Single Purpose Entity Provisions in CMBS Loans in the Wake of Wells Fargo Bank, NA v. Cherryland Mall Ltd. P'ship, et al. (Mich. App. Dec. 27, 2011)

Background

This alert discusses possible "springing recourse" liability for borrowers and guarantors arising out of last month's decision in Wells Fargo Bank, NA v. Cherryland Mall Ltd. P'ship (Cherryland), decided last month by the Michigan Court of Appeals. If you are a lender, borrower or guarantor of a non-recourse loan in Michigan, pay close heed to this decision.

Several characteristics of CMBS loans have made them attractive to owners of commercial real estate. Generally speaking, such loans have been underwritten on the basis that they are non-recourse and the lender's sole remedy in the event of a default is to realize on the collateral provided for the loan, such as foreclosing on the real estate and exercising the assignment of rents. Even so, CMBS loan documents have generally included carve-outs from the general non-recourse provisions, meaning that the CMBS loan obligation would convert from non-recourse to recourse upon the occurrence of certain conditions, including, among others, failure of the borrower to maintain its SPE status and certain affirmative "bad boy" acts such as the commission of fraud, intentional misrepresentation or waste. 

The Cherryland Decision

Wells Fargo Bank, NA was the REMIC Trustee for the investors owning participation interests in the commercial mortgage-backed securities (CMBS) loan pool that included an $8.7 million loan (Loan) made to Cherryland Mall Limited Partnership (Cherryland). Consistent with general CMBS documentation practices, the Loan was evidenced by a Promissory Note containing both general non-recourse and recourse carve-out provisions, secured by a Mortgage on the real estate project owned and operated by Cherryland and also containing similar general non-recourse and recourse carve-out provisions, and further supported by a springing recourse Guaranty from one of Cherryland's principals, David Schostak.¹ When Cherryland failed to make its debt service payments on the Loan, Wells Fargo foreclosed the Mortgage. Immediately after the foreclosure sale, Wells Fargo sued Cherryland and Schostak to recover the claimed Loan deficiency, arguing that Cherryland and Schostak became personally liable for the Loan because of Cherryland's inability to make its debt service payments on the Loan, which rendered Cherryland insolvent and thus constituted a breach of the single purpose entity (SPE) covenants under the Note and Mortgage and likewise constituted a springing recourse condition under the Guaranty.  Both the trial court and the Michigan Court of Appeals agreed with Wells Fargo, awarding the Bank $2.1 million on its Loan deficiency claim, plus certain other costs, fees and interest.

Relevant Document Language. The Note included the following provision: "Notwithstanding anything to the contrary in this Note or any of the Loan Documents...(B) the Debt shall be fully recourse to Borrower in the event that:...(iii) Borrower fails to maintain its status as a single purpose entity as required by, and in accordance with, the terms and provisions of the Mortgage..." The Mortgage contains a provision identical in substance, substituting the terms "Mortgagor" and "Mortgagee" for the terms "Borrower" and "Lender."  The Guaranty contains a similar provision pursuant to which the guarantor's conditional recourse liability would arise.

While the Mortgage does not contain a provision expressly providing a definition for what constitutes a "single purpose entity," Paragraph 9 of the Mortgage is captioned "Single Purpose Entity/Separateness" and includes a number of covenants that Cherryland agreed to perform or adhere to, including a covenant that Cherryland "is and will remain solvent and...will pay its debts and liabilities...from its assets as the same shall become due."

Legal Arguments and Trial Court Decision. Wells Fargo asserted that these Paragraph 9 covenants collectively constitute the test of whether Cherryland maintained its status as a "single purpose entity" as required by the Mortgage and Note and also asserted that the loan documents are unambiguous on this point. Cherryland disagreed, arguing that solvency is not an SPE requirement, but instead is related to separateness, and that the two concepts (i.e., single purpose entity and separateness) are distinct and therefore Cherryland could fail to meet certain Paragraph 9 covenants without being deemed to fail to maintain its status as an SPE. Cherryland also argued that, because its failure to make its debt service payments on the Loan was due to the general economic downturn and therefore outside of its control and not attributable to any ill motive or wrongful act of Cherryland or its principals, the facts did not support the finding of an insolvency of Cherryland as contemplated by Paragraph 9 of the Mortgage.

The case ultimately turned on a technical interpretation of Michigan contract law. Thus, even though the trial court agreed with Cherryland's contention that solvency is not necessarily an SPE requirement, it held that Paragraph 9 of the Mortgage should properly be construed as the parties' unambiguously agreed upon and bargained for definition of "single purpose entity" requirements for purposes of the Loan and it awarded judgment in favor of Wells Fargo on the Loan deficiency claim.

Appellate Ruling. The Michigan Court of Appeals affirmed the trial court's holding, emphasizing that well-established principles of Michigan contract law provide that where the language of commercial loan documents is unambiguous, despite conflicting interpretations by the parties to litigation, the documents must be construed as written according to their plain meaning, without regard to the motive of the borrower or the guarantor. 

Implications for CMBS Lenders, Borrowers and Guarantors

Borrowers and guarantors in the process of obtaining new CMBS financing will likely heed the Cherryland case message and attempt to negotiate provisions that specifically and clearly define and enumerate the SPE requirements as distinct from separateness provisions, as well as the nature of the liability arising out of a breach of those provisions. That is, if borrower insolvency is a breach of separateness, such a breach would not result in full recourse against the borrower and guarantor, whereas a breach of any SPE requirement would give rise to springing full recourse liability. The latest iterations of CMBS loan documents (CMBS 2.0) generated beginning in 2011 do incorporate clarifying provisions regarding SPE requirements and separateness provisions and the liability implications arising out of a violation of each.  While it remains to be seen whether borrowers and guarantors will find those provisions acceptable in light of Cherryland, it is also likely that there will be significant pressure on the CMBS lender not to negotiate these provisions, given the stricter representations and warranties that CMBS lenders are now expected to provide to the purchasers of the CMBS loans they originate.

Lenders are the obvious beneficiaries of the Michigan Court of Appeal's decision in Cherryland. Given the number of CMBS loans outstanding (total loans over the past decade estimated at approximately $1 trillion) and assuming that the loan documents provide for the same or similar SPE requirements as found in the Cherryland case, such loan deficiency judgments will afford CMBS lenders with additional leverage and may afford CMBS lenders with additional remedies in the event of a borrower default. 

There likely will be additional court challenges to the Cherryland decision by Cherryland and Schostak, especially given the interest of the business and legal community, as evidenced by amicus curiae briefs filed in support of Cherryland and Schostak by the Michigan Attorney General, Michigan Association of Realtors, Michigan Chamber of Commerce, and Building Owners and Managers Association.

CMBS loan parties who are interested in learning more about their rights in relation to springing guarantees and non-recourse carve-out provisions in notes and mortgages, particularly in light of the Cherryland opinion, please contact Adam Fishkind at 248-203-0749 or Brian Page at 616-776-7509.  

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<sub>¹A springing recourse guaranty is a guaranty that becomes effective only upon occurrence of certain conditions described in the guaranty agreement.

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