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transfers or encumbrances, waste, and the like.6 These historical recourse events led to the “bad boy carveout” moniker that remains today. The “bad boy” label, ...
BAD BOYS, BAD BOYS, WHATCHA GONNA DO: HOW “NON-RECOURSE” IS YOUR LOAN? Gary Fluhrer, Scott Osborne, Jim Wallenstein Under a nonrecourse carveout guaranty, a key principal or member of the borrower becomes personally liable for all or a portion of a nonrecourse loan upon the occurrence of certain “recourse events.” This type of guaranty has been in the legal limelight recently by virtue of two Michigan cases: Wells Fargo Bank, NA v. Cherryland Mall1 and 51382 Gratiot Avenue Holdings, Inc. v. Chesterfield Development Company.2 The decision in each case significantly expands the liability of a guarantor beyond that which borrowers and many lenders previously believed to exist under a nonrecourse carveout guaranty. However, in spite of the notoriety brought about by these cases, nonrecourse carveout guaranties are not a recent innovation.3 Although most closely associated with CMBS securitized lending (which greatly expanded the availability of nonrecourse financing), the use of nonrecourse carveout guaranties has been much broader: for example, specialized non-bank lenders, mezzanine lenders, life insurance companies, Freddie Mac and Fannie Mae for multifamily loans,4 and others utilize the nonrecourse carveout concept in various formulations.5 Prior to the advent of CMBS securitized lending, the events triggering recourse liability of the borrower and in turn the guarantor were generally limited to “bad acts” (referred to herein as “recourse events”) that encompassed a range of affirmative actions by the borrower that either interfered with timely payment of interest and principal on the loan or impaired the collateral: fraud and misrepresentation, misapplication of insurance or condemnation proceeds, diversion of cash flows after a default, non-permitted transfers or encumbrances, waste, and the like.6 These historical recourse events led to the “bad boy carveout” moniker that remains today. The “bad boy” label, however, has become something of a misnomer as lender and CMBS rating agency requirements have expanded the definition of recourse events to include acts and/or events that may be inadvertent, unintentional or not directly within the borrower’s control.7. 812 N.W. 2nd 799 (Mich. Ct. App. 2011). As of this writing, an appeal is pending. 2 835 F. Supp.2d 384 (E.D. Mich., 2011). The authors are advised the case has been settled and therefore no appeal is pending. 3 See, e.g., Vista Development Joint Venture II v. Pacific Mutual Life Insurance Company, infra (subject loan was originated in 1981). See Cassidy, Cowan and Mixon, One Armed Bandits: The Lender's Case For Nonrecourse Carveouts, ACREL (March 2003). 4 The FNMA forms can be found at documents.html and the FMLC forms at 5 See cases in Part B below. 6 See, e.g., Portia Owen Morrison & Mark Senn, Carving Up the “Carved-outs” in Nonrecourse Loans, 9 Prob. & Prop., May-June (1995), and Stein, The Scope of the Borrower’s Liability in a Nonrecourse Loan, 55 Wash. & Lee L. Rev. 1207 (1998). 7 See, e.g., Heller Financial v. Lee, infra & Pineridge Associates, L.P. vs. Ridgepoint, LLC, infra (lien filing by contractor); LaSalle Bank Nat’l Ass’n. v. Belle Meadows Suites, LP, infra (judgment lien obtained by third party); Wells Fargo Bank, N.A. v. Daniel, infra & 111 Debt Acquisition LLC v. Six Ventures, Ltd., infra (unauthorized bankruptcy filing); GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC NNN Holdings, LLC, infra (lease 1

Judicial interpretation has also expanded somewhat the scope of recourse events by limiting guarantor defenses. More significantly, the Cherryland Mall and Gratiot cases have substantially expanded the carveout guarantor’s liability by holding that a decline in the value of the collateral below the outstanding loan balance and a default on the loan due to a reduction in available project cash flow resulting from general economic conditions—and without any other act or neglect by the borrower or guarantor ─ would qualify as a recourse event. These holdings were contrary to the common understanding of nonrecourse debt, resulted in the “carveout” swallowing the nonrecourse concept altogether and, some argue, could have a chilling effect on credit markets.8 The Michigan legislature responded to this concern in 2012 by enacting a statute called the Nonrecourse Mortgage Loan Act (the “Act”), the stated purpose of which was to declare any solvency covenant in a nonrecourse loan to be against public policy and therefore invalid and unenforceable; by its terms, the Act purports to apply to all nonrecourse loans “in existence on or entered into on or after, the effective date of this Act.”9 The Michigan Attorney General has intervened in another Michigan case following the Cherryland Mall and Gratiot cases, 5417 Bay Road Holdings, LLC v. Landmark Plaza Associates Limited Partnership10, to defend the constitutionality of the Act. The Landmark case has yet to be tried as of this writing. The purpose of this article, however, is not to critique further the Cherryland Mall and Gratiot cases, which have been ably analyzed elsewhere.11 Rather, this article briefly discusses the documentation and structure of carveout guarantys, surveys the nonrecourse carveout cases and discusses their trends, and then suggests revisions to the nonrecourse and recourse event language that more adequately expresses the intent of the parties. A.

Documentation/Structure of Carveout Guaranty

The documentation structure of most carveout liability is relatively straightforward: (i) the promissory note sets forth various recourse events that are exceptions to the general nonrecourse provisions and by which the loan becomes recourse to the borrower, and (ii) the carveout guarantor executes a customary unconditional guaranty with the usual waivers and foreboding guaranty language, except that the guarantied obligations are the recourse events to the borrower set forth in the promissory note and incorporated by reference in the carveout

termination by third party). Another example is the liability arising under Environmental Indemnity Agreements executed by carveout guarantors that impose liability for releases of hazardous materials caused by third parties in addition to the borrower and are almost universally recourse events. 8 See Forte, Topsy-Turvey: The World of Real Estate Finance Turned Upside Down, Bloomberg BNA (March 20, 2012). 9 MICH. COMP. LAWS § 445.1595 (2012); see also AG brief. 10 5417 Bay Road Holdings, LLC v. Landmark Plaza Associates Limited Partnership, Eastern District of Michigan, Northern Division, Case No. 1:11-cv-12347-TLL-CED (2011). 11 See Forte article cited in fn. 8 supra; see also Wallenstein, Negotiating Non-Recourse CarveOuts in Light of Recent Court Decisions, University of Texas Law School 2012 William W. Gibson, Jr. Mortgage Lending Institute; Wallenstein, Negotiating Liability Provisions for Promissory Notes and Guaranties, University of Texas Law School 2009 William W. Gibson, Jr. Mortgage Lending Institute.

guaranty. Because the borrower is generally an SPE (and must be an SPE for CMBS loans12) whose only assets are already encumbered by the Lender’s security instrument, the carveout guaranty is necessary for the recourse events to have any teeth. In addition, to accomplish the purpose of encouraging good borrower behavior, most lenders require the guarantor to be a “warm body” in control of the borrower. The recourse events are generally broken into two categories as follows: 1. Recourse events by which loss, cost, damage, or expense suffered by Lender become recourse to the borrower and in turn the guarantor. Utilizing the loan documentation from the Gratiot case as an example, a customary list is: (a) fraud or intentional misrepresentation by Borrower or any of the Exculpated Parties in connection with the Loan; (b)

the gross negligence or willful misconduct of Borrower;


the removal or disposal of any portion of the Property after an

Event of Default; (d) Borrower’s misapplication, misappropriation or conversion of Rents received by Borrower after the occurrence and continuance of an Event of Default; (e) Borrower’s misapplication, misappropriation or conversion of tenant security deposits or Rents collected in advance; (f) the misapplication, misappropriation or conversion of insurance proceeds or condemnation awards; (g) Personal Property (as defined in the Security Instrument) taken from the Property by or on behalf of Borrower or any of the Exculpated Parties and not replaced with Personal Property of the same utility and of the same or greater value; (h)

any act of arson by Borrower or any of the Exculpated Parties;

(i) any fees or commissions paid by Borrower after the occurrence of an Event of Default to any Exculpated Party in violation of the terms of this Note, the Security Instrument or the Other Security Documents; (j) failure to pay charges for labor or materials or other charges that can create liens on any portion of the Property; (k) any security deposits, advance deposits or any other deposits collected with respect to the Property not being delivered to Lender upon a foreclosure of the Property or action in lieu thereof, except to the extent any such security deposits were applied in accordance with the terms and conditions of any of the Leases (as defined in the Security Instrument); 12

Standard & Poor’s Legal Criteria for U.S. Structured Finance Transactions (April 2004).

(l) any failure by Borrower to permit on-site inspections of the Property as required by the Security Instrument and/or the Other Security Documents; (m) any failure of Borrower to appoint a new property manager upon the request of Lender as required by the terms of the Security Instrument and/or the Other Security Documents; and/or (n) Borrower’s breach of, or failure to comply with, the representations, warranties and covenants contained in Section 5.8(b) [tenant status representations], Section 5.19 [no breaches of fiduciary duties among members of borrower] and/or Article 12 [environmental representations] of the Security Instrument. 2. Recourse events by which the entire debt, or deficiency following a foreclosure, becomes fully recourse (so-called “springing recourse” events) to the borrower and guarantor. Utilizing again the documentation from the Gratiot case as an example, a customary list is: (a) Note is not paid when due;

the first full monthly payment of principal and interest under this

(b) Borrower fails, after lapse of all applicable notice and cure periods, to provide financial information to Lender as required by Section 3.12 of the Security Instrument or fails to comply with any provision of Section 4.2 of the Security Instrument [SPE and Separateness Covenants] (other than subsections (i), (r) or (x) thereof); (c)

Borrower defaults under Article 8 [transfer restrictions] of the

Security Instrument; (d) Borrower files a voluntary petition under the U.S. Bankruptcy Code or any other Federal or state bankruptcy or insolvency law; (e) an affiliate, officer, director or representative which controls Borrower, directly or indirectly, files, or joins in the filing of, an involuntary petition against Borrower under the U.S. Bankruptcy Code or any other Federal or state bankruptcy or insolvency law, or solicits or causes to be solicited petitioning creditors for any involuntary petition against Borrower from any person or entity (other than Lender); (f) Borrower files an answer consenting to or otherwise acquiescing in or joining in any involuntary petition filed against it, by any other person or entity under the U.S. Bankruptcy Code or any other Federal or state bankruptcy or insolvency law, or solicits or causes to be solicited petitioning creditors for any involuntary petition from any person or entity; (g) any affiliate, officer, director or representative which controls Borrower consents to or acquiesces in or joins in an application for the appointment of a custodian, receiver, trustee, or examiner for Borrower or any portion of the Property (other than in connection with any such proceeding initiated by lender); or

(h) Borrower makes an assignment for the benefit of creditors, or admits, in writing or in any legal proceeding, its insolvency or inability to pay its debts as they become due. As contrasted with the “loss, cost, damage or expense” recourse events in subsection 1 above, the customary provisions for springing recourse events set forth no contractual requirement that the lender suffer any loss resulting from the springing recourse event commensurate with the deficiency being sought (or for that matter any loss related to the springing recourse event, only that the recourse event has occurred) or, except as expressly stated in the recourse events, that the borrower/guarantor intended to violate any of the covenants included in the recourse events. As will be noted below, the Courts have not implied either of those limitations and generally have enforced the express language of the recourse event covenants. The Borrower will seek to limit the number and scope of these “springing recourse events” and/or move as many as possible into the “loss, cost, damage or expense” category. B.

The Carveout Cases and Trends 1.

Trend of the Cases

Most “bad boy” carveouts do not present any particularly new legal issues. Courts have dealt numerous times with borrower conduct that has created post-foreclosure liability in the context of non-recourse loans and by analogy nonjudicial foreclosures that in many states normally result in no right for deficiency judgments against the borrower (as opposed to guarantors). Although not every occurrence that is typically covered by a carveout clause or recourse event has been litigated, the cases that have been decided provide some guidelines for advising clients as to how Courts view these clauses. The cases establish the following trends: (a) With very few exceptions, the lenders (often a purchaser of the loan) have prevailed in the cases against the carveout guarantors.13 (b) The Courts have uniformly rejected guarantor/borrower arguments that the carveout guaranty (and in particular springing recourse events) are or should be unenforceable as a penalty, an in terrorem clause, an invalid liquidated damage provision, by reason of public policy, by reason of good faith and fair dealing, by reason of materiality, and similar defenses. The Courts frequently note these cases involve sophisticated parties in commercial transactions, and therefore the guaranty should be enforceable as written. Although some doubt as to their enforceability (and springing recourse provisions in particular) may have existed in the past, there is no doubt in these reported cases.


See ING Real Estate Finance (USA) LLC v. Park Avenue Hotel Acquisition LLC, which is discussed as case number 24 below. See also the analysis by one of our panelists as to why the penalty concept might still be relevant in this area. Wallenstein, An Updated Report and Analysis on Springing Recourse Guaranties in Mortgage Loan Transactions, June 2011 issue of eReport published by the American Bar Association’s Real Property, Trust and Estate Law Section.