• When Is a Non-Recourse Loan Fully Recourse?: Insolvency as a Full-Recourse Trigger in Non-Recourse Lending
  • February 29, 2012 | Author: John R. Rutledge
  • Law Firm: Miles & Stockbridge P.C. - Baltimore Office
  • A recent decision by the Michigan Court of Appeals could significantly increase the financial risk undertaken by individuals and entities who guarantee the carve-out liabilities often associated with non-recourse loans secured by commercial real estate.  The outcome in Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership, et al., (Mich. App. Dec. 27, 2011) is noteworthy because the court held the guarantor liable for the entire deficiency incurred by the foreclosing lender when it was less than clear that such a result was intended by the parties.

    Under certain conditions, lenders may be willing to limit their recourse following a default to the real property pledged as collateral for their loans.  A loan characterized by such a limitation is commonly referred to as a "non-recourse loan."

    Generally, lenders willing to make non-recourse loans require (a) that the pledged collateral be isolated from certain external influences (e.g., poor economic performance by other commonly-owned projects), and (b) that the responsible parties not engage in conduct that may impair the ability of the lenders to realize upon their collateral in a timely and cost-effective manner.  The foregoing requirements are reflected in extensive and often inter-related provisions contained in the documents executed in connection with non-recourse loans.

    To achieve the desired asset isolation, non-recourse lenders typically mandate that the borrowing entity (a) own no assets other than the property pledged as collateral for the loan and (b) conduct no business other than the ownership and operation of the pledged property.  To enhance the separation of the borrower’s single asset from outside forces, non-recourse lenders generally require compliance with a long list of additional covenants, including (a) prohibitions against additional indebtedness, certain contracts with related entities, advances to third parties, and the commingling of funds, (b) the maintenance of separate books and records, and (c) the continued existence of the borrower as a separate legal entity.  An entity that satisfies the foregoing requirements is generally referred to as a "special purpose entity" (SPE).

    The concept of carve-out liability has been developed to protect non-recourse lenders against conduct by certain parties that may impair the ability of such lenders to realize upon their collateral following a default.  In particular, the carve-out liability provisions in non-recourse loan documents impose liability on designated parties (generally the borrower and one or more guarantors) upon the occurrence of certain enumerated events.  The specified events that may trigger such liability are often referred to as "bad boy acts" and include, among other things, the violation of prohibited transfer provisions, the misuse of rental income following a default, the misapplication of condemnation or insurance proceeds, and the voluntary bankruptcy of the borrower.  The liability imposed upon the borrower and/or the carve-out guarantor upon the occurrence of a triggering event may be limited to the actual loss incurred by the lender as a result of the designated event, or it may extend to the full amount of the indebtedness.  Generally, liability for the entire indebtedness is reserved for the most egregious acts, such as violations of the prohibited transfer provisions and voluntary bankruptcy.

    The carve-out liability language in the Cherryland loan documents provided that the indebtedness “shall be fully recourse to Borrower [and, therefore, the guarantor] in the event that Borrower fails to maintain its status as a single purpose entity as required by...the Mortgage.”  Furthermore, the section of the Cherryland mortgage entitled “Single Purpose Entity/Separateness” included a covenant pursuant to which the borrower agreed to “remain solvent and...pay its debts and liabilities...from its assets as they shall become due.”  The Cherryland court agreed with the lower court’s decision that the borrower’s failure to remain solvent ... a fact that was not disputed by the parties - breached its covenant to maintain its status as an SPE and that such failure triggered the full recourse provision of the loan documents.  At the same time, the Cherryland court acknowledged that its decision “seems incongruent with the perceived nature of a non-recourse debt.”

    In conclusion, a non-recourse loan may impose full recourse liability on the borrower and the carve-out guarantors if the documentation (a) requires the borrower to remain solvent, and (b) includes a violation of the solvency requirement as a triggering event resulting in full recourse for the entire indebtedness.  In today’s business environment, it is not unreasonable to conclude that a single-asset borrower in serious payment default under its mortgage debt is likely to be insolvent.  Such a conclusion is almost inescapable if insolvency is determined by the borrower’s inability to pay its debts as they become due.  Borrowers and lenders must pay particular attention to the interaction between the carve-out liability provisions and the SPE requirements set forth in their loan documents.  Failure to do so may produce unexpected results.  As the Cherryland court stated, “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.”