The Michigan Court of Appeals recently decided a case that has garnered the attention of lenders, real estate owners, and developers nationwide. In Wells Fargo Bank, N.A. v. Cherryland Mall LP, et al., the Michigan Court of Appeals affirmed a trial court’s holding that a single-purpose entity (“SPE”) borrower and its guarantor were subject to full recourse liability for the entire postforeclosure deficiency (i.e., the excess of the debt above the foreclosure sale price for the subject property) on the basis that the borrower violated its SPE status, thereby triggering recourse liability under the guarantee. The decision in Cherryland, if broadly adopted, would have a significant negative effect on guarantors in nonrecourse loan transactions, would likely have a material effect on future loan transactions, and would almost certainly result in intensified scrutiny and negotiation among lenders, borrowers, and guarantors of what had, for many years, been treated as somewhat standard “boilerplate” provisions.
With the growth of the commercial mortgage-backed securities (“CMBS”) loan market, the non-recourse loan has become the prevalent construct in commercial real estate finance. Generally, in a non-recourse real estate loan, the lender looks solely to the real estate collateral for the recovery of amounts due under the loan, with no recourse to the borrower or guarantors other than for certain fairly standardized non-recourse “carveouts.” These so-called “bad boy” acts fall into two distinct categories. The first category, which typically includes the occurrence of particular acts such as, among other things, fraud, waste, intentional misrepresentation, and misappropriation of rents or insurance proceeds, which trigger recourse liability against the guarantor to the extent of the actual loss suffered by the lender. In the second category, the occurrence of particular acts, which typically include transfers of the property without lender consent, any voluntary or collusive bankruptcy or insolvency filing by or on behalf of borrower and a breach of the SPE/ separateness covenants described below, which trigger recourse liability against the guarantor for the full amount of the loan. This common structure (particularly in the CMBS loan market) provided borrowers and guarantors with comfort that so long as they did not violate the non-recourse carve-outs in the loan documents, if the real property pledged to the lender as collateral did not perform as expected and borrower was unable to make debt service and other required payments under the loan, both borrower and guarantor would be protected from personal recourse liability under the loan.
Another common feature of the customary non-recourse loan is the requirement that borrower be structured as an SPE with a number of “separateness” covenants that require borrower to remain separate and distinct from its parent and its affiliates. The inclusion of these “separateness” covenants mitigated the likelihood of a substantive consolidation of borrower with other entities in a bankruptcy, thereby reducing the lender’s risk of borrower’s ultimate bankruptcy.
The facts of the Cherryland case are hardly unique and are all too common in the current real estate finance landscape. In October 2002, Cherryland Mall Limited Partnership (“Borrower”) obtained an $8.7 million non-recourse mortgage loan (the “Loan”) from Archon Financial LP (“Archon”). As a condition precedent to making the Loan, Archon required Borrower and a principal of Borrower (“Guarantor”) to execute a standard “bad boy” guarantee (the “Guarantee”) guaranteeing the nonrecourse exceptions set forth in the Loan documentation. The mortgage securing the Loan included standard SPE/separateness provisions whereby Borrower made covenants to remain solvent and to pay its debts and liabilities when the same become due. In addition, the non-recourse carveouts in both the mortgage and the promissory note evidencing the Loan included a provision that the Loan shall become fully recourse to Borrower in the event that: “[borrower] fails to maintain its status as a single-purpose entity as required by and in accordance with the terms and provisions of the mortgage.” Archon subsequently transferred the loan to Wells Fargo Bank, N.A. (together, with its successors, “Wells”), who then securitized the Loan in a CMBS transaction.
Borrower defaulted on the Loan in 2009 by failing to make its required mortgage loan payments and Wells commenced a foreclosure proceeding. At the foreclosure sale for the property, Wells submitted a credit bid of $6 million and was the successful bidder, leaving a deficiency of approximately $2.1 million. Wells then sued both Borrower and Guarantor to enforce the Loan documents and recover the entire deficiency, arguing, in part, that it was entitled to recover damages in the amount of the Loan deficiency from Borrower and Guarantor on the basis that the mortgage contained a covenant that Borrower would remain solvent and Borrower’s insolvency therefore constituted a failure to maintain its SPE status, a breach of the non-recourse covenants of the Guarantee.
Borrower and Guarantor argued that (i) the Loan was unambiguously non-recourse and that the insolvency of Borrower was not a violation of Borrower’s SPE status and (ii) the Loan documents were ambiguous and failed to clearly define the term “singlepurpose entity” and that the SPE/ separateness sections in the mortgage were not clearly defined as SPE covenants. In addition, amicus briefs filed on behalf of Borrower and Guarantor by the Commercial Real Estate Finance Council (formerly the Commercial Mortgage Securities Association) and the Mortgage Bankers Association argued that the covenants in the Loan documents were “separateness” covenants and not SPE covenants.
The Court of Appeals ultimately rejected such arguments, concluding that although the Loan documents did not specifically define “single-purpose entity,” the list of covenants in the SPE/ separateness sections of the mortgage was customary and commonly found in CMBS loan documents and were customarily considered SPE covenants. The Court of Appeals held that it was more logical to conclude that SPE status and separateness are distinct concepts but also intertwined “such that maintaining SPE status requires abiding by the separateness covenants.” Wells Fargo Bank, N.A. v. Cherryland Mall LP, et al., No. 304682 (Mich. Ct. App. Dec. 27, 2011 at 11.
Furthermore, Borrower and Guarantor argued that, even if the solvency requirement was in fact an SPE covenant, such covenant was not breached because the parties did not intend to make the Loan full recourse to Guarantor unless Borrower’s insolvency was the result of its intentional and/or willful bad acts. Borrower and Guarantor argued that Borrower’s eventual insolvency was not the result of its own action, but instead was the result of difficult market conditions. Again, the Court of Appeals rejected this “intent” argument, holding that the Loan documents did not require the insolvency to occur in any particular manner and, in fact, clearly stated that “any failure to remain solvent, no matter what the cause, is a violation.” Id. at 3. The Court of Appeals was unwilling to explore the “intent” of the parties because it determined that the language in the Loan documents was not ambiguous and would not require any extrinsic evidence (e.g., evidence other than the express terms of the Loan documents themselves).
In rejecting the defendants’ argument that a holding that interpreted the carve-out language to the Guarantee to provide for full recourse to Guarantor if Borrower became insolvent for any reason was against public policy and would lead to “economic disaster for the business community,” the Court of Appeals did not ignore and “recognized that [its] interpretation seems incongruent with the perceived nature of a non-recourse debt,” stating that “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. at 16.
In response to the Cherryland decision and another recent Michigan case (51382 Gratiot Avenue Holdings Inc. v. Chesterfield Dev. Co., No. 2:11- cv-12047 (E.D. Mich. 2011)) with a similar outcome, the Michigan legislature quickly enacted (and on March 29, 2012, the Act was signed by the governor) a new statute, titled the “Nonrecourse Mortgage Loan Act,” which invalidates the Cherryland and Chesterfield rulings rendering unenforceable deficiency judgments obtained against a borrower or guarantor that are based upon a borrower’s breach of a post-closing covenant to remain solvent and/ or adequately capitalized and also purports to provide guidance to Michigan courts construing solvency covenants in existing loans.
It is difficult to anticipate the scope of the impact of the Cherryland ruling. However, should courts around the country adopt its holding, the effects could be profound and, by many accounts, disastrous on the real estate market because guarantors who previously anticipated having no personal liability could now be personally liable for the entire debt (both on loans that have not yet been foreclosed and those which have been foreclosed or a deed-in-lieu delivered to lender where a broad release was not given to the guarantor). While it is unlikely that the decision of the Court of Appeals in Cherryland will be the final word with respect to the tenuous relationship between SPE covenants to remain solvent and the non-recourse carve-outs under traditional nonrecourse loans, the real estate markets anxiously await further interpretations and decisions of courts in other jurisdictions around the country. In the interim, as the markets absorb the impact of the Cherryland ruling, it is critical the borrowers, lenders and guarantors carefully examine the specific language of the loan documents with their legal counsel to ensure that the documents accurately capture the intent of the parties at closing.