That great whooshing sound you heard a few weeks back may have been the air being sucked out of the room for thousands of warm bodies that penned recourse guaranties on (now) underwater loans during the market’s run-up. The cause: two recent cases coming out of Michigan (Wells Fargo Bank, NA v. Cherryland Mall and  51382 Gratiot Avenue Holdings v. Chesterfield Dev. Co.) sticking recourse guarantors with deficiency judgments on heretofore non-recourse loans based on the interplay of two fundamental tenets of CMBS lending – “bad boy” carve-outs and single purpose entity covenants.

Non-recourse lending is a lynchpin of American real estate finance. The lender is limited in the exercise of its remedies upon default to the collateral – for all intents and purposes, the Borrower gets a check at origination and a put at maturity should things go south. But there are limits – carve outs for fraud, selling the property, stealing rents, filing bankruptcy and other naughtiness will give the lender the right to look to the guarantor to make good on the loan.

A corollary concept common to almost all sizable CMBS loans is the single-purpose entity borrower. Because the loans are nonrecourse, the importance of proper underwriting of the underlying collateral is heightened and asset isolation is critical. SPE covenants seek to ensure that the underwritten collateral is the only asset that will have a material economic impact on the success (or failure) of your borrower. This isolation extends to make the SPE “bankruptcy remote” – a commonly, sometimes ruthlessly, misunderstood phrase. A duly formed, validly existing, properly structured, perfectly documented, independent director possessing, rating agency-compliant, Delaware governed SPE with twenty seven eight-by-ten color glossy pictures with circles and arrows and a paragraph on the back of each one is most likely bankruptcy-remote and most certainly not bankruptcy-proof. Rather, the structure seeks to isolate the assets of the SPE from a bankruptcy of a parent entity – the thought being, even if a sponsor is underwater on all of its other investments and goes casters, the lender will be comfortable that its collateral will not become subject to the bankruptcy estate.

One common SPE covenant that takes various incarnations – that the borrower will remain solvent and pay its debts when they come due – found itself at the very center of both of Cherryland and Chesterfield. There was no question that the covenant had been breached. Rather, the issue before the bench was essentially whether the enforcement of the recourse provisions as written contradicted the very non-recourse nature of the loan (“It can’t possibly mean what it says”). The courts were un-persuaded by the guarantors’ arguments and, in each case, found the failure to pay the loan back violated the relevant SPE covenants and triggered carve out liability.

The industry is split on this issue. There are those who tend to think it is unlikely that a lot of loans were intended to be non-recourse so long as they were paid back. And there are those who welcome this new arrow (this really, really long arrow with green eyes and sharp teeth that scares the hell out of everyone) to their quiver when dealing with the realities of negotiating a seemingly inexhaustible supply of DPO’s, DIL’s and DOA’s. Both, to be sure, are taking a fresh read of the loan files.

By Matthew Clark and Matthew Ginsburg