CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

The Cherryland case (discussed here and here) concerns one lender’s enforcement of a non-recourse guaranty pursuant to which the guarantor agreed to be personally liable in the event the borrower failed to maintain its status as a single purpose entity (which included an agreement by the borrower to remain solvent). As you might have guessed by now, the borrower failed to make payments due under the loan and the lender foreclosed, leaving a $2.1 million deficiency. The lender sued the guarantor for the deficiency, arguing that the borrower’s insolvency breached its single purpose entity requirements. A Michigan lower court agreed with the lender, finding the guarantor liable for the full amount of the loan under the guaranty as a result of the borrower’s inability to remain solvent. The Michigan Court of Appeals initially agreed with the lower court, noting that the failure of the borrower to remain solvent, regardless of the reason, was a violation of the single purpose entity requirements of the loan documents.

The guarantor appealed this ruling, and while on appeal, the Michigan legislature passed the Nonrecourse Mortgage Loan Act (the “Act”), a quirky bit of legislation which sought to protect guarantors from their own bad bargains. The Act provides, in relevant part, that a post-closing solvency covenant should not be used, directly or indirectly, as a nonrecourse carveout or as the basis for any claim or action against a borrower or any guarantor or other surety on a nonrecourse loan (with any such provision being deemed invalid and unenforceable).

With the Act then on the books, the Michigan Supreme Court remanded the Cherryland case back to the Michigan Court of Appeals, which overruled its prior ruling and found that, as a matter of public policy, a guarantor could not be liable to a lender as a result of a borrower’s insolvency. While any first year law student can tell you that invalidating a contract entered into by two sophisticated parties with a statute passed years after said contract is entered into raises numerous constitutional concerns, the Michigan Court of Appeals determined that the public purpose of averting “a broader economic problem of immense proportion in the interest of the public good” outweighed any such constitutional concerns. A more cynical blogger might interpret the legislation as protecting the very private interests of local landowners and developers at the expense of banks and investors (not always local) – but we won’t draw those same conclusions.

Where does this leave us? Prior to the Cherryland decision, there had been a string of recent cases in which courts either found or upheld recourse liability on the part of guarantors (discussed here) giving lenders confidence that their guaranty would be similarly upheld in court if the need for litigation ever arose. This decision has brought unwanted uncertainty to non-recourse lending as this case lays out a map to effectively undermine guaranties contracted between sophisticated parties. The Michigan Court of Appeal’s decision to affirm the 2012 legislation, which invalidates a guaranty made years prior to its enactment, may embolden other states to pass similar laws (protecting local guarantors and sponsors from the bad bargains they made in the boom years, and preventing lenders from exercising their contracted rights), which is something we should all pay attention to.

By: Matt Ginsburg and David Pildis
 

The Potter Trophy: “Qualified Residential Mortgages”

Potter Stewart famously refused to define obscenity in Jacobellis v. Ohio.  “But I know it when I see it”.  Perhaps that’s how we’re fated to look at the QRM. It’s eighteen months after the end of the initial comment period, and thousands of comments were made.  And we’ve heard?  Crickets.  But now, we hear we may be close to a pronouncement of the scope of the QRM exemption to the Dodd Frank risk-retention rules.  This is important.  Securitizing a pool of QRMs is the only way to avoid the notorious and economically inefficient 5% retention requirement imposed upon the capital markets in a misguided effort to improve underwriting.  During last month’s ABS East Conference, keynote speaker Lewis Ranieri announced (unexpectedly) that the criteria for QRM’s could be finalized by the end of November.  Huh!  It’s the end of November.  Nothing yet.  And by the way, we have heard officials say in various public forums that they hate QRM and would prefer almost nothing to qualify, so let’s hit pause on declaring good news.  I’m afraid I really will know it (for what it is) when I see it.

The Lunch Pail Award: REO-to-Rental

This award recognizes really hard ways to make money.  Owning bunches of single family rentals for income and eventual appreciation strikes us as particularly hard duty.  Nonetheless, the conversion of distressed or foreclosed single family homes into rental properties on a mass scale is one of 2012’s most discussed real estate investment ideas, with the FHFA’s Real Estate Owned Initiative already offering product in bulk sales and major institutions stepping up to finance the buyers.  Investors are still trying to determine if securitization will develop into a viable exit, and although many Rating Agencies have offered initial indication of how they view the segment, none have published official criteria.  Will REO-to-Rental strategies serve as an important way to stabilize neighborhoods and infuse private capital into the housing market?  Maybe.  Will it be a hard way to make a buck?  For sure.

Rookie of the Year: The Fiscal Cliff

The “Fiscal Cliff” succeeds last year’s “Eurozone Crisis” as the financial catastrophe of the moment.  Bernake’s felicitous description of this looming disaster captures what happens when the State increases payroll taxes, raises income taxes (a lot) on businesses and individuals, introduces new Obama-care taxes, ends Bush-era tax cuts, slashes spending on thousands of government programs while fleecing anyone who may have been missed with increases in the AMT.  Are we going over the cliff?  The stock market says "no" one day and "yes" the next.  Perhaps our elected leaders, with the flittering attention span of, well, elected leaders, can’t get their collective brain around the fact that this has to be fixed now and not on December 31 (or February 28th!) because if they delay, the ride up the precipice may be almost as bad as the ride over it.  Wanna bet we won’t go over in any event?

Plymouth Rock Award: The Electorate of the Commonwealth of Massachusetts

In a rare Election Day triple witching, Massachusetts voters overwhelmingly supported the re-election of President Obama, replaced centrist Senator Scott Brown with the decidedly left-of-center Elizabeth Warren and defeated a referendum permitting physician-assisted suicide, leaving Bay State republicans demoralized, depressed and devoid of options.

James Madison Constitution Award: California Municipalities’ Condemnation of Underwater Mortgages

In an attempt to stimulate local economies and avoid the inevitable blight of mass foreclosure, Golden State municipalities this year considered a controversial eminent domain plan whereby underwater residential mortgage loans held in private-label securitizations would be seized, refinanced or restructured and sold to third-party investors.  As we wrote this summer, the plan promised to garner legal challenge, with even the FHFA expressing “significant concerns about the use of eminent domain to revise existing financial contracts”.  We have a social problem, and it’s serious.  But there are some things that pesky Constitution just won’t let governments do, and that’s not so bad now, is it?

Comeback Player of the Year: Financial Innovation

2012 saw the successful issuance of several highly structured deals, including the first U.S. liquidating trust vehicle successfully securitized in the United States since the 1990s.  As we noted in May, the liquidating vehicle deal – involving a plan to orderly resolve a pool of poorly (or non-) performing loans and REO assets – was successfully closed and sold, while other high-profile transactions merged CMBS and CLO technology to securitize bridge and unstabilized loans while addressing the sponsor’s need for flexibility with the investors’ need for stability.  Financial complexity – the scapegoat for the credit failure of the last half of last decade – may finally cease to be a dirty word.  That would be good.  Hard problems sometimes need complex solutions.  If the Luddites had its right, we’d all be knitting sweaters and mucking barns.

The Midnight in Paris Award: The EU 

The EU continues to flounder gently but inevitably towards economic ruination.  Days, years, months go by without much fundamentally changing.  Debt won’t fix debt.  Countries and regions in deep depression need to control monetary policy and depreciate their currency.  The modern European welfare state is exhausted by the reality that they are running out of other people’s money (Mrs. Thatcher has always been right).  It seems the economic political class closes their eyes regularly and wakes up in a world where none of that is true.  All is well.  Then the markets nudge the politicos to wakefulness, they stare at the crisis, have a moment of panic, hold a summit and back to Midnight in Paris where all is swell and beautiful.  Sweet movie.  Lousy way to run a continent.

The Alex Haig I’m in Charge Award: The Consumer Financial Protection Bureau

The CPFB concluded that their mandate of protecting consumers confers a right and moral imperative to regulate almost anything and everything.  While the financial marketplace worries about capital formation and getting back to business, the CPFB is stomping on the rule making authority of half a dozen other agencies and issuing tracts and rules conflicting with the rule making authority of many other financial sector agencies.  At best, we end up with expensive duplicate regulatory regimes.  At worst, we get conflicting regulatory regimes.  Here again, we see another regulatory agency which conflates what works on the chalkboard with what works in the real world.  For example, the CPFB’s efforts to simplify mortgage disclosure is creating a dog’s breakfast of complicated arcane mechanistic rules and procedures which reduces capital flow to the consumers that the CPFB had set out to protect.  It’s not hard to see that very little changes.

The Willy Sutton Award for Robbing the Banks Because, as Mr. Sutton Famously Said, that’s Where the Money is: Governmental Entities that Filed Suit Against Major Banks

During the years running up to the credit crisis, there was sloppiness, blindness, indifference to risk and, it turns out, in some cases, truly bad behavior in the residential mortgage lending business.  But adding to the tsunami of private suits, from sea to shining sea, governmental entities have decided that the major banks are a piggy bank of money which can be tapped through lawsuits.  Typically, the conceit is that the money will be used to right those wrongs and help individual consumers but, oddly enough, it seems that much of the money is flowing into the general coffers of the states and other governmental entities and gets spent like any other tax dollar.  Stop.  It is wrong, it is disingenuous, and it is hurting the banks at a time when the health of the banking system is critical to the restoration of the markets.

Caligula’s Horse Award: Wells Fargo Bank NA v. Cherryland Mall Limited Partnership

An event completely devoid of the exercise of common sense.  Presumably the good people of Rome some 2,000 years ago were a bit put off when Caligula made his horse a senator (one might be tempted to suggest our recent elections may have partially accomplished that goal in several instances).  Here, I’m talking about the Cherryland case.  It was late last December that the Court of Appeals of Michigan issued a widely-discussed decision in Wells Fargo Bank NA v. Cherryland Mall Limited Partnership – holding a guarantor liable under a non-recourse carve-out for a borrower’s failure to remain solvent.  It’s a non-recourse loan, people.  The lender knew that, the borrower knew that.  Bad drafting allowed a crafty trial lawyer to argue that even though the parties said the loan was non-recourse, it was only non-recourse as long as the borrower could pay.  Like in the novel Catch 22, you can only see the Major when he is not there.  Do we really need decisions like this?  Well, at least it caused the industry to scurry off and tighten the language of guarantees but, come on.

And so another year ends with the full measure of silliness and inanity we expect.  Traditions are wonderful.

By: Rick Jones, Matthew Clark & The CrunchedCredit Team
 

So what does Charlie Brown’s cheery optimism in the face of Lucy’s perfidiousness have to do with lenders and Bankruptcy Court? The U.S. Bankruptcy Court in the Southern District of Indiana has been green lighting a debtor’s use of a bit of boldface legerdemain, over and over again, to keep control and ownership of his properties post-default and post-bankruptcy. If this were to become a common outcome for single asset bankruptcy cases, lenders’ reasonable expectations about bankruptcy would be fundamentally frustrated. So why should a lender keep making non-recourse loans and have the ball pulled away?

It began with In re Greenwood Point, LP, 445 B.R. 885 (2011). There, the court confirmed a plan in which the wife of debtor’s sole direct and indirect owner (the “Owner”) purchased the debtor’s assets for $100,000 under a chapter 11 plan. The debtor (a SARE debtor) owned a retail shopping center in Indiana, which was subject to a mortgage and assignment of leases and rents that served as security for a $7,650,000 loan. The loan went into maturity default, and on the day the Superior Court was scheduled to hold a hearing on the secured party’s motion for a receiver to be appointed, the debtor filed a voluntary petition for relief under Chapter 11. The property was managed by an affiliate, (the “Manager”), and after filing for bankruptcy, the Owner sold his equity in the Manager to his wife in exchange for $50,000. The Owner kept his position as president and CEO of the Manager, and continued to receive an annual salary of $500,000 from the Manager. Over the objections of some of the debtor’s creditors, including the lender, the Court approved the Chapter 11 plan wherein the debtor’s assets were purchased by the Owner’s wife (yup, the same wife who purchased the interests in the Manager), in exchange for a cash infusion of $100,000.

In the next, nearly identical case, In re Castleton Plaza, LP, the same Owner owned all of the equity interests in a different SARE debtor that owned a different retail shopping center in Indiana, on which it had taken out a $9,500,000 loan. In a familiar turn of events, the court confirmed a plan of reorganization in which the equity in the debtor was transferred to the Owner’s wife (same wife) and the Manager (which, if you remember, is now owned by his wife and managed by Mr. Owner as president and CEO) in exchange for a $75,000 cash infusion from the missus. This case is currently on appeal before the Seventh Circuit.

But wait, and I’m not making this up, there is a third case, In re Georgetown Plaza LP, working its way through Bankruptcy Court in Indiana, in which the same Owner owns yet another retail shopping center and has proposed yet another cramdown plan of the same type. And if the courts will keep confirming them, why not! This case is currently before the Bankruptcy Court and no plan of reorganization has yet been approved.

The issue in each of these cases is the same. The courts have had to evaluate whether the plan violated the Bankruptcy Code’s Absolute Priority Rule (11 U.S.C. §1129(b)(2)(B)(ii)). The Absolute Priority Rule requires that the claims of an objecting impaired class of creditors must be paid in full before the equity may retain any interest, unless the equity contributes “new value” to the enterprise. New value must be contributed (1) in money or money’s worth, (2) be reasonably equivalent to the value of the new equity interest in the reorganized debtor and (3) be necessary for implementation of a feasible reorganization plan. (See the LaSalle case for an in depth discussion of the Absolute Priority Rule.) Although the court in Castleton Plaza held that the Owner’s wife and Manager were insiders, and any proposed sale to an insider is subject to a higher degree of scrutiny when evaluating the Absolute Priority Rule, the court stopped short of requiring that such a sale to an insider be market tested to establish that the “new value” was adequate. The court determined that because the Owner’s wife was not just a “straw man” for the Owner (she was using her own money to fund the purchases, which would be added to her own substantial investment portfolio), she was not former equity – only an insider of former equity. Other courts (for example, here and here) have required a market test where sales to insiders are concerned. That is just common sense.

In addition to the outcome of the application of the Absolute Priority Rule, the other issues before the Seventh Circuit on appeal are (1) whether the sale of equity interests to an insider violates the Bankruptcy Code (§363(b)) where there has been no market test, (2) whether treatment of the lender’s secured claim was “fair and equitable” (§1129(b)(1)) and (3) whether the plan was “feasible” (§1129(a)(11)). (Similar issues were raised in Greenwood and are being argued in Georgetown Plaza).

In each instance, the lenders’ primary objection is that the amount of money constituting the “new value” was not market tested, and was far below any reasonably equivalent value of the equity stake in question. And in each case, the debtor’s argument was that there was no market for the asset and any market test was impossible. To make it worse, in the Castleton Plaza case, the lender offered to pay double what the Owner’s wife had paid, but the court still confirmed the debtor’s proposed plan.

This just doesn’t seem to pass the giggle test. You should not be able to avoid the clearly intended outcome of a completely underwater single asset real estate bankruptcy, e.g., turnover of the collateral to the lender, by having some blood relative shill for the old equity where the only testimony on the value of the equity interests comes from the debtor and pretend it’s all an arm’s length bona fide reorganization through the infusion of new equity. I mean, I give our debtor points for chutzpah and creativity, but this is wrong and we hope the Seventh Circuit gets it right. The Bankruptcy Code needs to provide consistent and predictable outcomes for situations where the debtor cannot repay the debt. This isn’t that. Bad decisions like these impair credit formation. Add this to other recent regulatory and judicial mischief which frustrates the reasonable expectations of the parties to a lending relationship and the willingness of lenders to lend will be suppressed.

Maybe this gets fixed. If not, it’s yet another “teachable moment” that the judicial process will often disappoint. Decisions like these serve as a reminder of the difficulty lenders can face in bankruptcy, which at times seems less like a sensible and predictable process for resolving insolvency and more like a get-out-of-jail card for the nimble debtor. I guess this is what is meant by a “fresh start”.

By: Linda Ann Bartosch, Krystyna Blakeslee, and Rick Jones.
 

As I discussed last spring, this year has seen a series of attention-grabbing decisions as lenders sharpen their pencils when looking to enforce guaranties in defaulted deals. Foremost among these cases were two Michigan decisions (Wells Fargo Bank, NA v. Cherryland Mall and 51382 Gratiot Avenue Holdings v. Chesterfield Dev. Co.) that found recourse liability based on the failure of a borrower to comply with SPE capitalization covenants. These were scary decisions for lots of property owners, and resulted, in some states, in hastily passed legislation aimed at keeping nonrecourse loans nonrecourse (see this piece on Michigan's “Nonrecourse Mortgage Loan Act”).

While the Inland case has received less attention, it nonetheless reinforces the central lesson of Cherryland – be very sure of what you are promising when borrowing money. The litany of boilerplate waivers contained in these guaranties often goes un-remarked upon when deals are negotiated – from time to time I recall good borrowers’ counsel commenting on waivers of notice (I’ve caved on this one – I’ve always found it difficult to defend asking someone to waive a defense to payment based on the premise that I’ve failed to notify them of how much to pay). In Inland, the lender had auctioned the property after default, taking title after winning with a credit bid of $7 million (in Georgia, foreclosure is customarily accomplished through non-judicial power of sale). The $7 million auction price was substantially short of the principal balance of debt (something like $63,000,000 short), leaving the lender with a significant deficiency (which was guaranteed by the guarantors).

Deficiency judgments are tricky business, however, in non-judicial jurisdictions, as statutory schemes and judges are wary of hastily auctioned properties that are sold at depressed prices – with the borrower left to pick up the tab. In Georgia, for instance, the deficiency (the difference between the auction price and the OPB) can only be obtained if a court confirms that all notices and other pre-requisites were followed and that the price reflects the “true value of the property." The lender was unable to meet its burden before a Georgia court to show that the true value of the property had been obtained – and therefore, under Georgia law, a deficiency claim was disallowed.

Boilerplate waivers are similarly tricky business, however. Let’s move 800 miles or so north to Illinois, the locus of law that governed the guaranty in question. Here, Judge Shadur held the guarantor liable for the disallowed Georgia deficiency based on two waivers included in the text of the guaranty. Specifically, the guarantors had agreed to pay any post-sale deficiency even if lender had lost its rights to collect from the borrower. Further, the guarantors had specifically waived the statutory provision by which Georgia courts approve foreclosure sales (leading to Judge Shadur's query as to why the lender had bothered to pursue a deficiency claim in Georgia at all).

The experience of the credit crunch has had a significant impact on the role of guaranties in real estate lending. Lenders have toughened their stances with respect to the need for a pocket to reach into in the event of misbehavior. Borrowers have sought relief from guaranties in the event that they lose control of the property to mezzanine lenders. Cherryland led to almost immediate attempts by borrowers to limit recourse in the event that SPE covenants are breached. I would expect the Inland decision to similarly result in an increased level of scrutiny afforded the boilerplate waivers contained in guaranties.

By: Matthew Clark  

Still, the bad boy guaranty (together with amendments to the Bankruptcy Code rendering single-asset bankruptcies less attractive to borrowers) did, in fact, work to reduce the number of bankruptcy filings during this most recent downturn and provided lenders with a measure of dry powder when seated at the negotiating table. A warm-body guarantor is often thought of as the gold-standard of behavior modification – no one wants to explain to their children how their college fund was paid over to a CMBS trust. Of course, a high-net worth entity can be equally as effective – so long as its assets extend beyond the subject real estate. Lenders’ confidence should be bolstered by the recent Empire State decision, which is in line with the majority of legal precedent on this issue:

● Blue Hills Office Park LLC v. J.P. Morgan Chase Bank  - Massachusetts court applies plain language of guaranty to uphold claim arising from misapplication of settlement proceeds;

● CSFB 2001-C-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC – New Jersey court rejects argument that recourse guaranty constituted an unenforceable liquidated damages provision;

● GCCFC 2006-GG7 Westheimer Mall, LLC v. Edward H. Okun - New York court finds guarantor liable for full amount of the loan after voluntary bankruptcy petition; and

● Diamond Point Plaza L.P. v. Wells Fargo Bank, N.A. – Maryland court holds guarantor responsible for full amount of loan after misapplication of rents and failure to maintain SPE status.

Recent vintage loans are, generally, including expanded carve-outs that are supported by stronger credit (indeed, the CREFC model representations and warranties include a specific representation on the presence of a recourse guaranty). Moreover, there has been a significant push by 2.0 issuers and rating agencies to require foreclosing mezzanine lenders to provide a substitute guaranty from credit-worthy entities - in some cases, that meet objective asset and shareholder equity thresholds - as a condition precedent to foreclosure (whether or not the existing guarantor is released).

Alternatively, sophisticated borrowers – themselves weary from the battles of the past half-decade – are now insisting that mortgage loan guaranties burn-off after they’ve been removed from control as a result of mezz foreclosure. Telling the kiddies that the tuition is gone because your mezz lender filed the property into bankruptcy is a different conversation altogether.

By Matthew Clark