Coronavirus Fallout for Guarantors: Recourse Events Back in Focus

A feature of many structured commercial mortgage financings is the limited recourse nature of the debt. 

Most permanent commercial mortgage-backed security (CMBS) financing programs require that the borrower is a bankruptcy-remote entity, the concept being that, in the event of a default, the servicer or trustee can recover the collateral with minimal time and cost.  The borrower cannot file bankruptcy without triggering recourse to a guarantor, so the borrower’s sponsor is highly motivated to deed the property to the lender if the project fails.

The guaranty executed by the borrower’s sponsor typically contains several limited and full recourse carve-outs to the non-recourse status of the loan.  Bankruptcy is a full recourse carve-out and triggers personal liability for the entire amount of the debt.  The limited recourse carve-outs, on the other hand, make the guarantor personally liable only for the lender’s losses and may include events such as waste to the property; failure to apply rents to debt service, insurance premiums and real estate taxes; failure to provide timely financial reporting; and failure to adhere to certain other loan covenants (as specifically negotiated in each loan or loan program). The limited recourse carve-outs can be problematic in a recessionary economy as borrowers encounter cash flow, liquidity and other problems, particularly with defaulting tenants. 

During the last recession, most bankruptcy-remote borrowers were established with covenants that they must maintain separateness from any other entity, not commingle funds, and maintain adequate capital for operations.  This last covenant, the so-called “solvency covenant,” was typically a full recourse carve-out and was designed to keep the borrower separate and prevent substantive consolidation of the borrower in a bankruptcy of the sponsor.  However, in two notable cases out of Michigan (Cherryland^[1] and Gratiot Avenue^[2]), lenders successfully argued that the guaranty was triggered when the borrower defaulted and was insolvent.  Therefore, the guarantors became liable for the entire amount of the debt as a result of the borrower’s failure to maintain adequate capital to support its operations. 

The Cherryland and Gratiot Avenue cases created much consternation amongst borrowers and guarantors. A typical default happens because the borrower lacks revenue to service the debt. If failure to make debt payments is itself a full recourse event for a guarantor, a violation of the solvency covenant ends up swallowing the nonrecourse nature of the loan entirely.  A solvency covenant essentially required the guarantors to continue to fund the shortfall and prevent a financial default, making the loan fully recourse to the guarantor until repaid in full. 

To address these decisions, legislatures in Michigan and Ohio adopted laws to override the solvency covenant as applied to a nonrecourse carve-out guarantor.  Ohio’s law is codified at Revised Code Sections 1319.07 to 1319.09.  These statutes provide that “a post-closing solvency covenant shall not be used, directly or indirectly, as a nonrecourse carve-out or as the basis for any claim or action against a borrower or any guarantor or other surety on a nonrecourse loan.” The statute is subtle in its application.  It does not prohibit solvency covenants in loans that are extended by lenders to borrowers on a full recourse basis, such as construction loans where there are no recourse exceptions in the guaranty.  And it does not preclude a covenant that a party not file a voluntary bankruptcy or collude in an involuntary case. 

There have not been any reported cases in Ohio or federal courts testing the Ohio statute.  The Michigan statute, on the other hand, was upheld in the Cherryland appeal.^[3]  It was also endorsed and applied by the Sixth Circuit Court of Appeals in Borman.^[4]  The court in Borman prevented a buyer of a foreclosed property subject to a limited recourse note, who had been assigned the lender’s rights, from obtaining any recourse recovery from the borrower or its guarantor.  The court dispatched several constitutional arguments against Michigan’s statute and found that the Michigan statute could be applied retroactively to loan document terms in effect when the statute was enacted.

Although the Ohio statute has not been tested in Ohio or federal courts, the legislative history of Ohio’s statute is illustrative. The uncodified final bill analysis states that use of a post-closing solvency covenant as a nonrecourse carve-out is an unfair and deceptive business practice and is against the public policy of Ohio.  The uncodified final bill analysis further states that the statute will apply to limited recourse notes and guaranties in existence on the bill’s effective date, March 27, 2013.  Finally, the Ohio General Assembly recognized that an inherent aspect of a nonrecourse loan is that the lender takes the risk of the borrower’s insolvency, inability to pay, or lack of adequate capital.  This reasoning was also part of the Cherryland appeal and Borman decisions.

The lender response to these cases and the related statutes has been generally to eliminate a post-closing solvency covenant from the loan documentation.  However, this is not a universal position.  Further, the laws governing CMBS and other structured loan documents are typically the laws of New York or wherever the lender’s principal place of business is located.  Ohio’s statute purports to apply to any loan where the real property collateral is located in Ohio.  This would appear to give Ohio courts jurisdiction and also a nexus between Ohio and the laws of the other state if a lender attempted to enforce non-recourse exception obligations against a borrower (or guarantor) that was formed or has its principal place of business outside of Ohio.  However, choice of law provisions electing the laws of New York or the lender’s home state are usually rigidly applied by lenders, and choice of law principles may in a given case defeat the application of the Ohio statute.

Now, perhaps the perfect storm is just over the horizon.  We will be watching for a guarantor who is pursued in Ohio to utilize these statutes defensively and prevent a judgment or enforcement of a foreign state judgment based on the solvency covenant.  Defensive litigation strategy is crucial.

Of course, violation of other loan covenants can trigger recourse under a guaranty, and perhaps the most troublesome in current times would be the alleged failure to properly apply rent after default.  A covenant violation can be very specific, and attention should be given to the precise wording that is negotiated among the lender, the borrower and the guarantor in the note and the guaranty.  In a future article, we will explore some variations in loan document language and when rent application covenants may be in play.

Please contact Ken Kreider, Emily Schott, Kal Steinberg, Joe Lehnert, Steve Coffaro, Bob Sanker or any other attorney in KMK’s Real Estate Group for further assistance in evaluating your particular situation. 

Kenneth P. Kreider
513.579.6457
kpkreider@kmklaw.com

Emily Wurtenberger Schott
513.579.6575
eschott@Kmklaw.com

Kal Steinberg
513.579.6910
ksteinberg@kmklaw.com 

Joseph E. Lehnert
5113.639.3929
jlehnert@kmklaw.com 

Steven C. Coffaro
513.579.6489
scoffaro@kmklaw.com 

Robert G. Sanker
513.579.6587
rsanker@kmklaw.com 

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[1] Wells Fargo Bank, NA v. Cherryland Mall Ltd. P’ship, 295 Mich. App. 99 (Ct. App. 2011)

[2] 51382 Gratiot Ave. Holdings, LLC v. Chesterfield Dev. Co., LLC, 835 F. Supp. 2d 384 (E.D. Mich. 2011)

[3] Wells Fargo Bank, NA v. Cherryland Mall L.P., 300 Mich, App. 361 (Ct. App. 2013)

[4] Borman, LLC v. 18718 Borman, LLC, 777 F.3d 816 (6th Cir. 2015)