June 13, 2012

In the relatively simple days before the advent of the commercial mortgage backed securities (CMBS) market, commercial real estate was typically financed on a "recourse" basis. If a borrower defaulted, the lender could attempt to recover the unpaid balance of the mortgage debt from the borrower or a guarantor.

With the development of the CMBS market, nonrecourse loans became common. Under a typical CMBS nonrecourse loan, the borrower was required to be a single purpose entity (SPE). Unless certain "bad boy" provisions were violated, the lender could not obtain a monetary judgment against a borrower or guarantor even if the borrower defaulted under its loan. Instead, the lender's sole remedy was to foreclose and take back the property.

To borrowers, the nonrecourse feature of a CMBS loan was one of its main attractions. CMBS lenders packaged billions of dollars of loans into investment pools, and portions of the debt were sold to investors.

An important exception to the nonrecourse feature was triggered when the borrower violated one of the bad boy covenants. The customary bad boy covenants related to misapplication of rents and proceeds from a project, misrepresentations in obtaining the loan, and violation of due on sale provisions. One particular bad boy covenant involved a borrower's agreement to maintain its status as an SPE that owned and operated the mortgaged property as a single asset. This requirement prevented the borrower from commingling an asset with any other entity, thereby reducing the risk that a borrower's ability to repay the loan would be affected by the bankruptcy of an affiliated entity. The SPE structure included a covenant that the borrower would remain solvent during the term of the loan. If the borrower violated a bad boy covenant, the lender could bring an action against any guarantor who signed a nonrecourse guaranty.

Michigan Appellate Court Takes on Nonrecourse Loans

A recent decision by an appellate court in Michigan has refocused attention on the conditions under which a lender may pursue a borrower or guarantor for a loan deficiency when a project fails through no fault of the borrower. In Wells Fargo, N.A. v. Cherryland Mall Limited Partnership, the owner of Cherryland Mall in Traverse City, Michigan, entered into an $8.7 million nonrecourse mortgage loan. A principal of Cherryland executed a guaranty for bad boy acts. The loan documents contained the typical carveout provisions and provided that the loan would be fully recourse to the borrower and guarantor if the SPE covenants were violated.

A default event occurred when Cherryland missed a required monthly mortgage payment. The lender foreclosed on the property, resulting in a deficiency (the difference between the amount remaining due on the loan and the value of the property) of approximately $2.1 million. The lender sued the borrower and guarantor, arguing that the guarantor was liable for the deficiency because the borrower breached an SPE covenant requiring it to remain solvent and pay its debts as they became due. The trial court agreed and entered a judgment for the full amount of the deficiency against the guarantor.

On appeal, the defendants did not dispute that Cherryland was insolvent. They argued, however, that the loan documents did not specifically define the term "single purpose entity." The Court of Appeals rejected this argument, finding that the covenants listed in the mortgage were common SPE covenants.

The defendants next argued that the SPE covenants were not breached because the parties did not intend to make the loan fully recourse to the guarantor unless the borrower became insolvent as a result of its intentional or willful bad acts. They argued that Cherryland's inability to make its required payment resulted from the recent economic recession, not any willful or intentional "bad act." The court also rejected this argument because the loan documents did not specify the manner in which the insolvency must occur. Instead, the documents stated, "any failure to remain solvent, no matter what the cause, is a violation."

Finally, the defendants argued that allowing the carveout language to become fully recourse to the guarantor was against public policy and could lead to "economic disaster for the business community." The court acknowledged that its interpretation of the loan documents "seems incongruent with the perceived nature of a nonrecourse debt" but rejected this argument as well, holding that it would not save the borrower from a bad bargain and that it was up to the legislature to address matters of public policy.

Michigan Legislature Reacts to Cherryland

Following the decision in Cherryland, the Michigan legislature quickly passed the Nonrecourse Mortgage Loan Act, which became effective on March 29, 2012. The Act provides that for any nonrecourse commercial loan secured by a mortgage on property located in Michigan, a post-closing solvency covenant may not be used as the basis for a claim against a borrower or guarantor. The Act—which effectively overturns the decision in Cherryland—is itself expected to be challenged in court.

While neither the decision in Cherryland nor the legislation passed by the Michigan legislature are binding outside of Michigan, anyone involved with a CMBS loan should be aware of the potential implications of these developments. Lenders and borrowers alike should negotiate the SPE provisions of a loan carefully so all parties are aware of the circumstances under which a nonrecourse loan may become fully recourse to a borrower and guarantor.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.