What is a Gap Indemnity Agreement?
A gap indemnity agreement is a contract. In commercial real estate transactions, a lender will demand that a borrower give it an indemnity for the gap. That in itself has little meaning to most people so I’ll break this down. In commercial real estate, we usually speak of a "closing" – that is when the title to the property is transferred from the seller to the buyer. The gap is the period after the seller gives the buyer his deed and before the buyer’s deed is recorded. The time frame can be anywhere from a few minutes to a few weeks and generally depends upon how many lenders are involved (if any). The buyer wants to close the deal immediately so he controls the closing date. Not surprisingly, the lender wants to wait until it has all its documents, all its inspectors have signed off and it has all its money in hand before closing.
Generally, a lender won’t lend unless it is first secured by a mortgage on the property being bought. Most mortgages have to be recorded in the local land records before the lender is protected. That’s because of something called a "race-notice statute." Most states have these laws which essentially say that the first in time to have its deed recorded wins; if you don’t get your deed recorded, you may not be the owner. For better or worse, commercial real estate is full of surprises. Sometimes, a day or two after the financing has closed, someone else ends up with a better title to the real estate. It may be someone who didn’t record their deed, or it may be a contractor who did work and then forgot to file his mechanics lien (which in some states is the same thing as recording a deed). This is also why a lender and borrower both will pay a title insurance premium. The title insurance policy will protect against someone else claiming the property as their own. Generally , however, the title insurer won’t cover these issues right away. It can take weeks for the title insurer to investigate the situation and report back to the lender who then has to read and understand the entire title insurance policy and the endorsements before he will agree to continue lending money. Because this period can take some time, the lender then asks the borrower to sign a gap indemnity agreement.
Typically, a lender will hand the borrower two things at closing. The first is a deed to the property from the seller and the second is a mortgage from the borrower to the lender (the borrower signs both documents at the same time and effectively assigns the risk of gap issues to the lender). The gap indemnity agreement then acts as a bridge between these two documents. The gap indemnity agreement indemnifies the lender for any costs it incurs while convincing the title insurer that the borrower still owns the property, even though the lender’s mortgage was recorded second. Generally, the indemnity is limited to the amounts actually paid by the lender. A further advantage of the gap indemnity agreement is that it applies to any contract (written or oral) that the lender has with its borrower. Therefore, a lender who requires the indemnity will also require the borrower to give it a million dollar gap indemnity even though all of the other documents granted a one hundred thousand dollar loan. In the mind of the lender, a one hundred thousand dollar loan is a good enough reason to require the borrower to commit a million dollars. And the borrower will have no way of stopping the lender because lenders hold the purse strings (of course, the borrower could always refuse to provide the indemnity which would leave the lender with the options of breaking the deal or not providing the financing at all).
Components of a Gap Indemnity Agreement
The holding over of an investment property is sometimes unavoidable, but it can lead to tense situations with friends and family members who are unwilling to wait for another day of fun before it’s time to return home. However, to better protect your investment, a Gap Indemnity Agreement can be implemented to more formally outline the terms, conditions, and obligations of said agreement. A gap indemnity agreement is generally based on the specific investments of the parties involved. Therefore, each agreement may vary, but the document will likely contain the following components:
- Definitions: Parties should define the following terms in the context of the agreement: Owner, Indemnitor, Indemnitee, Gap Date, Gap Time, etc.
- Background: The parties should outline a sufficient description (address, unit number, description of interior, etc.) of the subject property, including owner and owner’s address.
- Term: The period of time during which the agreement will be in force.
- Termination: Terms under which the agreement can be terminated, such as failure to pay an insurance required by the agreement or a judicial order precluding its performance.
- Obligations of Owner: Owner shall be responsible for:
- Obligations of the Indemnitors: Indemnitors should assume the following responsibilities:
- Revisions: A Gap Indemnity Agreement can be modified with written consent of all mentioned parties.
Supplemental provisions should address periodic updates, indemnification, requirements for documentation, etc.
How Gap Indemnity Agreements Benefit Lenders
Recognizing the need for lenders to secure their investments, gap indemnity agreements address potential discrepancies that may arise during the period between issuing a commitment to insure and the actual transfer of title and funds. Essentially, the purpose of these agreements is to indemnify the lender from loss in the event that it discovers a lien exists at the time of transfer. Title defects may exist as a result of matters such as executing an incorrect deed, failure to properly record documents, or inadvertently transferring title to the wrong party. It is not uncommon for these types of defects to go undetected at the time of transfer – thereby leaving the lender vulnerable to a potential loss. Lenders have actuary scrutinized the terms of gap indemnity agreements underwritten by the ALTA title insurers that comprise the Title Insurance Rating Bureau of Illinois. In order to keep pace with the heightened level of scrutiny, the Title Insurance Rating Bureau of Illinois endorsed the 2006 ALTA Commitment for Title Insurance and promulgated a Gap Indemnity Endorsement to the 2006 title forms. The Gap Indemnity Endorsement indemnifies the lender (ALTA 27) for specified losses arising out of initial inaccuracies in the date of a document being recorded, errant indices, erroneous indexing of the insured mortgage and/or deed, and missing or ineffective documents.
The Role of Borrowers in Gap Indemnity Agreements
Borrowers of loans secured by a Michigan mortgage must understand their obligations under a gap indemnity agreement. Gap indemnity agreements have become a common part of the Michigan commercial real estate closing process. Performing due diligence in connection with a gap indemnity agreement has its challenges due to the fact that a lender’s reliance upon the gap indemnity agreement typically occurs long after the closing of the transaction.
Typically, the gap indemnity agreement is entered into by the borrower and the title company at or around the closing of the loan to the borrower. All title insurance issued on the loan is endorsed to require the title company to honor their obligations under the gap indemnity agreement. The gap indemnity agreement typically specifies the scope of the indemnification obligation of the borrower. The issue typically addressed by the borrower’s counsel when negotiating the terms of the gap indemnity agreement is the extent to which the indemnity obligation of the borrower survives the termination of the indemnity obligation. Consider the example of a title company that provides a title policy to a lender secured by a first mortgage at a closing of a loan to a borrower. On the date of the loan closing, a mechanic’s lien is filed against the property, but is not discovered by the title company until after the loan closing. The failure of the title company to discover the mechanic’s lien suggests that the title insurance should cover the claim made under that mechanic’s lien because it was within the title company’s ability to discover the lien. The fact that the borrower actually opened up its property for mechanics’ lien liability does not absolve the title company of having to cover a valid claim against the property. The scope of the indemnity provisions of a gap indemnity agreement may be subject to negotiation between the borrower and the lender. In the example above, the scope of the indemnity obligation may be negotiated so that the lender is covered for losses incurred by it regardless of whether the mechanic’s lien would have been discovered upon the title company’s further review of the property. Although this may provide to the lender certainty that the title company will indemnify the lender for a valid claim against the property, if the property suffered a loss under the mechanic’s lien and the insurer had the ability to discover the lien, the borrower should not have to indemnify the lender for the amount the borrower would have otherwise covered via the lender’s title insurance policy. Put simply, absent language indicating to the contrary, if the title company would have otherwise covered a claim against the property under the title policy, a borrower should not be responsible for indemnifying the lender for that claim in the gap indemnity agreement. Borrowers of loans secured by a Michigan mortgage should expect their attorney to investigate the integrity of the gap indemnity agreement. Negotiating the terms of the gap indemnity agreement is just one part of that process.
Legal Issues and Considerations
When a gap indemnity agreement is entered into, to clarify the scope of its provisions, there can be latent risks in the event that a shorter named policy has been issued for the purpose of the policy period to be complied with under gap indemnity. For example, exclusion clauses may differ between the gap and the shorter policy, thereby unfairly impacting on the indemnities given. In some instances there may not be a short term policy in place or one issued that covers the period ("gap") between the respective policies. It then becomes necessary, to ensure coverage for the gap period, to extend the gap indemnity agreement or take out a third policy that covers the gap period. As alluded to above, the gap indemnity agreement is on the sale of the shares and is separate from the contract of sale: it is important that it should not be confused with the sale agreement. The contracting parties, therefore, have to ensure that there are no contradictions between the gap indemnity agreement and the sale agreement, that both the gap indemnity agreement and the sale agreement do not contradict one another, that they do not cause a hybrid contractual situation and lead to confusion between the parties afterwards. It is also important not to confuse the rights that parties have under the gap indemnity agreement during the life of the gap indemnity with the civil actions that can be brought against a seller by a purchaser for misrepresentation under the common law. Disclosure under the gap indemnity becomes part of the contract and therefore a statutory misrepresentation with obligations to disclose arises to a degree in respect of information which should have been disclosed by the seller in the gap indemnity. In addition, in South African law, the prescript period for a claim under a gap indemnity is three years.
Common Myths About Gap Indemnity Agreements
Unfortunately, as is usually the case, there are also misunderstandings and myths about Gap Indemnity Agreements. Gap Indemnity Agreements are NOT the same thing as PCOs. They are not the same thing as indemnity agreements in general. Often they are much more expensive alternatives to the other options available and they do have some negative aspects that PCOs and other indemnity agreements do not have.
SOME OF THE MISUNDERSTANDINGS:
Gap Indemnity Agreements are not always a free pass for the claims-made carrier to get out of covering the claim. So, the myth may just be that Gap Indemnity Agreements are the same thing as PCOs. The truth is, Gap Indemnity Agreements have become less prevalent because, in the past, it was found that they were not actually valid. Today, Gap Indemnity Agreements may be valid if they meet certain requirements for retroactive dates and do not have a material adverse impact on the insured PI (Professional Indemnity) entitlement to the benefit of the PCO.
Gap Indemnity Agreements are NOT the same thing as indemnity agreements in general . Not all Gap Indemnity Agreements indemnify the PI for defence costs. So, they should not be treated as interchangeable with indemnity agreements. Even if Gap Indemnity Agreements do provide indemnity for defence costs, they also have to be carefully worded so that the indemnity is both substantive and practical.
Gap Indemnity Agreements are not the only option for coverage. Gap Indemnity Agreements can be much more expensive than PCOs or even indemnity agreements, depending on the wording. Plus, it is not the financial benefit of PCOs and indemnity agreements which is most important. It is the certainty of defence cover and the level of cover available that is the key because defence costs can be significant for PI practices.
Gap Indemnity Agreements have some negative aspects that PCOs and other indemnity agreements do not. Gap Indemnity Agreements can exclude defence costs, can lead to coverage being cut off when the PI opts to cancel their policy, and can lead to caps on the amount available under the Gap Indemnity Agreement. While there may be undoubted benefits to Gap Indemnity Agreements, there are concerns as well.
Gap Indemnity Agreements: Case Studies
Ultimately, the use of gap indemnity agreements can be as varied as the businesses and organizations that utilize them. However, we can offer some concrete examples to illustrate their uses:
Example 1: Software Purchase Agreement
A large organization decides to purchase a custom software program from a vendor. The customer’s business involves strict security and privacy obligations. As part of the software purchase agreement, they require the vendor to enter into a gap indemnity agreement with its sub-contractors to manage risks associated with security and privacy.
Example 2: Non-Profit Partnership Agreement
A non-profit organization is in the process of entering into a grant agreement with a funding organization. As a condition of receiving the grant monies, the non-profit organization is utilizing a contractual gap indemnity agreement with the grantor.
Example 3: Construction Project
During a construction project, your organization hires a third-party contractor under a master services agreement. As part of the master services agreement, you and the contractor identify some risk transfer strategies to decrease your organizations risk as a result of damages arising from the project. You and the contractor may enter into a contractual indemnity agreement to further identify the possible damages and the appropriate parties that conference the indemnity.
Drafting and Negotiating a Gap Indemnity Agreement
When entering into a contract where gap indemnity coverage is desired, it is advisable that the parties spend time addressing their expectations with respect to that coverage. This can be done through drafting and negotiation of a gap indemnity agreement. Drafting such an agreement is often not difficult and can be tailored to meet the parties’ needs while offering them comfort regarding a major part of their risk transfer program. Below are some drafting and negotiation tips regarding gap indemnity agreements.
Identify Covered Parties
Identifying which parties are protected by the gap indemnity program (e.g., client, joint venture partners, affiliates, agents, employees): if not specifically mentioned in the gap indemnity agreement, all insured and additional insured entities should also be identified. Identifying these parties is especially important if there is a multi-tier structure or joint venture relationship involved in the project.
Define Specific Claims to be Covered
As discussed above, an Owner Controlled Insurance Program (OCIP) is set up for a specific project or multiple projects and encompasses all operations deemed necessary by the owner of the project. Often the timing of the tasks is not agreed upon or does not coincide with the beginning of the project, due to the industry’s extended contract negotiations and slow start up of operations. In addition, most policies offer 30 days from the first day of coverage for additional insured entitlements to become effective. All of these factors must be considered in the negotiation of a gap indemnity agreement.
Define Work to be Covered
Ensure that the specific work is covered under the gap indemnity program. The work to be covered should be identified clearly so that there are no gaps in coverage.
Agreement and Acceptance Period
It should be made clear how long the gap indemnity agreement covers the work and when the agreement is to be executed.
Resolution of Claims
How are claims to be addressed? Who determines whether a claim is covered? Who sets up reserves for the claims?
Insurance Market
Lastly, it is advisable to consult with insurance agents/brokers who have extensive experience with gap indemnity programs. They should be able to provide general knowledge regarding the gaps that might arise in the insurance coverage on the project.
Gap Indemnity Agreements: Future Trends
One future trend that could impact the negotiation of gap indemnification agreements is the recent decided case of Nucor Corp. v. Bell, where the plaintiff claimed and the jury awarded indemnity for "all costs of any investigation, repair and cleaning" of contamination which the perpetations owner had deliberately concealed from buyers. Notably, this high level of coverage was before North Carolina’s legislative change obtaining indemnity under common law (which is much narrower coverage, except in breach of contract cases) and essentially requires most indemnity claims to rely on the terms of the contract.
This is something we will continue to keep an eye on and if any new developments come about we will let you know. As such, with the trend towards gap indemnification agreements covering breach of contract claims as well as common law claims , one cannot simply rely on the language used to determine the scope of indemnity. Those negotiating gap indemnity agreements should take care to pay attention to the cardinal rule of contract interpretation, namely, to effectuate the intent of the contract.
In closing, we note that the prevailing trend is for lenders/financers to require broad gap indemnification, not only as an "out" in situations where the title policy is subsequently issued with exceptions and exclusions not present in the pro forma commitment. We believe that this trend is unlikely to change much any time soon, as implementing this requirement is easy and generally a simple issue of pricing to obtain broad or narrow gap indemnification. Therefore, even if the case law does shift in the direction furnished by the Nucor Corp. v. Bell case, the overall trend of requiring broad indemnity is likely here to stay.