Court Ruling and New Legislation Have Implications for Non-Recourse Loans

James J. Rabaut

Source: Grand Rapids Business Journal

Borrowers and lenders may be having some difficulty following the implications of a recent decision by the Michigan Court of Appeals and a subsequent piece of legislation affecting so called "non-recourse" commercial loans.

One court's interpretation of the "recourse provisions" of a non-recourse loan was quickly overturned by legislative action. The case and legislation confirm the need for extra diligence by parties when drafting and reviewing non-recourse loan documents.

First, a little background: a non-recourse commercial real estate loan is generally a loan under which the lender may not, except in specific circumstances, enforce the liability of the obligation by obtaining a money judgment against the borrower. In the event of default, the lender must look to its security interests in the assets of borrower, which are often real estate, pledged for the loan.

These types of loans are particularly helpful in situations in which parties are developing significant real estate projects but do not wish to be personally liable for the amount of the borrowed debt. The borrower under such loan arrangements is often a single purpose entity whose sole asset is the real estate secured by the loan. The individuals behind the project typically do not make personal guarantees to support such loans. As the logic goes, the value of the project is enough to make the loan worthwhile for the lender.

It’s easy to see why borrowers like this type of loan. Non-recourse loans provide them with the benefits and potential profits associated with property development without exposing them personally beyond their equity in the borrowing entity.

Despite the potentially greater risk, lenders have remained willing to offer non-recourse loans. Lenders do so to capture the profits associated with such loans and to maintain key customer relationships. In making such loans, lenders must carefully examine the collateral to confirm that it is sufficient to cover the debt in the event of a borrower default.

But that’s not the end of the story. Non-recourse loans often have carve-outs for so-called “bad-behavior.” For example, if the borrower commits fraud or makes deliberate misrepresentations to the lender – the loan documents may provide that the lender may seek a money judgment against the borrower, as well as a claim against the owners of the borrower under separate guaranties.

Herein lies the rub. Over time, the boilerplate "recourse language" in non-recourse loan documents has gone beyond intentional malfeasance to include matters such as the insolvency of the single purpose borrower – from the borrower's perspective, the very issue from which the non-recourse loan was intended to protect the borrower. Given the difficult times, lenders have started enforcing these provisions, which has led to some unintended – and unpleasant – consequences.

Personal Liability in Non-recourse Commercial Loans

That’s the case in Wells Fargo Bank v Cherryland Mall Limited Partnership, a Michigan Court of Appeals ruling in December 2011. In this case, the limited partnership – which owned Cherryland Mall in Garfield Township – secured an $8.7 million commercial mortgage-backed securities loan in 2002. When Cherryland failed to make a mortgage payment in August 2009, Wells Fargo foreclosed on the property in a sheriff’s sale for $6 million – then sued Cherryland investors individually to recover the remaining $2.1 million owed under the terms of the loan.

The suit alleged that insolvency of the borrower triggered the recourse language of the loan documents. The note, mortgage and guaranty all provided that the loan debt would become fully recourse if the borrower failed to maintain its status as a single purpose entity. The mortgage contained several covenants, including a requirement that the borrower remain solvent. The Court of Appeals ruled that Wells Fargo had the right to collect the deficiency because the insolvency of the borrower violated its duty to maintain its status as a single purpose entity. This decision, while understandable given the language of the loan documents, surprised many borrowers and property developers, who expected that, short of fraud or other malfeasance, the loan would remain non-recourse.

As a result of this case, the Michigan Legislature stepped in, passing Senate Bill 992 in late March. The legislation now specifically prohibits non-recourse loan documents from containing a recourse carve-out for the insolvency of the borrower. Although this legislation addresses the specific borrower concern raised in the Wells Fargo case, it does not address other potential recourse carve-outs. Not only will lenders need to carefully draft such provisions to avoid running afoul of the new law, borrowers must carefully review such provisions to avoid personal liability on otherwise non-recourse loans.