Prior to the inception of securitized lending, real estate mortgage loans often were made on a recourse basis, meaning that upon a default, the lender could enforce both its foreclosure remedy and its right to sue for any balance due on the note. One of the selling points for securitized mortgage loans has been the nonrecourse nature of the loans; if a borrower accepts a nonrecourse loan and then defaults, the lender has recourse only against the collateral for the loan. To balance this approach, the lender needs to be confident that the collateral will be available, without competing creditors clamoring for a piece of the borrower’s assets and without the delaying tactic of a bankruptcy filing by the borrower. The structure of securitized mortgage loans thus includes requirements for a single-purpose entity (SPE) that exists separately from affiliates, in the form of so-called SPE and separateness covenants; and disincentives to a bankruptcy filing, in the form of “carveouts” to the nonrecourse provisions. The carveouts consist of “bad boy acts” that would override the nonrecourse provisions, resulting in full or partial liability of the borrower and any guarantor. The typical bad boy acts include fraud, misappropriation, the borrower’s violation of the SPE covenants or the borrower’s violation of the separateness covenants.
Recent decisions by Michigan state and federal courts regarding triggers for full recourse provisions surprised all participants in the securitized loan markets, and the state has passed legislation that attempts to override these decisions. The Michigan courts’ analysis of the loan structure and the effect of the document language will affect workout strategy and tactics and future loan documents.
In 2005, Chesterfield Development Co. obtained a $17 million nonrecourse loan secured by a shopping center in Chesterfield Township, Michigan. The borrower defaulted in its loan payments and, after foreclosing on the shopping center, the lender initiated an action for a deficiency judgment against the borrower and guarantor.1 The lender asserted that the borrower, by failing to make debt service payments, violated an exception to the nonrecourse provision of the loan documents. The lender relied on a requirement that the borrower shall not “become insolvent or fail to pay its debts and liabilities from its assets as the same shall become due and payable.” The borrower and guarantor argued that there was a mutual mistake and the parties did not intend that the borrower and guarantor would incur full recourse liabilities solely because of the borrower’s failure to make loan payments. The court ruled in favor of the lender, stating that the borrower and guarantor could not use extrinsic evidence “to vary unambiguous contract language,” and that the borrower and guarantor were personally liable under the terms of the loan documents.
The owner of Cherryland Mall in Traverse City, Michigan entered into a nonrecourse loan in 2002. The borrower and guarantor, a principal of the borrower, retained liability for bad boy carveouts. When the borrower was unable to service its debt payments, the plaintiff, the trustee of a large pool of securitized loans including the Cherryland loan, foreclosed on the property. Subsequently, the lender separately sued the borrower and guarantor to recover a $2.1 million deficiency on the loan. The trustee’s primary argument in the suit seeking the deficiency relied on a carveout to the nonrecourse provision, namely, that the borrower’s insolvency constituted a failure to maintain its status as an SPE. The parties never disputed that the borrower was always an SPE, owning and operating a single asset, but the lender relied on language in the guaranty providing that the guarantor would be liable for the loan if the borrower failed to “maintain its status as a single purpose entity as required by … the Mortgage.” The mortgage included a section titled “Single Purpose Entity/Separateness” that did not define either “single purpose entity” or “separateness,” but did require that the borrower remain solvent and pay its debts from its assets as they become due.
The court found that the borrower became insolvent, as the mortgage debt exceeded the value of its assets, and that the borrower failed to pay its debts by defaulting on the loan. The borrower presented evidence and testimony that the covenant to remain solvent was a separateness provision, rather than an SPE provision. The lender argued, and the trial court agreed, that any extrinsic evidence must be excluded, as the loan documents are unambiguous and the case should be decided on the four corners of the loan documents. The court ruled that the borrower and guarantor were liable for the deficiency.2
Michigan lawmakers acted quickly in response to these two decisions. On March 29, 2012, Michigan Governor Rick Snyder signed into law Senate Bill 992, which had been introduced just a month earlier. The “nonrecourse mortgage loan act” provides that “[a] post-closing solvency covenant shall not be used, directly or indirectly, as a nonrecourse carveout or as the basis for any claim or action against a borrower or any guarantor or other surety on a nonrecourse loan.” The act, effective immediately, applies to any claims or actions made after its effective date and to any claim or action that currently is pending, “unless a judgment or final order has been entered in that action and all rights to appeal that judgment or final order have been exhausted or have expired.”3 The lender in the Cherryland case has challenged the constitutionality of the new legislation.
There has been considerable criticism from the perspectives of many points of view in the CMBS world of the decisions in the Cherryland and Chesterfield cases. Nevertheless, while previously reported cases have strictly construed nonrecourse carveout provisions of loan documents, there is little other case law on the particular issues raised by these cases as to whether a borrower’s insolvency alone should trigger full recourse. Anecdotally, special servicers are considering the circumstances under which a deficiency judgment may be pursued under comparable loan documents in the states in which they service loans, based on the theories put forth by the Cherryland and Chesterfield decisions.
While it’s not clear how or to what extent the developments in Michigan will affect nonrecourse loans in other cases or under the laws of other states, it is clear that borrowers, guarantors and lenders are well advised to review their loan documents carefully and to bear these cases in mind as workout scenarios develop for existing loans and as new loans are negotiated.