The Michigan Legislature recently passed an act known as the Nonrecourse Mortgage Loan Act. The Act provides that in the case of a nonrecourse commercial loan secured by a mortgage on real property located in the State of Michigan, a post-closing solvency covenant shall not be used, directly or indirectly, as a nonrecourse carve-out or as the basis for a claim or action against a borrower or any guarantor or other surety on such nonrecourse loan. The Act applies to the enforcement and interpretation of all nonrecourse loan documents in existence on, or entered into on or after, the effective of the Act. The Act became effective as of March 29, 2012.
The Act was passed in response to two recent Michigan court cases, Cherryland
, as discussed below. Both courts held that the insolvency of a borrower violated the single or special purpose entity (SPE) covenants of a nonrecourse loan, triggering nonrecourse carve-out provisions and making the loans fully recourse against the borrower and a guarantor. While the Act will likely be subject to legal challenges, including potential challenges on constitutional grounds, for the time being, the Act effectively makes the post-closing solvency provisions contained in the Cherryland
loans, and similar provisions of other nonrecourse loans secured by Michigan real property, invalid and unenforceable.
If you have any questions or would like to discuss the relevant cases or the Act, please contact one of the following members of our CMBS special servicing practice group: Matthew K. Casey at 248.784.5031 or firstname.lastname@example.org
, or David C.C. Eberhard at 248.784.5187 or email@example.com
One of the key elements of CMBS financing is the requirement that commercial property underlying securitized commercial loans be isolated. The purpose of isolating the commercial property is generally twofold, (i) to protect the asset from the potential bankruptcy or insolvency of related parties, and (ii) to adequately isolate the cash flows related to the commercial mortgage in order to accurately model the CMBS bond structure and related agency ratings of CMBS bonds sold to investors. In order to create the requisite isolation, CMBS loan documents require the borrower to hold the commercial property secured by the mortgage in an SPE. In addition, the loan documents will include SPE covenants that are intended to ensure that the borrower maintains the asset in isolation after the loan is originated. One such customary covenant requires the borrower to “remain solvent and pay its debts and obligations when due.”
The quid pro quo for the CMBS borrower’s agreement to separate the mortgaged property in an SPE is the CMBS lender’s agreement to finance the loan on a nonrecourse basis. In the event of a borrower’s default under the loan, the CMBS lender’s only recourse, generally, is against the property, typically by way of foreclosure, and not against the borrower and/or guarantor, except in very limited circumstances. The narrow exceptions to the nonrecourse nature of the CMBS loan are customarily referred to as the nonrecourse or “bad boy” carve-outs, which typically involve, among other things, actions such as fraud, waste or intentional misconduct by borrower or guarantors. Because asset isolation is a key element of CMBS financing, violation by the borrower of the SPE covenants is also customarily a nonrecourse carve-out.
The recent decline in commercial real estate values has created a precarious situation for many CMBS borrowers and guarantors. Many CMBS loans are now underwater, not cash flowing, and ultimately, in default. Lenders have recently argued, and Cherryland and Chesterfield courts agreed, that these CMBS loans, which were considered to be nonrecourse, are now recourse obligations as a result of the borrower’s insolvency and resulting breach of the SPE covenants.
In response to these recent cases, the Michigan Legislature passed the Act to make post-closing solvency covenants invalid and unenforceable in the case of nonrecourse commercial loans secured by mortgages on real property located in the State of Michigan.
RECENT CASE LAW
The Michigan Court of Appeals in Wells Fargo Bank, NA v. Cherryland Mall Ltd. considered whether a borrower’s alleged breach of an SPE covenant resulted in liability for a guarantor of the loan. The loan at issue was a traditional CMBS nonrecourse mortgage loan, secured by a limited guaranty of the borrower’s principal subject to traditional nonrecourse carve-outs. One of the nonrecourse carve-outs was “the borrower’s failure to maintain its status as a single purpose entity.” A section of the mortgage entitled “Single Purpose Entity/Separateness” listed a number of covenants, including the obligation that the borrower “is and will remain solvent. . . . and will pay its debts and liabilities….from its assets as the same shall become due.”
The borrower defaulted on the loan. The trustee foreclosed the mortgage and pursued the guarantor for the deficiency. The trustee argued that the loan became full recourse against the borrower and guarantor because the borrower failed to maintain its status as an SPE. The Court of Appeals agreed, rejecting the borrower’s argument that the solvency covenant related to the borrower’s separateness and not the borrower’s status as an SPE. The borrower’s arguments that a breach of the solvency covenant due to a decline in the property value was never contemplated by the parties when the loan was originated, and that holding a guarantor personally liable for otherwise nonrecourse CMBS loans in these circumstances would lead to economic disaster for the business community, fared no better with the Court:
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.
The United States District Court sitting in the Eastern District of Michigan considered a similar issue in Gratiot Avenue Holdings, LLC v. Chesterfield Development Company. The Chesterfield case also involved a defaulted CMBS loan. The lender foreclosed the mortgage and pursued the guarantor for the deficiency, claiming that the loan had become fully recourse against the borrower and guarantor. The Court found that the language of Chesterfield loan documents, which provided that the loan would become recourse against the borrower and guarantor in the event of borrower’s “insolvency and failure to pay its debts and liabilities from its assets as the same become due,” was clear and unambiguous. As a result, the Court held that the borrower’s default under the loan triggered recourse liability against the borrower and guarantors.
THE NONRECOURSE MORTGAGE LOAN ACT
The Act, known as the Nonrecourse Mortgage Loan Act, provides that a post-closing solvency covenant shall not be used, directly or indirectly, as a nonrecourse carve-out or as the basis for a claim or action against a borrower or any guarantor or other surety on a nonrecourse loan. Any provision of a nonrecourse loan that does not comply with the foregoing is invalid and unenforceable. The Act applies to the enforcement and interpretation of all nonrecourse loan documents in existence on, or entered into on or after, the effective of the Act.
A nonrecourse loan is defined under the Act as a commercial loan secured by a mortgage on real property located in the State of Michigan and evidenced by loan documents that meet any of the following: (i) provide that the lender will not enforce the liability or obligation of the borrower by an action or proceeding in which a money judgment is sought against the borrower, (ii) provide that any judgment in any action or proceeding on the loan is enforceable against the borrower only to the extent of the borrower's interest in the mortgaged property and other collateral security given for the loan, (iii) provide that the lender will not seek a deficiency judgment against the borrower, (iv) provide that there is no recourse against the borrower personally for the loan, or (v) include any combination of the paragraphs above or any other provisions to the effect that the loan is without personal liability to the borrower beyond the borrower's interest in the mortgage property and other collateral security given for the loan.
A post-closing solvency covenant is defined under the Act as any provision of the loan documents for a nonrecourse loan, whether expressed as a covenant, representation, warranty, or default, that relates solely to the solvency of the borrower, including, without limitation, a provision requiring that the borrower maintain adequate capital or have the ability to pay its debts, with respect to any period of time after the date the loan is initially funded. The term does not include a covenant not to file a voluntary bankruptcy or other voluntary insolvency proceeding or not to collude in an involuntary proceeding.
The Legislature provided insight into the rationale for the Act in the Enacting Section 1 of the legislation, which provides:
The Legislature recognizes that it is inherent in a nonrecourse loan that the lender takes the risk of a borrower's insolvency, inability to pay, or lack of adequate capital after the loan is made and that the parties do not intend that the borrower is personally liable for the payment of a nonrecourse loan if the borrower is insolvent, unable to pay, or lacks adequate capital after the loan is made. The Legislature recognizes that the use of a post-closing solvency covenant as a nonrecourse carve-out, or an interpretation of any provision in a loan document that results in a determination that a post-closing solvency covenant is a nonrecourse carve-out, is inconsistent with this act and the nature of a nonrecourse loan; is an unfair and deceptive business practice and against public policy; and should not be enforced. It is the intent of the Legislature that this act applies to any claim made or action taken to enforce a post-closing solvency covenant on or after the effective date of this act; to any claim made to enforce a post-closing solvency covenant that is pending on the effective date of this act, unless a judgment or final order has been entered in that action and all rights to appeal that judgment or final order have been exhausted or have expired.
The Act was specifically passed to address nonrecourse loans similar to the nonrecourse loans that were the subject of the Cherryland and Chesterfield cases. In Cherryland, the post-closing solvency covenant required that the borrower “will remain solvent. . . . and will pay its debts and liabilities . . . from its assets as the same shall become due,” and in Chesterfield, the applicable nonrecourse exception provided that the loan would become fully recourse in the event of the borrower’s “insolvency and failure to pay its debts and liabilities from its assets as the same become due.” As a result of these provisions, the courts held that each of the loans were full recourse against the borrower and guarantors. Now, however, as a result of the Act, post-closing solvency covenants in nonrecourse commercial loans, the same as, or similar to, those contained in the loans in Cherryland and Chesterfield, are no longer valid and enforceable.
The Cherryland and Chesterfield decisions and their implications have drawn the attention of the CMBS industry, commentators, the Bar and now the Legislature. As a result of the Act, post-closing insolvency provisions in nonrecourse commercial loans secured by mortgages on real property located in the State of Michigan are invalid and unenforceable.
The Act will likely be challenged on a number of fronts, including potential constitutional challenges. Warner Norcross & Judd LLP will continue to keep you apprised of further developments.