This guest column was written by Paul Fisher, partner with the Chicago law firm of McGuireWoods LLP
We may be on the verge of seeing the commonly understood expectation of the scope of liability under so-called “bad boy” guaranties in real estate loans being blown apart, with enormous implications to all parties in the real estate business.
There are two recent cases decided in Michigan that have held that one of the events triggering full recourse liability to the guarantor, based on the express terms of the loan documents, is the failure of the borrowing entity to remain solvent and to pay its debts as they become due. The cases are Wells Fargo Bank v. Cherryland Mall and David Schostak, decided by a Michigan state appellate court, and 51382 Gratiot Avenue Holdings v. Chesterfield Development Company and John D’Amico, decided by the Federal District Court, Eastern District.
The provisions in the loan documents in these cases are virtually identical to the triggering language in almost all CMBS loans and real estate loans that are made to “single purpose entities” (SPEs). These loans are likely in the hundreds of billions of dollars and they touch virtually every major developer and lender in the United States, as well as the attorneys representing them and loan originators and others.
One of the essential elements of CMBS loans and loans to SPEs is that the mortgaged asset is isolated from all other endeavors, creditors and liens other than nominal trade debt. Thus the loan documents in these loans will typically require that the borrowing entity be, at all times a “single purpose entity.” This is generally known as the separatedness covenant. Another essential element is that recourse against the guarantor is limited so that only in the case of specific acts and events will there be recourse liability. In a subset of these acts and events, liability for the entire debt (as opposed to just the damage caused by the act or event) will be triggered. As the term “bad boy guaranty” suggests, some type of bad act is commonly thought to be necessary as the trigger. Beware though what is commonly thought!
One of these triggering events in these loans is typically the failure of the borrower to remain an SPE. The standard definition of a single purpose entity used in CMBS loans and approved by the rating agencies is that the borrower must remain solvent and that it must pay its debts as they come due from its own assets. Note that, despite conventional thinking to the contrary, this standard definition does not say that the failure to remain solvent must be caused by some act or omission of the borrower or the guarantor or anyone associated with them. With a dramatic decline in real estate values, a substantial number of real estate borrowers are now insolvent. Likewise, despite conventional thinking to the contrary, the standard definition does not exclude the very mortgage debt that was the subject of the guaranty from the debts to be paid as they become due. As we know, a substantial number of real estate borrowers have not and will not pay their mortgage loans because the value of the property is now less than the mortgage debt. The conventional thinking has been that if a non-recourse loan was not paid but the borrower either voluntarily gave the lender a deed or didn’t resist a foreclosure and the borrower did not do some bad act to thwart the lender’s right to the property and the income from it, such as file a bankruptcy or collusively assist a bankruptcy filing, the guarantor would avoid the trigger and would not be liable. The holding in these cases directly contradicts that conventional thinking.
In the Cherryland case, the borrower stopped making mortgage payment and the lender foreclosed by advertisement or non-judicially. The borrower made no attempt to stop or interfere with the foreclosure sale. The day after the sale, the lender filed suit for a deficiency against the guarantor citing the trigger based on failure to remain an SPE, which in turn required that the borrower remain solvent and pay its debts as they become due. The guarantor claimed that neither the borrower nor guarantor had taken money improperly out of the project or done any other bad act. The Court, however, said it is unambiguous that no bad act is required in determining whether the borrower is solvent and whether it has paid its debts as they become due. The Court said “[W]e recognize that our interpretation seems incongruent with the perceived nature of a nonrecourse debt and are cognizant of the [Commercial Mortgage Security Association’s] arguments and calculations that, if accurate, indicate economic disaster for the business community …” However, unambiguous language in a contract is enforced as it is written and words are taken in their common meaning, not as a party claims they were intended to be interpreted. The guarantor and Commercial Mortgage Security Association also said it would violate public policy to come to a conclusion that would upend the common understanding that the trigger required a bad act. The Court said public policy is made by the Legislature and not the Courts, and there is no evidence that enforcing this contract language as written is against a public policy of the Legislature.
In the Chesterfield case, after the borrower stopped making payments on the loan, the lender filed a foreclosure action that included a separate claim under the guaranty for the deficiency based on the trigger that the borrower must remain solvent and pay its debts as they become due. The guarantor said that surely this very mortgage debt can’t be one of the debts that was meant by this provision because to do so would defeat the purpose of the non-recourse provisions and nature of the loan. The Court however said there is nothing ambiguous about the term “its debts” and nothing to support excluding this mortgage debt from the term. The guarantor further argued that the effect of holding that the trigger had occurred would be that the exception to the non-recourse provisions would swallow the rule. The Court rejected the argument. As an indication of the certainty that the guarantor and its lawyers had that the Court could not possibly interpret the language to mean what it says, they argued that the result was “extremely absurd,” “ridiculous” and “draconian.”
Barring a reversal on appeal, what do these cases mean to you? Since they are the first reported cases interpreting these specific provisions defining an SPE by reference to the borrower remaining solvent and paying its debts as they come due, they are likely to be followed widely. One result is that a huge volume of these loans would be in default and the guarantors who previously expected not to have personal liability would in fact have personal liability for the entire debt. Not only would this be the case with loans that have not yet been foreclosed, but even the guaranties on those loans previously foreclosed or where a deed in lieu had been given could be pursued unless the lender had given a broad release in favor of the guarantor.
In some cases it might be better for a guarantor exposed in this fashion to inject equity into the borrower to avoid the insolvency and allow the borrower to continue to make payments, although that may just be making the death a bit slower. In many cases, parties who signed these guaranties signed them on many transactions, so some guarantors may find themselves insolvent as a result of recourse liability being triggered. All of the guarantors affected would have to restate financial statements, which might possibly trigger other defaults for misrepresenting their financial position. Lawyers will have to counsel their clients (where they are lenders) that they may have guaranty claims whether or not they expected to have them and (where they are borrowers/guarantors) that they might have exposure where they expected not to have exposure and in many cases were advised by their lawyers that they wouldn’t have exposure unless they committed a bad act. There would also potentially be no incentive for a borrower and guarantor to cooperate in a foreclosure or to make a voluntary deed to the lender unless the lender agreed to give a release to the guarantor. Where a guarantor has substantial assets, it might be a better strategy for the lender to refuse to give a release and deal with the contested foreclosure or bankruptcy filing but in response it might also be a reason for the borrower and guarantor to divert funds from the project or otherwise commit bad acts since full recourse would already exist.
If these decisions stand on appeal and are followed generally, the CMBS market, already weak, and a large part of the real estate finance market beyond the CMBS market would be upended. All transactions in the future would require specific negotiation and revised language to avoid the results discussed here and the revised language and structure would (in the case of the CMBS loans) require rating agency blessing that in turn would require that they can get a legal opinion that the new provisions in the SPE definition replacing or modifying the provisions that the borrower remain solvent and pay its debts as they come due would not diminish the benefits in a bankruptcy proceeding of having an SPE borrower.
It would be a good idea for all parties potentially affected by this development to go back and read their documents. While the language discussed is widespread, you can only determine how it affects you by checking your documents.
Paul Fisher is a partner with Chicago law firm McGuireWoods LLP. He can be reached at 312-849-8244 or by e-mail at firstname.lastname@example.org.