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Enforceability of Carveouts to Nonrecourse Loans: Recent Cases

By: John C. Murray,
©2012 First American Title

Introduction

Since the mid-1980s, lenders have been qualifying and restricting nonrecourse provisions in commercial real-estate loans by making exceptions for certain acts by borrowers that are deemed to be within the borrower’s control. In recent years, many lenders have expanded the scope of such “carveouts” to include risks of exposure to the property’s economic deterioration or neglect. Some nonrecourse provisions provide that the borrower is liable for the specific damages resulting from the violation or breach of a carveout, while others state that the entire loan becomes recourse to the borrower if any of (or certain of) the excepted acts occurs. In some cases the exceptions have virtually swallowed the rule; i.e., the clause is drafted so that the borrower has personal liability for virtually all defaults under the loan documents except the failure to pay the principal and interest due on the loan (and, under the most recent case law discussed below, even the failure to pay principal and interest alone may trigger total recourse liability under certain circumstances if the language in the nonrecourse and carveout provisions is so drafted and interpreted). There has been relatively little case law regarding the validity and enforceability of such carveouts, as these provisions have rarely been challenged by borrowers or guarantors. But in the current severely depressed commercial real estate market, with the commensurate increase in mortgage loan defaults (especially with respect to commercial mortgage-backed securities (“CMBS”) loans, where the isolation, preservation and continuation of the income stream from the mortgaged property are especially important), more federal and state court actions challenging the validity and enforceability of carveout provisions are being brought by borrowers and guarantors (mostly without success). This article will discuss and analyze the most recent court decisions in this area.

Background

True nonrecourse loans are rare today. Commercial real estate values have substantially declined. In the past (and even currently, to a lesser extent) much real estate value was created by investors seeking tax or related benefits who were not particularly concerned about adding to – or in some cases even maintaining – the value of the property, or by foreign investors seeking unique opportunities or higher returns (however modest) than were available in their own countries. Many lenders began to realize – especially after being “burned” in bankruptcy proceedings filed by or against their borrowers – that standard nonrecourse mortgage provisions in some cases actually encouraged borrowers to contest lender enforcement actions and to file bankruptcy proceedings, as borrowers had no risk of personal liability and could delay or even avoid unfavorable tax consequences. Lenders learned that, because of the absence of personal risk to borrowers and the lack of a direct monetary incentive for borrowers to properly operate and maintain the property, their security could suffer a substantial loss in the value that was originally determined as the basis for underwriting the loan.

The carveout exceptions to nonrecourse mortgage provisions have evolved from traditional borrower acts such as fraud, material misrepresentation, and the diversion of the loan proceeds, to include matters of conduct (or inaction or misconduct) related to the economic performance of the property, such as the misapplication of rental income, environmental contamination of the property, and physical or economic waste of the property. The exceptions to nonrecourse have expanded to include obligations to properly maintain the property and preserve its value.

Certain carveouts relating to the lender’s efforts to protect itself from a loss of the property’s value, or the diversion, misappropriation, or misapplication of the property’s income stream, may be more amenable to a limited quantifiable-damages remedy. The following are examples of these types of covenants: the failure to properly apply insurance or condemnation proceeds to the restoration or repair of the property and the improvements thereon; the diversion or misapplication of security deposits and unpaid rents; the misapplication or diversion of rental income after a loan default; the failure of the borrower to perform its obligations as landlord under leases in effect on the property; physical neglect or waste of the property; “economic waste” of the property (such as the failure to pay property taxes and assessments); failure to discharge mechanic’s liens and other monetary encumbrances and judgment liens against the property; failure to insure the property or pay the insurance premiums when due; failure to comply with applicable laws and regulations affecting the property; failure to maintain the property in a “suitable condition” to prevent loss of value; and removing or “stripping” personal property essential to the use and operation of the property and the buildings and improvements thereon.

The lender must be realistic in the assessment of its ability to recover against the borrower if the borrower becomes personally liable as the result of the breach of a nonrecourse carveout. For example, the right to assert recourse liability against a single-purpose, bankruptcy-remote entity such as a limited liability company, business trust, thinly capitalized corporation, or a limited partnership with a single-member limited liability company as the general partner may be virtually worthless.

CMBS Loans – Current Cases

A. The Chesterfield Decision.

In a recent case involving a nonrecourse securitized loan, 51382 Gratiot Avenue Holdings, LLC v. Chesterfield Development Co., LLC, 2011 WL 6153023 (E.D. Mich., Dec. 12, 2011), the plaintiff lender (“51382”), successor in interest to the original mortgage lender, Morgan Stanley Mortgage Capital Holdings, LLC (“Morgan Stanley”) foreclosed its mortgage on the shopping-center property owned by the borrower (“Chesterfield”) at a non-judicial Michigan foreclosure sale and purchased the property for an amount that was more than $12 million less than the outstanding balance of principal and interest due on the loan (“Debt”). Article 11 of the note contained an “exculpation” provision that made the Debt nonrecourse to Chesterfield and the guarantor (collectively, “Defendants”), except for certain designated “springing recourse obligations” that would make the Defendants fully liable for the Debt. (The guarantor, John Damico, signed a “Guaranty of Recourse Obligations of Borrower” at the time of execution of the mortgage and other loan documents, which provided that the guarantor “absolutely and unconditionally guarantees to Lender the prompt and unconditional payment” of “all obligations and liabilities of Borrower for which Borrower shall be personally liable pursuant to Article 11 of the Note.”)

51382 subsequently sued Defendants for the deficiency based on violation of one of the springing-recourse exceptions to nonrecourse, notably a provision in Section 4.2(j) of the mortgage that Chesterfield shall not “become insolvent or fail to pay its debts and liabilities from its assets as the same shall become due and payable.” The court ruled in favor of 51382, holding that Defendants were personally liable for the full amount of the remaining unpaid deficiency because “the Loan Agreement unambiguously provides that Defendants are liable for the deficiency balance.” Id. at *3.

Defendants argued that they could not incur full recourse liability solely due to nonpayment of the Debt. But the court dismissed Defendants’ argument, stating that “this dispute is merely one of semantics,” Id. at *6 n.2, and that “the terms of the Loan Agreement unambiguously show that Plaintiff is correct.” Id. at *7. The court found that notwithstanding the testimony offered with respect to the intention of Defendants and Morgan Stanley, there was no fraud, misrepresentation, or mutual mistake. The court stated that:

At most, the evidence Defendants present shows that, though both they and Morgan Stanley intended to be bound by the terms of the Loan Agreement, both parties misunderstood the legal effect of the terms contained in that agreement.
Id. at *18.

The court ruled that there was no equitable reason to deny personal liability or reform the note, stating that:

There are no equitable considerations in this case that urge the court to reform the Loan Agreement or otherwise relieve Defendants of their obligations under it, as Defendants are sophisticated parties who had the benefit of counsel when executing the Loan Agreement. Accordingly, the court will grant Plaintiff summary judgment on the Defendants’ counterclaims for fraud and reformation.
Id.

The court further stated that “[e]xtrinsic evidence cannot be used to vary unambiguous contractual language” and “the court will hold those parties to their bargain.” Id. at *15. Defendants argued that the court’s ruling would cause the non-recourse exceptions to “swallow the rule” of the specific nonrecourse provision regarding payment of the Debt, making it meaningless. But the court rejected this argument, stating that “insolvency would not have resulted if the value of the property had been greater than the balance owing on the loan.” Id. at *10. The court further stated that “the ‘fail to pay’ prong of Section 4.2(j) is broader than the ‘insolvent’ prong.” Id. at *12. Thus, according to the court, “Chesterfield had an obligation to repay the loan in full, not an obligation to make payments on the Loan until doing so became financially undesirable and then await a foreclosure action.” Id. at *13.

The court distinguished the “insolvency” exception to the nonrecourse language from the separate exception for a bankruptcy filing by or against Chesterfield, reasoning that the specific bankruptcy exception involved a different interest of a lender than the insolvency exception, i.e., the bankruptcy exception “protects a lender’s interest in the collateral and the loan by ensuring that a borrower remains a single-purpose, bankruptcy-remote entity.” Id. at *10. The court noted that:

Subsections (iv) through (vii) of Article 11(c) proscribe affirmative acts of a borrower that do not necessarily occur when a borrower becomes insolvent but that uniquely threaten a lender’s ability to recover on the Loan. In light of the interests at stake, Lender was entitled to bargain for extra assurances that full recourse liability will result when the specific events of Article 11(c)(i), (iv), (v), (vi), and (vii) [contained in the note] occur. The fact that Lender ensured those provisions were contained in the Loan Agreement, along with the springing recourse obligation reflected in Article 11(c)(ii) [of the note] and Section 4.2(j) [of the mortgage], does not change the plain meaning of Section 4.2(j).
Id.

The court also rejected Defendants’ argument that Chesterfield did not breach Section 4.2(j) of the mortgage because it used the assets it had available to pay its debts and liabilities. According to the court:

Section 4.2(j) must require Chesterfield to pay its debts and liabilities both “from its assets and “as the same shall become due,” otherwise one of these phrases is written out of the contract.
Id. at *13 (emphasis in text).

Unfortunately for Defendants, the court found that it was their own fault that the language regarding the nonrecourse carveouts (or “springing recourse events,” as characterized by the court) was imprecisely negotiated and drafted. The court stated that:

Before executing the Loan Agreement, Chesterfield was free to negotiate terms favorable to its interests or acquiesce to terms favorable to Morgan Stanley’s interests, but it cannot take the latter course and then void the agreement when that decision produces unfavorable consequences. Plaintiffs [sic] acknowledge that the springing recourse events contained in the Loan Agreement are extremely, even unusually, favorable to Lender: the “fail to pay” prong of Section 4.2(j) is not ubiquitous to CMBS contracts.
Id. at *16.

Thus the court concluded that “Defendants’ buyer’s remorse occasioned by Plaintiff’s efforts to exercise the rights accorded them by the Loan Agreement is not cause for voiding the contract.” Id.

Finally, Defendants devoted the majority of their briefing and oral argument to their belief that, on public-policy grounds, the court’s decision “does violence to the very nature of commercial mortgage-backed security loans (‘CMBS’ loans), and the court’s enforcement of those provisions as written will have disastrous consequences in the real estate market.” Id. at *15. Defendants argued that “[A] commercial mortgage-backed security deal . . . does not provide for personal liability 100 percent of the time Not 90, not 95, not 99 . . . [A]sk anyone in the entire universe.” Id. Apparently not pleased with the strident tone of Defendants’ arguments in this regard, the court rejected these assertions and stated that:

What Defendants seem not to grasp is that the court does not sit to propagate or enforce best business practices; instead, it is the court’s duty to give effect to discrete agreements executed by individual parties. When those agreements provide that the occurrence of a springing recourse event makes a borrower or its guarantor personally liable for a commercial mortgage debt that would have otherwise been nonrecourse, the court will hold those parties to their bargain.
Id.

The court further stated that “Defendants are bound by the terms of the Loan Agreement they actually signed,” Id at *16, noting that Defendants (who were represented by sophisticated counsel) were free to negotiate more favorable terms in the Loan Agreement with respect to the non-recourse language in the loan documents, but failed to do so.

B. The Cherryland Decision

In another recent case, Wells Fargo Bank, N.A. v. Cherryland Mall Ltd. Partnership, 295 Mich. App. 99, 2011 WL 6785393 (Mich. App. Ct., Dec. 27, 2011), based on facts similar (but not identical) to those in the Chesterfield case, supra, the Michigan appellate court held, in connection with a securitized commercial real-estate loan that had been assigned to the plaintiff lender (“Wells Fargo”), that the borrower (“Cherryland”) and the individual guarantor (collectively, “Defendants”) were liable for the entire loan deficiency of $2.1 million because the borrower was insolvent and had thereby violated the note and mortgage covenants regarding the borrower’s failure to maintain its status as a special purpose entity (“SPE”).

The court began its decision with a lengthy and comprehensive analysis of the structure of CMBS loans and the concept of “asset isolation,” as described by the Commercial Mortgage Securities Association and the Mortgage Bankers Association. The court then rejected Defendants’ initial argument that Wells Fargo’s foreclosure of the mortgaged property at a Michigan non-judicial foreclosure sale extinguished the mortgage, holding instead that Michigan law was clear that “actions at law are permissible for deficiencies on foreclosures by advertisement.” Id. at *5. The court then ruled that Wells Fargo was entitled to specific enforcement of the language regarding solvency in the mortgage provision entitled “Single Purpose Entity/Separateness,” under which one of the covenants provided that Cherryland would remain solvent and pay its debts and liabilities from its assets as they became due.

The court acknowledged that “there are no cases that have held that insolvency is a violation of SPE status,” Id. at *11, but quoted at length from a copy of a transcript, provided by Wells Fargo, of a 2001 hearing in Wells Fargo Bank Minnesota, NA v. Leisure Village Assoc, Wayne Circuit Court, Docket No. 00–031860–CZ. According to the Cherryland court, “The Leisure Village documents are slightly different and, arguably, more clearly written, but suggest the same result.” Id. at *12. The Cherryland court noted that the Leisure Village case “dealt with, and rejected, all of the arguments made by defendants in this [Cherryland] case.” Id. at *13. The Cherryland court held that in this case the particular language regarding insolvency required Cherryland to remain solvent in order to maintain its SPE status; thus its failure to do so triggered “full recourse against the borrower and the guarantor pursuant to the loan documents,” Id. at *8, and it was irrelevant which of the listed covenants in the “Single Purpose Entity/Separateness” mortgage provision was actually breached.

The Cherryland court quoted the trial court decision in Leisure Village that such relief “seems extreme” and that the loan possibly could become recourse if the borrower ever failed to pay any debt, but the Leisure Village court noted that the loan agreement executed by the parties provided that the exceptions to nonrecourse were placed in the mortgage “in order to induce Wells Fargo to make the loan and that (similar to the court’s reasoning in the Chesterfield case, supra) “ [t]he borrowers were apparently not able to negotiate for less strict language and this Court declines to write it into the contract.” Id. at *13. The Cherryland court also rejected Defendants’ argument that they should not be personally liable because the borrower’s insolvency was not caused by its own actions, but rather by the downturn in the real-estate market, holding that “any failure to remain solvent, no matter what the cause, is a violation.” Id. at *14. See also LaSalle Bank N.A. v. Mobile Hotel Properties, LLC, 367 F. Supp. 2d 1022, 1029-31 (E.D. La. 2004) (ruling that carveout provision in nonrecourse mortgage providing that debt would become fully recourse to borrower and guarantor if borrower failed to maintain its status as single purpose entity was triggered by borrower’s amendment of its limited liability company Articles of Organization, without lender’s knowledge or consent, to provide that borrower could engage in other activities, thereby making mortgage a full-recourse obligation), court stated that “motive . . . is . . . irrelevant”).

Amicus Curiae briefs were filed arguing on behalf of Defendants in the Cherryland case, alleging that Defendants should prevail as a matter of public policy. But the court rejected the public-policy arguments raised by the amici, finding (similar to the court’s holding in the Chesterfield case supra) that it was the role of the legislature, and not the court, to address matters of public policy.

As was the case in Chesterfield, supra, the court’s ruling in Cherryland was based on the court’s strict construction of the language in the nonrecourse and carveout provisions in the loan documents, which was (as pointed out by the court in each of these cases) negotiated and drafted by experienced and sophisticated parties. As stated by the court in Cherryland, “It is not the job of this Court to save litigants from their bad bargains or their failure to read and understand the terms of a contract.”
Id.

Conclusion

The Chesterfield and Cherryland cases, supra, have certainly gotten the attention of mortgage lenders and commentators. See, e.g., Prof. Dan Schechter, Borrower’s Default and Insolvency Constitute Violations of “Separateness” Covenants, Thus Triggering Recourse Provisions in Note and Guarantee, 2012 COMM. FIN. NEWS. 4 (2012) (discussing Cherryland case and arguing that “bad act” of borrower’s insolvency was attributable solely to circumstances beyond its control and that an allegedly nonrecourse obligation is meaningless if it only exists until default occurs); The guarantor in the Cherryland case has made application for leave to appeal the Michigan appellate court’s decision, and several parties (including the Michigan Attorney General) have made application to file Amicus briefs in support of the borrower/guarantor. (The author understands that the Chesterfield case also is in the process of being appealed.)

Taking to heart the court’s admonition in Cherryland that that it is the role of the legislature, and not the court, to address matters of public policy, the Michigan legislature quickly passed a bipartisan bill, S.B. 992, which was introduced on February 29, 2012. The bill, to be known and cited as the Nonrecourse Mortgage Loan Act (“Act”), was signed into law by Gov. Rick Snyder on March 29, 2012. The Act regulates the enforceability of certain loan covenants in nonrecourse commercial loans in Michigan and is a direct result of the holdings in the Chesterfield and Cherryland cases, effectively making the deficiency judgments rendered in those cases unenforceable and overturning those rulings.

The Act provides that any provision in the loan documents that does not comply with the prohibition against a post-closing solvency covenant from being used, directly or indirectly, as a nonrecourse carveout or as the basis for any claim or action against a borrower, guarantor or other surety would be invalid and unenforceable (Secs. 3(1)and (2)). The Act also contains a definition of “Nonrecourse carveout” (Sec. 2(a)), “Nonrecourse loan” (Sec. 2(b)), “Nonrecourse provisions” (Sec. 2(c)), and “Post closing solvency covenant” (Sec. 2(d))). The Act does not prevent mortgage loans secured by property in Michigan from being fully recourse to the borrower or guarantor if the loan documents do not contain nonrecourse provisions (Sec. 4).

It is likely that as a result of the respective federal and state court decisions in Chesterfield and Cherryland (notwithstanding the passage of the Act), attorneys for lenders and borrowers (especially in connection with CMBS loans and commercial loans on property in states other than Michigan) will in the future negotiate and draft nonrecourse provisions in loan documents (including separateness covenants and isolation of cash flows) much more carefully and precisely to prevent any similar “semantic” issues from occurring. The Chesterfield and Cherryland cases arguably may be limited by their specific facts (notably the strict analysis and interpretation of the language contained in the nonrecourse and carveout provisions, which, as noted by the court in each case, was in its view not ambiguous or subject to reformation), but it serves as a “wake-up call” with respect to negotiating and drafting non-recourse provisions (and carveouts thereto) to reflect exactly the parties’ intentions and expectations. Careful borrowers’ and guarantors’ attorneys have in fact negotiated out the “offending” language in non-recourse carveout provisions (i.e., insolvency covenants, “fail to pay” covenants, and certain SPE covenants) in the past with respect to CMBS (and other commercial) loans. As noted earlier, the court in Chesterfield stated that Defendants were free to negotiate the terms of the non-recourse carveout provision that were more favorable to their interests, but failed to do so. The role of the borrower/guarantor’s attorney is crucial in this connection. For example, if the borrower/guarantor’s attorney discussed this issue with the borrower/guarantor and was unable to negotiate out the offending SPE and insolvency provisions after warning the borrower/guarantor of the possible negative consequences, there may be no cause for a court to order reformation to conform to the alleged intent of the parties.

***Nothing contained in this Article is to be considered as the rendering of legal advice for specific matters, and readers are responsible for obtaining such advice from their own legal counsel. This Article is intended for educational and informational purposes only. The views and opinions expressed in this Article are solely those of the Author, and do not necessarily reflect the views, opinions, or policies of the Author’s employer, First American Title Insurance Company.

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