Most of us understand the term "non-recourse financing" to mean that in the event of a borrower default the lender's sole remedy lies in foreclosing the lien of its mortgage on the real estate collateral. The fundamental risk allocation that defines a non-recourse loan is that, ultimately, the risk of a market-based reduction in the value of the collateral resides with the lender.
However, two Michigan cases decided last year -- Cherryland and Chesterfield -- impugn this fundamental risk allocation in the context of commercial mortgage backed securitized (CMBS) non-recourse financing, based on the interplay between two elements of a typical CMBS loan structure.
The first element is the group of borrower covenants known as the SPE covenants. "SPE" stands for "single purpose entity", and the SPE covenants are designed to ensure that the CMBS borrower is a stand-alone, bankruptcy remote entity whose assets are not commingled with those of any other person or entity. One covenant typically included among this body of SPE covenants is that the borrower will remain solvent. A typical formulation will read as follows: "[The Borrower shall not] become insolvent or fail to pay its debts and liabilities from its assets as the same shall become due."
The second element is the limited recourse or, colloquially, the "bad boy" guaranty. This is a guaranty of the loan by the borrower's principal(s) that is intended to take effect if the borrower does something bad (the so-called "non-recourse carve-outs"). Thus, if the borrower engages in fraud, waste, rent skimming, etc., the loan's non-recourse provisions are altered such that the borrower and guarantor can be liable for the damages resulting from the "carve-out". However, in the event of a breach of the SPE covenants, the entire loan may become recourse to the borrower or guarantor.
What we have seen over time is that these "non-recourse carve-outs" have continued to increase in scope and number as lenders discovered (or imagined) more and more bad actions that either diminished the value of the collateral (e.g., allowing of environmental contamination) or were impediments to realizing upon the collateral (e.g., the filing of bankruptcy). Though non-recourse carve-outs are not unique to CMBS financing, they are ubiquitous in this type of financing and one tends to see the most exhaustive carve-out lists in CMBS documents.
Lenders include any breach of the SPE covenants in their carve-out lists because of a concern about the borrower filing bankruptcy. If the SPE covenants aren't broken and the borrower remains a stand-alone entity, the borrower theoretically cannot qualify for bankruptcy protection. Thus this carve-out was intended as a strong disincentive to behavior that would impede the lender's realizing on the collateral after default.
Cherryland/Chesterfield addressed a circumstance where the borrower became insolvent due to the decrease in market value of the property. Both cases held that, despite evidence that the lender intended to own this risk, the language of the written loan documents says that this is a violation of the SPE covenants, which is a trigger for liability under the bad-boy guaranty. In other words, under Cherryland/Chesterfield, non-recourse financing became full recourse solely because of the decline in the real estate market, without any bad act by the borrower or guarantor and without any impediment to the lender's realization upon the collateral.
There are several steps a borrower can take to protect itself from the Cherryland/Chesterfield result. First, all borrowers should review their loan documents to see if they contain the solvency covenant. Some borrowers may have negotiated this language out of their loan agreement.
Second, keep in mind that this only applies if there is a lender taking an action because of a default. Many mortgage loans placed in the early 2000's are at or near maturity. Borrowers considering renewing, extending, or refinancing these loans should prepare to insert language in the new documents that neutralizes the effect of these cases.
Finally, in a worst case scenario, if there is a foreclosure action by a lender, a borrower should prepare facts and arguments to address the merits of this potential issue. Cherryland and Chesterfield were decided under Michigan law, which contains some unique rules of contract interpretation that might not control in other jurisdictions. There may be other factual or legal arguments to further protect borrowers or guarantors. If it appears that a default and/or foreclosure is imminent, it is critical to carefully review all notes, rough drafts, etc., from the loan process to determine the extent of a factual basis for contesting an effort to impose recourse on a borrower and guarantor.
Lindquist Gets Real is a periodic publication of Lindquist & Vennum LLP and is intended to provide tips and basic information about real estate law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.