained by the community standard of care, while the insurance company is providing indemnity coverage. The lender’s action for damages under the legal opinion is in malpractice. The standard of care for an attorney who holds himself/herself out as a specialist is that, with regard to his/her specialty, he/she has and will employ not merely the knowledge and skill of a general practitioner, but that he/she has and will employ that special degree of knowledge and skill ordinarily or normally possessed and used by the average specialist in his/her field. But the law does not require that an attorney guarantee a favorable result. The law recognizes that the practice of law according to standard legal practice will not necessarily prevent a poor result. If the attorney has brought and applied the required knowledge and skill to his/her client, he/she is not liable simply because a favorable result has not been achieved or simply because bad results have occurred. The attorney is not an insurer, nor is he/she liable for every error in judgment or mistake. On the one hand, he/she is not to be held accountable for the consequences of every act that may be held to be an error by a court. On the other hand, he/she is not immune from responsibility if he/she fails to employ in the work he/she undertakes that degree of reasonable knowledge and skill exercised by attorneys of ordinary ability and skill.

UCC Insurance, on the other hand, is indemnity insurance. If there is a challenge to the lender’s status as the priority secured creditor or as a protected purchaser, the insurance company will have the duty to defend. As stated by the authors:

One of the challenges opinion givers face when sued is winning a motion to dismiss. Actions against opinion givers are fact specific, and judges generally have been unwilling to dismiss a complaint before giving an opinion recipient an opportunity to develop the facts. The consequence has been to expose opinion givers to defense costs of potentially tens of millions of dollars and damages claims that far exceed what they can afford to lose. When a firm faces the possibility of a catastrophic loss at trial, the pressures to settle are intense.14

So the clear first benefit to the lender -- a benefit not included with the legal opinion -- is that the UCC insurance company will front the defense cost to defend the challenge to the lender’s secured creditor and protected purchaser status.

The next step is that if there is a loss to the lender, after the carrier has paid the defense cost, the UCC insurance company will pay the claim. Again, as discussed above, the insurance carrier, given its own capital resources, statutory reserves, coinsurance and reinsurance, can stand behind the insurance. The law firm, even the largest, as fragile service providers, will have great difficulty surviving let alone financially standing behind its opinion even assuming the lender overcomes the defenses to the malpractice action in the first place.

The insurance provider can take prudent actuarial risks in shifting the risk of occurrence of a hazard from the insured to the carrier. This is the fundamental difference between the legal opinion and UCC Insurance. It is the attorney’s effort to avoid insurance risk that leads to the extensive discussions over the scope of the opinion and the pages and pages of qualifications and exceptions that follow the body of the opinion. With UCC Insurance the lender is dealing with an insurance company over matters of insurance risk, thereby eliminating the disconnect between the lender who wants the attorney to be an insurance company and the attorney who doesn’t want to be one. By matching expectations with results, UCC Insurance provides the lender with what the lender is really looking for, at a price often less than the legal opinion that, in the end, does not meet the lender’s expectations.

In conclusion, by utilizing UCC Insurance:

• The lender obtains security interest priority indemnity insurance coverage, often at a cost less than the cost of a borrower’s counsel legal opinion, whether negotiated or not;
  
• The borrower saves money by not having to pay for the opinion;
• The lender’s counsel is off the hook for priority secured creditor and protected purchaser issues now covered by the UCC Insurance;
• The borrower’s counsel avoids unnecessary legal malpractice risk;
• The significant due diligence matters are covered by the UCC Insurance (saving countless associates from boredom and drudgery); and
• Everyone gets the added benefits of the matters covered by UCC Insurance, such as gap coverage, coverage for mis-indexing, etc., not covered by the opinion of the borrower’s counsel.
  

Although admittedly biased, the point of this article is that the answer to the Tribar Report and the cost of closing opinions in commercial transactions is UCC Insurance. And in addition to the benefits of the insurance itself – which include both indemnity protection against actual loss and a legal defense against challenges to the security interest as insured – customers of UCC insurance providers also receive assistance with that portion of the due diligence process that underlies the creation, perfection and confirmation of priority of the lender’s security interest and compliance with the Article 8 prerequisites to protected purchaser status.