The Non-Recourse CMBS Loan: Apparently Not All It's Carved Out To Be

In the world of securitized commercial mortgages, non-recourse carveout guaranties have long been a matter of standard practice. For CMBS lenders, they offer a critical backstop against fiscal mischief by borrowers, and for responsible borrowers they provide access to real estate financing without fear of personal ruin. Nevertheless, two recent court decisions have thrown the non-recourse concept into turmoil and may spell big trouble for the entire commercial real estate lending industry.

In 51382 Gratiot Avenue Holdings, Inc. v. Chesterfield Development Company (Chesterfield), a single purpose entity borrower defaulted on a $17 million mortgage loan; the lender foreclosed on the mortgaged property but then sued the borrower’s guarantor for the $12 million deficiency based on a provision in the loan documents rendering the non-recourse clause void in the event that the borrower should “become insolvent or fail to pay its debts and liabilities from its assets as the same shall become due.” The defendant borrower (correctly) contended that by characterizing the mere inability to pay down its mortgage debt as a recourse-invoking default, the entire loan would be post facto transformed into a full recourse obligation. Nevertheless, the court held in favor of the lender.

In Wells Fargo Bank, N.A. v. Cherryland Mall (Cherryland), the action hinged on a loan document provision making the loan fully recourse in the event that the borrower “fails to maintain its status as a single purpose entity as required by, and in accordance with the terms and provisions of the Mortgage.” Here, the mortgage contained a section with the heading “Single Purpose Entity/Separateness,” which section in turn contained a covenant that the borrower “is and will remain solvent and [borrower] will pay its debts and liabilities . . . from its assets as the same shall become due.” Although the borrower argued that the solvency covenant fell under “Separateness” and not “Single Purpose Entity,” the court disregarded the distinction, and full recourse liability was imposed against the guarantor.

If other courts follow Chesterfield and Cherryland, the potentially catastrophic implications for borrowers and their sponsors are obvious, but these decisions portend grave consequences for CMBS lenders and investors as well. More to the point, it can be assumed that a large number of borrower sponsors have delivered guaranties on multiple loans. If a lender were to enforce even one such guaranty, the sponsor’s assets could be all but wiped out, creating a disastrous ripple effect for borrowers and lenders alike throughout the CMBS space.

There is some consolation here, given that both of these cases are being appealed and are constrained to Michigan, where, in fact, the state legislature has quickly passed a bill that would effectively overturn the decisions. What’s more, loan originators and their counsel can and well should regard Chesterfield/Cherryland as a cautionary tale, taking heed to pay special attention when drafting non-recourse carveout language in new loan documents. Still, what seems to be quite evident is that if these cases prove influential, the already-troubled CMBS market should brace itself for more dark days ahead.
 

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