Two Michigan court decisions issued in December 2011 exposed drafting weaknesses that were exploited by lenders to impose full recourse liability for guarantors of CMBS loans based upon breaches of loan covenants. Every CMBS loan contains a covenant requiring that the borrower maintain itself as a single-purpose entity (SPE) for the term of the loan. Standard & Poor’s definition of an SPE is an entity “that is unlikely to become insolvent as a result of its own activities and that is adequately insulated from the consequences of any related party’s insolvency.” The purpose of the SPE requirement is to reduce the risk that the borrowing entity will either file for bankruptcy (or be owned by a company that files for bankruptcy), and isolate the asset used as collateral from all other endeavors, creditors, and liens. In other words, lenders don’t want the property tied up in a bankruptcy or other litigation in the event it desires to foreclose on the mortgage.
In Wells Fargo v. Cherryland Mall Limited Partnership (Mich. Ct. App. Dec. 27, 2011, 2011 WL 6785393) the borrower obtained a non-recourse CMBS loan in 2002 using real property it owned as collateral. The borrower eventually defaulted on its mortgage payments. The lender foreclosed and bought back the real property at a sheriff’s sale resulting in a deficiency of approximately $2.1M. The day after the sheriff’s sale, the lender amended its complaint to recover the $2.1M deficiency from the borrower and its guarantors.
The lender claimed that the insolvency of the borrower (evidenced by its failure to make its mortgage payments) was a violation of the carve-out provision of the loan guaranty stating that the debt becomes fully recourse as to the guarantor in the event the 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.” However, the loan documents did not define the term “single purpose entity.” The term could only be found in a section heading titled “Single Purpose Entity/Separateness” containing a covenant (among others) that the “Mortgagor is and will remain solvent and Mortgagor will pay its debts and liabilities * * * from its assets as the same shall become due.”
The court in Cherryland determined that the loan documents were unambiguous on their face and would not consider CMBS industry practices to determine what constituted an SPE. Instead, the court concluded that the parties intended for every covenant contained in the section titled “Single Purpose Entity/Separateness” to be a condition of maintaining SPE status. Since the borrower violated a provision in that section of the mortgage (failure to remain solvent), the court held that the borrower violated the carve-out provision of the guaranty and held the guarantor liable for the $2.1M deficiency. Essentially, the court’s decision destroyed the non-recourse nature of the loan based on a covenant that has never been a condition of maintaining SPE status according to standard CMBS industry practice.
A similar result occurred in 51382 Gratiot Avenue Holdings, LLC v. Chesterfield Development Co., LLC (2011 U.S. Dist. LEXIS 142404 (E.D. Mich. 2011). In Chesterfield, the borrower stopped making payments four and half years after obtaining a commercial mortgage loan in the amount of $17 million. The loan was secured by a shopping mall owned by the borrower. The loan contained a recourse carve-out stating that, “* * * Lender shall not enforce the liability and obligation of Borrower to perform and observe the obligations contained in this Note or the Security Instrument by any action or proceeding wherein a money judgment or any deficiency judgment or other judgment establishing any personal liability shall be sought against Borrower * * * shall not, except as otherwise provided in this Article 11, sue for, seek or demand any deficiency judgment against Borrower.” Article 11 of the note enumerated several covenants that would expose the borrower to full recourse liability including the failure of the borrower to “fail to pay its debts and liabilities from its assets as they [became] due.” The court, finding no ambiguity in the loan documents, interpreted and enforced the documents as written despite the fact that the effect was to completely eviscerate the non-recourse nature of the loan.
The consequences of the Cherryland and Chesterfield decisions are potentially far reaching. Cherryland has been appealed to the Michigan Supreme Court. The Michigan Legislature has already enacted legislation providing that “a post-closing solvency covenant shall not be used, directly or indirectly, as a non-recourse carveout or as the basis for any claim or action against a borrower or any guarantor or other surety on a non recourse loan.” (2012 Mich. Act No. 67.) There is an estimated $700 billion of outstanding non-recourse CMBS financing in the United States. The CRE Finance Council estimates that as much as ten to fifteen percent of the outstanding CMBS loans are drafted on loan documents similar to that found in Cherryland and Chesterfield. Borrowers should carefully review their loan documents to make sure they are not subject to the same risks exposed in these cases. You can be sure that lenders will be looking for the same opportunity to impose full-recourse liability against defaulting borrowers.