United States: How Can I Possibly Be Liable For A Non-Recourse Loan?

Last Updated: November 4 2014
Article by Jo-Ann Marzullo

Just because the lender agreed to a loan being non-recourse does not mean that giving the mortgage lender the keys to the failed real estate project is the end of the story. Individuals or entities who signed an indemnity as to "bad boy" carve-outs (or guaranty of recourse obligations) may find themselves liable for repayment of what was always described as a non-recourse loan. The loan documents may contain a nonrecourse statement, but that statement is almost always subject to exceptions.

Traditionally, only intentional misconduct on the part of the borrower, such as waste (meaning allowing physical deterioration of the mortgaged property), fraud, misapplication or diversion of funds, material misrepresentation or intentional interference with the lender's ability to foreclose on collateral, would terminate the protection of a non-recourse loan enjoyed by the borrower. The theory was that it would be unfair to the lender to protect a borrower if that borrower intended to interfere with repayment of the loan. There was an element of "bad" behavior that converted the otherwise nonrecourse loan and rendered the borrower liable. Many people still believe that the exceptions to a non-recourse loan remain so narrowly defined. Increasingly, lenders have been able to broaden the circumstances under which a guarantor or the borrower will be deemed to have waived non-recourse protections, and many people are now surprised to find that there are so many circumstances where the non-recourse protection is terminated and therefore the loan is basically a full recourse obligation.

One must concentrate on the exceptions to non-recourse liability. The exceptions control whether one can walk away from a failed project without liability, face liability based on harm from certain actions, or face full recourse liability. A careful consideration of the facts and the loan covenants is necessary.

Exceptions to Non-Recourse Liability

Lease termination may trigger liability. A tenant's failure to pay rent and abandonment of the leased property was held not to be a lease termination by the landlord without the lender's consent in a recent California case. See GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC NNN Holdings, LLC, 204 Cal. App. 4th 998 (2012). However, if the landlord had signed a termination agreement based on the idea that he was merely acknowledging the reality of the circumstances, he would have triggered full recourse liability.

Insolvency may trigger liability. For example, insolvency of the borrower may be one of the listed recourse events, so that the mere financial failure of a project could result in liability to those who signed the non-recourse carve-outs indemnity. If the loan documents so provide, then notifying the mortgage lender of the financial trouble of a shopping center by providing a current rent roll as required by the loan covenants may be an admission resulting in recourse liability. Or, the borrower's being put into involuntary bankruptcy by vendors could create recourse liability for the principals unless it is able to have the bankruptcy quickly discharged. It does not matter that logically insolvency should not be an exception to the non-recourse agreement. What matters is what the loan documents state. This was the situation in the 2012 Michigan case 51382 Gratiot Avenue Holdings, LLC v. Chesterfield Co., LLC, 2012 WL 205843 (2012), in which recourse liability for the shortfall from the foreclosure sale was upheld by the court.

Minor errors may trigger liability. An action that the average person would consider a minor error could result in full liability for the full amount of the loan and collection costs if the loan documents so state. For example, if a borrower diverts project funds (that is, uses them for a purpose other than to operate the mortgaged property—even a very small amount), then it is possible that the borrower may incur full liability, not just an obligation to pay over to the mortgage lender the amount diverted.

SPE Covenants

Before entering into a new loan, the individuals or entities taking on this liability need to read the loan covenants and exceptions to non-recourse status carefully. Then the responsibilities that are being undertaken must be negotiated with the prospective mortgage lender. Special purpose entity ("SPE") covenants can go on for pages, but one must resist the temptation to allow one's eyes to glaze over. It is imperative to understand them and be prepared to comply with the covenants as stated in the executed loan documents. If they are not understood, do not enter into that loan. The commonly accepted SPE covenants include:

  • Borrower has been and shall be organized only to own and operate the mortgaged property.
  • Borrower has and shall own and operate only the mortgaged property.
  • Borrower has not and shall not make any loans.
  • No debt shall be secured by the mortgaged property other than the subject mortgage loan.
  • Borrower has maintained and will maintain all of its books, records, financial statements and bank accounts separate from its affiliates and any other persons or entities.
  • Borrower has not and will not commingle the funds and other assets of borrower with those of any affiliate, constituent party or any other person or entity and has held and will hold all of its assets in its own name.
  • Borrower has not and will not assume or guarantee or become obligated for the debts of any other person or entity and does not and will not hold itself out to be responsible for or have its credit available to satisfy the debts or obligations of any other person or entity.

Violations of SPE covenants often trigger recourse liability. That liability has been upheld in Wells Fargo Bank, NA v. Cherryland Mall Ltd. Partnership, 812 NW 2d 799 (Mich. Ct. App. 2011). In response to the Cherryland and Chesterfield cases, Michigan enacted a law prohibiting recourse liability on a non-recourse loan due to mere insolvency.

One should carefully consider and explicitly exclude from recourse liability breach of covenants that the borrower remain solvent, maintain adequate capital, and pay its own liabilities and expenses. The author recently negotiated a securitized loan of a shopping center so that these covenants were exceptions to recourse liability from breach of any SPE covenants. Also, violations of other SPE covenants that are inadvertent, immaterial and non-recurring should not give rise to recourse liability. For example, if any membership interest transfer requires lender approval, then transfer of even a very small membership interest could violate the SPE covenants, and that transfer may be by an individual not controlled by the person having full liability.


Only a breach of a material representation, warranty, covenant or indemnification provision should trigger recourse liability, and even in the case of such an event, the liability should extend only as to the harm done by such breach, without triggering full recourse liability. Be sure to maintain the right to contest mechanic's and materialmen's liens, or else the mere filing of such a lien could trigger recourse liability. Even in Massachusetts (which does not recognize commercial revolving or installment loans except for funds already advanced or must be advanced without conditions), a fully disbursed lender's mortgage is superior to a later filed mechanic's lien. Consequently, it is illogical that a junior lien against the property should trigger recourse liability on a non-recourse loan.

Does the duty to pay real estate taxes and maintain property and liability insurance (and concomitant failure to do so will trigger recourse liability) continue until the lender actually accepts a deed in lieu of foreclosure? The author has negotiated provisions terminating such duty when the borrower tenders a deed in lieu of foreclosure. Otherwise, unless and until the lender accepts the deed in lieu of foreclosure, the guarantors must continue to fund the real estate taxes and insurance premiums or risk triggering full recourse liability. Once the borrower is willing to turn over control and ownership of the property to the lender, such financial obligations should end. There is no "bad act" in handing over the keys.

Distributions and Payments

If all rent for a particular shopping center must be deposited in a separate bank account that only has funds for that shopping center, then depositing any of the rent checks into an account used by more than one shopping center or commingling another shopping center's funds can trigger recourse liability.

Depending on the loan documents, distributions made to pay the real estate taxes or other operating expenses of the shopping center may have to be returned, at a minimum, and could possibly trigger full recourse liability.

To the extent permitted under the loan covenants, distributions may be made by the borrower to equity holders. However, the distribution step cannot be ignored, and individual expenses of the equity holders may not be paid from the shopping center's checkbook. In addition, skipping the distribution step and making a contribution to an affiliated entity is not allowed. Thus, the borrower may not use the borrowed funds to pay the obligations of an affiliated entity. In fact, invoices for affiliated entities should not list the borrower as the account holder— whether the invoice is from the landscaper, snowplow operator, accountant or law firm.

It is crucial to keep records showing that the borrower is separate from any affiliated entities. Review the terms of the loan and comply with those terms. Lending excess cash flow to an affiliated entity in need of a cash infusion may make business sense, but it likely is a violation of the SPE covenants.

If the borrower needs cash, he should charge business expenses to his personal charge card and get reimbursed once the business purpose of the expense has been approved. Never charge personal expenses to a credit card for which the borrowing entity is responsible.


Make no assumptions. Even breakage fees on the interest rate swap upon loan repayment might be considered recourse liabilities. It cannot be emphasized enough: Do not assume that the SPE covenants are solely the traditional "bad boy" covenants described above. Vigorously negotiate breach of which covenants should trigger a duty to pay for certain costs and which should trigger full recourse liability.

This article originally appeared in The Retail Law Strategist, published by The International Council of Shopping Centers, the trade association for the shopping center industry. www.icsc.org.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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