As we have discussed numerous times in this blog (here, here, here and here), the downturn in the commercial real estate market resulted in much litigation as to guarantor liability for non-recourse debt. As a brief refresher, many of the non-recourse loans made during the CMBS boom included an agreement that, in an event of default, the lender would only exercise remedies against the property securing the loan and not against the borrower (or its principals or sponsors), with an exception for certain borrower “bad-acts” (such as misappropriation of rents, fraud, and in certain instances, borrower bankruptcy or insolvency). In the event the borrower perpetuated any of these bad acts, the guarantor agreed to be liable either for the losses incurred by the lender, or for the full amount of the loan, depending on the bad act committed.
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