Two cases decided in late 2011 that held guarantors personally liable for loan repayment under "recourse carve-out" (also known as "bad boy") guaranties engendered significant criticism and fear of unanticipated liability among sponsors of commercial real estate projects. Both cases applied Michigan law, and in both cases the carve-out guarantor was held liable based on a "springing recourse" provision despite the fact that the guarantor claimed, with good reason, that it had committed no "bad act" but was rather simply a victim of adverse market conditions. The cases were criticized as imposing liability on guarantors in situations where liability was never intended to be imposed, and gave rise to ex post facto legislative action by the State of Michigan, resulting in one of the cases being remanded and reversed.
An Overview of the Cherryland and Chesterfield Cases
The two Michigan law cases are Wells Fargo Bank NA v. Cherryland Mall Limited Partnership, 295 Mich. App. 99 (Mich. Ct. App. Dec. 27, 2011) ("Cherryland"), decided by the Michigan Court of Appeals, and 51382 Gratiot Ave. Holdings, LLC v. Chesterfield Dev. Co., LLC, 835 F. Supp. 2d 384 (E.D. Mich. 2011) ("Chesterfield"), decided by the U.S. District Court for the Eastern District of Michigan, applying Michigan law. Both cases dealt with commercial mortgage documents that were in wide use at the time and continue to be widely used. Both Cherryland and Chesterfield involved a mortgage lender's claim that the guarantor was liable for a deficiency— that is, the amount by which the unpaid debt balance exceeded the amount received by the lender from a foreclosure sale—because (1) the borrower had breached the "Single Purpose Entity" ("SPE") covenants in the loan documents and (2) the guaranty by its terms imposed liability for full loan repayment ("springing recourse") if a breach of the SPE covenants occurred.
In Cherryland, the court held that the Guarantor was liable for a breach of a Borrower covenant to remain solvent. The specific SPE covenant at issue in Cherryland reads as follows:
"The Borrower shall not...for so long as the mortgage loan shall remain outstanding...fail to remain solvent or pay its own liabilities...only from its own funds."
The Guarantor in Cherryland did not contest the fact that the Borrower was insolvent (insolvency was in fact stipulated to the appeals court); the Borrower's insolvency was largely attributable to the steep decline in the real estate market that accompanied the financial crisis. Instead, the Guarantor argued that insolvency caused by market conditions—as opposed to affirmative "bad acts" of the Borrower or Guarantor—was never intended to be a violation of the SPE covenant or to trigger Guarantor recourse. The court recognized that holding the Guarantor liable for the full amount of the loan in such circumstances seemed inconsistent with the perceived nature of nonrecourse debt but, basing its decision on principles of contract interpretation, found the language of the guaranty to be unambiguous. The court stated that it was not the court's job to save litigants from their bad bargains or their failure to read and understand the terms of their contracts.
The Chesterfield case involved a claimed breach of an SPE covenant with similar wording, but the court's focus was different. In Chesterfield, the covenant stated that [the Borrower shall not] "become insolvent or fail to pay its debts and liabilities from its assets as the same shall become due." In Chesterfield, the lender claimed that there was a solvency covenant breach, and therefore springing recourse liability, by reason of the Borrower's failure to pay debt service under the mortgage loan. The Guarantor objected, saying that such a reading of the SPE covenant was improper and would produce "absurd," "ridiculous," and "draconian" results by imposing full recourse liability for any payment default, thus converting a nonrecourse loan into a recourse loan. The Chesterfield court rejected this argument, determining that such a result was the proper interpretation of the contract language, and holding the Guarantor personally liable for the deficiency.
Legal Criticism of the Cases
The Cherryland and Chesterfield cases were criticized as imposing unintended liability on guarantors based on overlyliteral readings of the guaranties, and gave rise to a large number of articles and to the Michigan legislature's adoption of the Michigan Nonrecourse Mortgage Loan Act, 2012 PA 67, MCL 445.1591 et. seq., effective March 29, 2012 ("NMLA"). The NMLA provides that any provision in a loan document resulting in the determination that a post-closing solvency covenant is a nonrecourse carve-out is against public policy and unenforceable. On appeal, the Michigan Supreme Court, after rejecting a constitutional challenge to the application of the statute in the case at bar, remanded Cherryland to be decided in light of the NMLA. Upon remand, the Michigan Court of Appeals held the guaranty provisions in Cherryland to be invalid and unenforceable. Wells Fargo Bank NA v. Cherryland Mall Limited Partnership, 300 Mich. App. 361 (Mich. Ct. App. April 9, 2013).
The Rich Albany Case
A New York trial court, when recently faced with similar questions, refused to enforce a carve-out guaranty for full recourse obligations, even though the SPE covenants at issue and the springing recourse provision were similar to those reviewed in Cherryland and Chesterfield. The case—U.S. Bank National Association v. Rich Albany Hotel, LLC, 2013 N.Y. Misc. LEXIS 5812 ("Rich Albany")—was decided December 16, 2013, by the New York Supreme Court (which is a trial level court, despite the court's name) in Albany County, by Justice Michael C. Lynch.
The Rich Albany loan documents were structured slightly differently than those in Cherryland and Chesterfield, but covered similar territory. In Rich Albany, (1) one of the SPE covenants, the breach of which gave rise to springing recourse, was a Borrower obligation to "remain solvent" and "maintain adequate capital in light of its contemplated business operations" and (2) another enumerated springing recourse event was if the Borrower "shall generally not be paying its debts as they become due."
With regard to the solvency covenant, the lender argued that (1) a decline in the value of the property to below the debt balance violated the covenant, and (2) the failure to pay debt service constituted failure to maintain adequate capital. The lender also argued, as the lender in Chesterfield had argued, that failure to pay required debt service payments triggered full recourse because the Borrower was generally not paying its debts.
The Rich Albany court rejected both the solvency and loan payment breaches as grounds for imposing recourse liability. It rejected the notion that either simple balance sheet insolvency (loan balance in excess of property value) or failure to make required loan payments was, without more, grounds for imposing recourse liability, stating that such holdings would nullify the loan's nonrecourse structure. Instead, it determined that proper construction of the contract dictated that the court not be overly literal in its interpretation of the debt and solvency covenants in its effort to construe and enforce the document.
Conclusion
The State of New York has not adopted legislation similar to the NMLA, and without the catalyst of New York court decisions that adopt the reasoning of Cherryland and Chesterfield, it is unlikely that the legislature will seriously consider such legislation. While the Rich Albany case provides some comfort to guarantors who fear they will be asked to repay nonrecourse loans in all cases, the case is not an authoritative precedent for other New York courts. Until either higher New York courts rule on the question, or the State of New York takes legislative action, lenders, borrowers, and guarantors should be sure to clarify whether failure to pay the borrower's debts or simple balance sheet insolvency will (or will not) impose full recourse liability upon the guarantors, and whether the violation of a solvency requirement due to circumstances beyond a borrower's control will (or will not) be considered a violation of SPE requirements.
As to existing documents on which the ink is already dry, there is hope that the reasoning applied by the court in Rich Albany will help counter overly expansive efforts to impose liability where no "bad acts" have occurred.
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