August 6, 2008

Despite the fact that mortgage foreclosures remain on the rise, there are still many lucrative deals to be made in the world of commercial real estate. Whether you are an investor hoping to find a bargain in the depressed economy or an owner facing a possible foreclosure, it is important to scrutinize the non-recourse provision of your mortgage loan, paying particular attention to the so-called "bad-boy carve-outs."

What Are "Bad-Boy Carve-Outs"?

Most non-recourse loans include exceptions (or "carve-outs") within the loan documents that result in full-recourse liability to the borrower and the guarantor when certain "bad-boy" behaviors exist. Examples of these "bad-boy" behaviors are (i) fraud or intentional misrepresentation by the borrower; (ii) waste occurring to or on the mortgaged property; (iii) gross negligence or criminal acts of the borrower that result in the forfeiture, seizure or loss of any portion of the mortgaged property; (iv) misapplication or misappropriation of rents, insurance proceeds or condemnation awards received by the borrower after the occurrence and during the continuance of an event of default; and (v) any sale, conveyance, mortgage, grant, bargain, encumbrance, pledge, assignment or transfer of the mortgaged property, or any part thereof, without the prior written consent of the lender.

A Recent Massachusetts Case

In the case of Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, decided in 2007 by the District Court in Massachusetts, the borrower's counsel had negotiated a provision in which the borrower's liability under the loan was limited to the mortgaged collateral itself, with the exception of a few "bad-boy carve-outs." However, the violation of one or more of these "carve-outs" would cause the borrower (Blue Hills) and the guarantors to become liable for the entire balance of the loan.

In 2003, four years after the borrower had closed on its loan, the largest tenant of the office park began negotiations with the owner of an adjoining lot for the purchase of a building into which the tenant would relocate upon the expiration of its lease with Blue Hills. As part of those negotiations, the adjoining lot owner successfully petitioned for a special use permit, which granted the right to build a parking garage on the adjoining lot. Blue Hills appealed the decision, claiming that the proposed parking structure would block the views of the mortgaged property and lead to a reduction in the property's value. A few short months later, without notifying or seeking the consent of its lender, Blue Hills entered into a settlement agreement with the adjoining lot owner and obtained a $2 million settlement award. Blue Hills then wired the money into an account held by the guarantors' lawyers and later distributed it between the company's two principals.

When the tenant's lease expired, the tenant vacated the office park and relocated to the building it had purchased on the adjoining lot. Shortly thereafter, Blue Hills began to default on its loan payments. A foreclosure sale soon ensued, which resulted in a $10.77 million loan deficiency. When Blue Hills filed a lawsuit against the lender for wrongful foreclosure, the lender filed a counterclaim against Blue Hills, as well as a third-party claim against the guarantors. The lender sought full-recourse liability against both parties, citing that the $2 million settlement award was transferred without the lender's consent and claiming that the money was actually a portion of the mortgaged property.

A Ruling in Favor of the Lender

As part of its ruling, the District Court rejected Blue Hills' argument that the mortgaged property consisted of only the real estate. Reading the text of the loan documents literally, the court determined that the zoning settlement award constituted "mortgaged property," as that term was defined in the mortgage to include causes of action related to the use, operation, maintenance, occupancy or enjoyment of the real estate, as well as the proceeds of those causes of action. Blue Hills was found to be in breach of the loan documents when it transferred a portion of the mortgaged property without the prior written consent of the lender. As a result, Blue Hills became liable for not only the $2 million that was transferred to an affiliated entity, but also the entire $17 million of debt, which included attorneys' fees and expenses.

In addition to liability on the part of the borrower, the district court deemed the guarantors to be liable under the full-liability "carve-outs" of the guaranty, which contained a provision providing for liability for the full amount of the debt (as defined in the guaranty) should the borrower transfer a portion of, or interest in, the mortgaged property.

Lessons Learned

So what are the critical lessons for an owner or a would-be investor?

  • Commercial borrowers must pay close attention to the wording of "carve-outs" when negotiating non-recourse loans. No matter how broad the "carve-out" provisions and the related definitions may appear, they will be strictly enforced by the courts.

  • As evident in the Blue Hills case, borrowers must understand that the term "mortgaged property" may include much more than just the real estate being pledged as collateral for the loan.

  • Further, borrowers must be cognizant of the fact that an event of default may cause the lender to search for prior "bad-boy" acts in an effort to trigger full-recourse liability against the borrower and the guarantor.

These issues are particularly relevant in the current economy, given the ongoing turmoil in the mortgage industry and the resulting scrutiny being placed on securitized mortgage transactions.

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.