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.

Breaches

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.

Conclusion

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.