The country’s largest commercial real estate organizations credit commercial mortgage backed securities (“CMBS”) with leading the United States out of the nationwide real estate depression caused by the savings and loan crisis of the late 1980s and early 1990s. These organizations, the Building Owners and Management Association (“BOMA”), the International Council of Shopping Centers (“ICSC”), the National Association of Industrial and Office Properties (“NAIOP”) and the National Association of Real Estate Investment Trusts (“NAREIT”) witnessed the judicial equivalent of a “lump of coal” for a Christmas present when the Michigan Court of Appeals handed down a decision on December 27, 2011 profoundly affecting the CMBS industry. In a decision of first impression, the court in Wells Fargo Bank, N.A. v. Cherryland Mall Limited Partnership, held that a borrower’s failure to remain solvent triggered full recourse liability to the guarantor without a finding of the customarily understood triggers of so called “bad boy acts,” e.g. bankruptcy, fraud, intentional misrepresentation and misappropriation.
THE CMBS MARKET AND NON-RECOURSE LOANS
Prior to the emergence of the CMBS market, commercial real estate was generally financed on a recourse basis by banks, thrifts, specialty finance companies and other lenders. The most common structure was a first mortgage lien and a recourse note or guaranty. The lender could sue on the note and guaranty or foreclose on the mortgage. If the lender chose to foreclose on the mortgage it would retain the right to pursue the borrower and guarantor for any deficiency arising from the foreclosure sale.
With the advent of the CMBS market a loan would be originated and packaged with other mortgages into a real estate mortgage investment conduit (“REMIC”) trust that would issue securities backed by the cash flow of the trust. Generally speaking the loan would be non-recourse, that is, if the loan did not repay the only recourse would be to the collateral and not to any other person or entity. The structural complement to the non-recourse nature of the loan, and a bedrock component of CMBS financing, is that the collateral would be “ring-fenced” or “isolated” from all other assets, endeavors, creditors and liens of the parent or affiliate of the property owner. This structure was and is referred to as “asset isolation.”
The Cherryland Mall court recognized the twin components of asset isolation: (a) the borrower’s covenants to keep the asset separate, which included the creation of a single purpose entity or special purpose entity (“SPE”) to hold title to the asset; and, (b) narrow limits on the lender’s general agreement not to pursue recourse liability against the borrower or guarantor (“Limited Recourse Provisions”).
LIMITED RECOURSE PROVISIONS: THE RECOURSE TRIGGERS
The Recourse Triggers, known colloquially as “bad boy acts” fall into two categories. The first category limits the lender’s monetary recourse to the actual losses incurred and usually covers fraud, intentional misrepresentation, misappropriation of rents and insurance proceeds and physical waste including arson. The second category of “bad acts” results in full recourse liability without a showing of actual damages up to the total indebtedness under the loan. This second category of Recourse Triggers covers violations of due-on-sale, due on encumbrance covenants, a voluntary or involuntary bankruptcy filing and a violation of the single purpose entity structure also known as the Separateness or SPE Covenants.
There is virtual unanimity that the Separateness/SPE Covenants were originally intended to discourage activities that would undermine the bankruptcy remoteness of the SPE. These covenants have as their seminal purpose that the SPE be strictly limited to the ownership and operation of the particular property that secures the mortgage. Omnipresent provisions include:
- maintenance of books, records, accounts and financial statements separate from another person or entity;
- no commingling of assets with another entity;
- prohibition against guarantying or becoming obligated for the debts of any other entity;
- obligation to maintain adequate capital in light of contemplated business operations; and,
THE CHERRYLAND MALL DECISION
Defendant Cherryland Mall Limited Partnership obtained a CMBS loan which was supported by a guaranty which would be triggered in the event of certain “bad boy acts” including the violation of the SPE covenants. The loan was then made part of a REMIC trust. Wells Fargo was the trustee of the REMIC. The loan went into default and the collateral was sold at a Sheriff’s sale resulting in a deficiency judgment of $2.1million. Wells Fargo then commenced an action against Cherryland Mall and the guarantor for the deficiency. Wells Fargo argued that Cherryland’s insolvency constituted a breach of the Separateness/SPE Covenants thereby triggering full recourse liability. The lower court found in favor of Wells Fargo and the borrower and guarantor appealed.
On appeal, BOMA, ICSC, NAIOP and NAREIT, on behalf of their 85,000+ members worldwide filed an Amicus Curiae (“friend of the court”) Brief. Positing that its members are participants in a substantial amount of CMBS financing with “the same or substantially similar” loan provisions, the Amici advanced two primary arguments in support of the reversal of the lower court decision: (1) that the mortgage was unambiguously non-recourse and insolvency was not a violation of SPE status; and, (2) that the mortgage was ambiguous and the extrinsic evidence showed that solvency was not required to maintain SPE status. The common thread interlaced in these two arguments was that the court should read the loan documents so that the Separateness and SPE covenants were in fact separate and distinct; that while a violation of the SPE covenants would undeniably trigger full recourse liability, such would not be the case in the event of a violation of the Separateness Covenants triggered by the SPE’s insolvency.
The Michigan Appellate Court found for Wells Fargo and against the defendants and Amici holding that the CMBS loan unambiguously required Cherryland to remain solvent in order to maintain its SPE status and having admittedly become insolvent Cherryland violated the SPE requirements resulting in the loan becoming fully recourse to the borrower and guarantor. In acknowledgment of the potential financial repercussions from the decision the Appellate Court stated:
We recognize that our interpretation seems incongruent with the perceived nature of a nonrecourse debt and are cognizant of the amici’s arguments and calculations that, if accurate, indicate economic disaster for the business community in Michigan if this Court upholds the trial court’s interpretation. Nevertheless, the documents at issue appear to be fairly standardized nationwide, and defendants elected to take that risk – as did many other businesses in Michigan and nationwide. 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.
SIGNIFICANCE OF DECISION
Covenants in CMBS loan documents requiring solvency and adequacy of capital should be reviewed to determine whether the breach of those covenants, in and of themselves, trigger full recourse liability. When entering into new CMBS loan transactions, borrowers, guarantors and their counsel must be particularly sensitive that the triggers for full recourse liability are clear and concise and reflect the parties’ intentions. Additionally, borrowers and guarantors should carefully examine their existing CMBS loan documents with respect to specific loans if the underlying collateral is anticipating or experiencing financial distress.
According to BOMA, ICSC, NAIOP and NAREIT there are over $1 trillion in CMBS loans currently outstanding which could be susceptible to recourse claims upon an insolvency default without any other indicia of the so-called “bad boy acts.” Moreover, these organizations estimate that there are over $500 billion in CMBS loans that have been terminated either through payment, foreclosure or deed-in-lieu of foreclosure where the statutes of limitations for suit on “non-recourse” guaranties have not expired. By virtue of the REMIC structure, trustees of the pooled CMBS loans have a fiduciary duty to maximize recovery for investors in the securitization pool. This obligation, read together with the Cherryland Mall decision, may cause the institution of suits throughout the country to pursue guarantors, where in the past there had been little thought of doing so, for a violation of the solvency covenant without a corresponding “bad act” trigger. This very well may signal the dawn of a new era of full recourse liability nullifying the whole concept of a non-recourse CMBS loan.
About the Author
Francis L. Gorman is a former member of Cayuga Hospitality Consultants.