The Ohio Legacy Trust Act went into effect on March 27, 2013. Of particular note to lenders and borrowers, it includes language that would render invalid certain loan provisions that expand the circumstances under which full recourse is triggered under a nonrecourse loan. A direct response to recent decisions by state and federal courts in Michigan, these provisions will curtail lender remedies in new and existing nonrecourse loans, except for lender rights that have already accrued prior to the act's effective date.
A major advantage to borrowers in securitized mortgage loans is the nonrecourse nature of the loans; if a borrower accepts a nonrecourse loan and then defaults, the lender's only recourse is to the collateral for the loan. To balance the risk incurred by the loans' nonrecourse nature, lenders include:
- Requirements that the borrower be a single purpose entity, existing separately from any affiliates, in the form of so-called "single purpose entity" (SPE) and "separateness" covenants.
- Disincentives to a borrower filing for bankruptcy, in the form of carveouts to the nonrecourse provisions.
Among other exceptions, a borrower's violation of the SPE requirements and separateness covenants constitutes two of the carveouts from the nonrecourse provisions.
In Wells Fargo Bank, N.A. v. Cherryland Mall Ltd. Partnership, et al,1 the Michigan Court of Appeals upheld the lender's assertion that the borrower's insolvency constituted a failure to maintain its SPE status, causing the loan to become full recourse. 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," which defined neither "single purpose entity" nor "separateness," and contained 15 separate items, including a requirement that the borrower remain solvent and pay its debts from its assets as they became due. The borrower presented evidence and testimony that the covenant to remain solvent was a separateness provision, rather than an SPE provision. The court ultimately ruled in the lender's favor, citing an interpretive rule that any extrinsic evidence had to be excluded, as the loan documents were unambiguous, thus the case should be decided on the four corners of the loan documents. The court went on to state that "[i]t 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 ...."
The District Court for the Eastern District of Michigan applied a similar analysis in the Chesterfield2 case, upholding a nonrecourse carveout in the loan documents stating 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," despite the borrower's and guarantor's argument that there was a mutual mistake, and that 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.
These pro-lender decisions caused concern in the borrower community and, to date, two states have responded with legislation intended to undermine the holdings in Cherryland and Chesterfield.
The Ohio Legacy Trust Act
Although neither Cherryland nor Chesterfield is binding on Ohio courts and no Ohio court has made a similar ruling, the Ohio legislature has preemptively acted to prevent similar interpretations of nonrecourse loan documents by the passage of the Ohio Legacy Trust Act (Am. Sub. H.B. 479).
Closely mirroring the Michigan Nonrecourse Mortgage Loan Act (described below), the Legacy Trust Act provides that "[a] postclosing 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 definition of "postclosing solvency covenant" does not encompass borrower covenants not to file a voluntary bankruptcy or other voluntary insolvency proceeding, which have typically triggered full recourse provisions. The Legacy Trust Act's provisions apply to all nonrecourse loan documents in existence on, or entered into on or after, the effective date, but do not interfere with the claims of secured or unsecured creditors that accrue prior to the effective date.
Section 5 of the Legacy Trust Act sets forth the legislature's analysis of the appropriate allocation of risk in a nonrecourse loan:
The General Assembly recognizes that it is inherent in a nonrecourse loan that the lender takes the risk of a borrower's insolvency, inability to pay, or lack of adequate capital after the loan is made and that the parties do not intend that the borrower is personally liable for payment of a nonrecourse loan if the borrower is insolvent, unable to pay, or lacks adequate capital after the loan is made ... [T]he use of a postclosing solvency covenant as a nonrecourse carveout, or an interpretation of any provision in a loan document that results in a determination that a postclosing solvency covenant is a nonrecourse carveout, is inconsistent with this act and the nature of a nonrecourse loan, is an unfair and deceptive business practice and against public policy, and should not be enforced.
The Michigan Nonrecourse Mortgage Loan Act
The Ohio Legacy Trust Act's language is nearly identical to that in the Michigan Nonrecourse Mortgage Loan Act, which was enacted on March 29, 2012. The Michigan statute also addresses postclosing solvency covenants as nonrecourse carveouts; however, in order to specifically address the Cherryland and Chesterfield cases, the Nonrecourse Mortgage Loan Act does not include an exclusion for claims that have accrued prior to the effective date.
The validity and applicability of the Nonrecourse Mortgage Loan Act will be tested in the near future as the Michigan Supreme Court remanded the Cherryland case to the Court of Appeals with instructions to "reconsider its decision in light of the Legislature's recent passage of the Nonrecourse Mortgage Loan Act ..., which retroactively prohibits a post closing solvency covenant from being used as a nonrecourse carveout or as a basis for any claim against a borrower, guarantor, or other surety on a nonrecourse loan."3
While the Ohio Legacy Trust Act's language is nearly identical to that of the Michigan Nonrecourse Mortgage Loan Act, the impetus for their enactment is not. Michigan had two cases that specifically upheld postclosing solvency covenants as nonrecourse carveouts. Ohio has not witnessed any similar cases, nor has an Ohio court referenced either the Cherryland or Chesterfield decision in connection with a case involving nonrecourse carveouts.
There has been considerable criticism of the Cherryland and Chesterfield cases from many different stakeholders in the combined mortgage backed securities community. While previously reported cases have strictly construed nonrecourse carveout provisions of loan documents, there is little other case law on the issue of whether a borrower's insolvency alone should trigger full recourse. It remains to be seen whether the Ohio Legacy Trust Act will trigger similar pro-borrower prospective legislation limiting lender rights in other states.