The U.S. Court of Appeals for the Sixth Circuit recently held that a solvency covenant in a commercial mortgage-backed securities loan was unenforceable under Michigan's Nonrecourse Mortgage Loan Act (MNMLA), and rejected various constitutional challenges to the MNMLA including under the Contracts Clause and Due Process Clause relating to the retroactive effect of the MNMLA.
A copy of the opinion is available at: Link to Opinion
A borrower defaulted on a nonrecourse loan secured by real property. The loan at issue was part of a commercial mortgage-backed securities ("CMBS") transaction. The lender foreclosed, and a purchaser ("purchaser") bought the property at auction. Standing in the lender's shoes, the purchaser sued the borrower and its guarantor to collect a $6 million deficiency. The lower court granted summary judgment in favor of the borrower, and the purchaser appealed.
On appeal, the Sixth Circuit began by reviewing the structure of CMBS loans, explaining that such loans typically contain two "bedrock elements" designed to protect investors: first, they are nonrecourse; and second, they contain a promise from the borrower to refrain from taking what the court termed "bad boy" acts, including an agreement that the borrower retains single-purpose entity status.
Further, CMBS loans typically include a covenant in which the borrower agrees to remain solvent - which, the Sixth Circuit explained, was intended to prevent borrowers from filing bankruptcy - and was not intended to apply to simple defaults due to loss of cash-flow.
The Sixth Circuit then reviewed recent case law pertaining to CMBS loans. In Wells Fargo Bank, NA v. Cherryland Mall Partnership, 812 N.W. 2d 799 (Mich. Ct. App. 2011) the court determined that a borrower's failure to remain solvent violated the applicable CMBS loan agreement, such that the borrower was personally liable for the loan amount.
In response, the Michigan Legislature passed the Nonrecourse Mortgage Loan Act in 2012 ("MNMLA"), which applied retroactively to render solvency covenants in nonrecourse loans unenforceable, finding such covenants to be against public policy.
On appeal, the purchaser argued that the solvency covenant in the borrower's CMBS loan was unenforceable, and that the MNMLA violated the Contract and Due Process clauses of the United States and Michigan Constitutions, among other arguments.
The Sixth Circuit rejected all of the purchaser's contentions, and affirmed the judgment of the lower court.
First, the purchaser argued that the MNMLA did not apply because the loan allegedly lost its nonrecourse status before the effective date of the act. The Sixth Circuit disagreed, noting that the purchaser's reading of the act was not the only possible reading, and was not the reading that "most closely hews to the legislature's intent."
Further, the Sixth Circuit found that the purchaser's reading of the MNMLA would "contradict the legislature's prohibition on the enforcement of solvency covenants as violative of public policy - in that the purchaser's reading would allow lenders to pursue recourse judgments as to many CMBS loans.
Next, the purchaser argued that the MNMLA was unconstitutional under the Contract Clauses of both the United States and Michigan constitutions. To determine the merit of that position, the Sixth Circuit considered whether the MNMLA substantially impaired the reasonable expectations of the purchaser. It agreed with the lower court that the purchaser's reasonable expectations were not substantially impaired, in light of the general practices in the CMBS loan industry - wherein the "nonrecourse promise performs a central function" by discouraging borrowers from filing for bankruptcy.
Accordingly, the Sixth Circuit rejected the purchaser's claim that the MNMLA violated the Contract Clause.
The purchaser also challenged the MNMLA's constitutionality under the Due Process Clause. The Sixth Circuit had little difficult in rejecting this challenge, finding that the legislature easily established a rational basis for enacting the MNMLA - which the Sixth Circuit noted is "all the law requires."
The Sixth Circuit therefore affirmed the lower court's judgment.
Ralph T. Wutscher
McGinnis Wutscher LLP
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