Non-Recourse Carveouts– Common Misconceptions

Since the advent of CMBS financing, non-recourse mortgages generally include provisions which limit the non-recourse nature of the obligations of borrowers and guarantors, with the consequence that the obligations of borrowers and guarantors may result in significant personal liability in certain circumstances. These exceptions and non-recourse carveouts are commonly and misleadingly understood to mean that personal liability may result from what are referred to as “bad boy acts,” such as acts of fraud and similar matters which are under the control of borrowers (and guarantors as well, since guarantors are generally principals and affiliate of the borrower) and therefore not of great concern.

A careful reading of the loan documents suggests otherwise. There are two types of non-recourse carveouts, those which impose liability for the lender’s loss, examples of these are, misappropriation of rents, insurance proceeds, failure to pay real estate taxes, fraud and waste, and, more worrisome, violation of SPE provisions resulting in full recourse for the entire amount of the loan indebtedness, some of which can be triggered by events beyond the borrower’s control. SPE covenants are designed to assure that borrowers are and remain special purpose entities (SPE’s) in order to eliminate the substantive consolidation of the borrower with other entities in bankruptcy whose credit defaults could affect the collectability of the mortgage.

These so called ”separateness covenants” are often overly broad and ambiguous, and can have unintended results. Examples of such provisions are “failure to maintain adequate capital”, “insolvency”, “failure to pay debts and obligations as they become due”, “breach of separateness covenants” and “transfers of beneficial interests other than permitted transfers.”

Borrowers and guarantors challenging these provisions on the grounds that they violate the inherent nature of non-recourse borrowing and the overall intent of the loan agreement, lead to unintended results and are against public policy confront the trend of recent court decisions which have upheld the lenders right to enforce non-recourse covenants. A recent Michigan case, Wells Fargo Bank, NA v Cherryland Mall LP, upholding full recourse liability under a guarantee provides an extreme example of this trend in a lawsuit brought by the lender for a deficiency judgment against the borrower and guarantor following foreclosure of the property. One of the loan document covenants provided that the loan would become fully recourse to the borrower and guarantor, in the event the borrower did not remain solvent or failed to pay its debts as they became due. The “Catch 22’ nature of these provisions are obvious since failure to pay debt service would inevitably and unavoidably result in liability for the full indebtedness under these covenants. The trial court rejected the defendants’ arguments and ruled in favor of the lender; the decision was affirmed on appeal.

While the Cherryland Mall case may be the most celebrated, several cases in other jurisdictions suggest that courts are not reluctant to enforce these provisions despite the contentions of borrowers and guarantors that they are contrary to public policy, are unconscionable, constitute unenforceable penalties and render the non-recourse nature of these transactions illusory.

Careful review of loan documents, consultation with legal counsel, and aggressive negotiation of non-recourse carveouts are essential to understanding and avoiding the traps for the unwary inherent in these provisions. Although not always feasible, it would be prudent to address these issues at an early stage of the transaction when borrowers have greater leverage, for example, in the loan application stage before issuance of the loan commitment or term sheet.

Real Estate lawyers at Stites & Harbison advise clients and assist with negotiation of non-recourse covenants.