Court Upholds Legislation Prohibiting the Springing of Full Recourse Liability Upon Breach of Covenant to Remain Solvent

On April 9, 2013, in the case of Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership et. al., 2013 Mich. App. LEXIS 651 (Mich. Ct. App. Apr. 9, 2013), the Michigan Court of Appeals rejected the mortgage lender’s constitutional challenges to the Non-recourse Mortgage Loan Act of the State of Michigan, 2012 PA 67, MCL 445.1591 et. seq. (the “NMLA”). The Court’s decision was the culmination of the saga that began with its earlier decision in December 2011, where the Court held that the borrower’s violation of the single purpose entity covenant to remain solvent resulted in full recourse liability under a non-recourse mortgage loan. The implications of the Court’s December 2011 decision on the real estate industry were discussed in our March 2012 Note from the Real Estate Group, Borrower’s Breach of Covenant to Remain Solvent Springs Full Recourse Liability Under Non-Recourse CMBS Mortgage Loan.

As discussed in greater detail in our March 2012 Note, the Court, in its earlier decision, found that the borrower’s violation of the single purpose entity covenant to remain solvent triggered full recourse liability to the borrower and the guarantor under customary non-recourse mortgage loan documents, even where it was acknowledged by all parties that the insolvency was simply due to general real estate market conditions. Such decision, which in effect provided that the loan is non-recourse only so long as the borrower is able to pay it, but with the loan becoming recourse as soon as the borrower is unable to pay, caught many commercial lenders and borrowers by surprise. In particular, the decision left many borrowers exposed to recourse liability under mortgage loans previously assumed to be non-recourse (excluding customary and specifically negotiated exceptions such as fraud, waste and environmental liabilities). As mentioned in our prior Note, a legislative reaction to this decision was expected.

On March 29, 2012, in a swift response to the Court’s decision, the legislature of the State of Michigan passed the NMLA. In pertinent part, the NMLA provides that a post-closing solvency covenant shall not be used as a non-recourse carveout or as the basis for any claim against a borrower or guarantor under a non-recourse loan; and any provision in a loan document which does not comply with this regulation is invalid and unenforceable [MCL 445.1593]. The NMLA expressly states that the legislature recognizes that the use of such a post-closing solvency covenant for such purpose is inconsistent with the nature of a non-recourse loan, and should be considered unfair and deceptive business practice and against public policy [MCL 445.1591].

It should be noted that the NMLA expressly provides that it does not prohibit a claim being made for recourse liability by reason of the breach of a covenant not to file a voluntary bankruptcy or collude in an involuntary proceeding [MCL 445.1592(d)].

On April 9, 2013, with the Cherryland Mall case having been remanded to the Court of Appeals for reconsideration in light of this new legislation, the Court rejected the lender’s various constitutional challenges* to the NMLA and upheld that the new legislation barred the lender from enforcing full recourse liability against the borrower and the guarantor under the non-recourse mortgage loan based solely upon the failure of the borrower to remain solvent.

As emphasized in our March 2012 Note, both lenders and borrowers are well advised to carefully scrutinize the language of so-called “standard” covenants in mortgage loan documents, such as single purpose entity covenants, in order to avoid the occurrence of unintended and material consequences. In the case of Cherryland Mall, a careful review may have avoided the guarantors being exposed to personal liability under the mortgage loan and years, and the considerable costs, of litigation.

* The lender alleged that the NMLA violated (1) the Contract Clauses of the United States and Michigan constitutions, (2) the due process protections of the United States and Michigan Constitutions, and (3) the separation of powers doctrine under the United States Constitution.

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05.23.2013  |  PUBLICATION: Note From The Real Estate Group  |  TOPICS: Real Estate, Construction, and Environmental  |  INDUSTRIES: Real Estate

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