United States: Springing Recourse For Breach Of Solvency And Debt Payment Covenants? Does New York Need Cherryland Legislation?

Last Updated: January 2 2015
Article by Michael J. Feinman

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.

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
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 you may opt out by clicking here

    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.

    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.

    By clicking Register you state you have read and agree to our Terms and Conditions