Sunday, January 8, 2012

FYI: Mich App Ct Holds Breach of CMBS Loan Agreement Resulted in Loan Becoming Fully Recourse

The Michigan Court of Appeals recently held that a borrower's violation of a CMBS loan agreement resulted in the loan becoming fully recourse against both the borrower and the guarantor.  A copy of the opinion is attached.
Defendant Cherryland Mall Limited Partnership obtained a commercial mortgage-backed securities loan, for which defendant David Schostak was the guarantor.  The loan was transferred to the plaintiff, and made part of a real estate mortgage investment conduit trust. 
When Cherryland failed to make payments on the loan, the plaintiff foreclosed.  After the sheriff's sale, the plaintiff was left with a substantial deficiency.  The plaintiff then sued Cherryland and Schostak, alleging that it was entitled to recover the deficiency because Cherryland's insolvency constituted a failure to maintain its single purpose entity ("SPE") status, as required by the agreement between the parties. 

Following discovery, the plaintiff filed several motions for summary disposition, seeking a judgment for the deficiency, among other things.  The lower court found for the plaintiff.  Cherryland and Schostak appealed, contesting whether Schostak was liable for the entire deficiency, because insolvency was a violation of Cherryland's SPE status. 
The Court began with an in-depth examination of the typical structure of CMBS loans of the sort at issue.  It noted that such loans typically feature an agreement by the lender not to pursue recourse liability against the borrower, in exchange for the borrower agreeing to a series of "separateness covenants," whereby the borrower agrees to "ring-fence" the financed asset from "all other endeavors, creditors and liens."  The separateness covenants may include an agreement by the borrower to remain solvent.  A breach of these separateness covenants allows the lender to seek recourse liability against the borrower. 
On appeal, the defendants argued that the mortgage was extinguished upon foreclosure, thus barring the plaintiff's lawsuit because the terms and conditions of the mortgage no longer existed. 
The Court disagreed.  It cited binding precedent providing that "an action at law may be instituted for the deficiency on statutory foreclosure of a mortgage."  New York Life Ins. Co. v. Erb, 276 Mich 610, 615 (1936).  The Court further observed that the basis for such a lawsuit is not the mortgage, but the note - and the note in this matter provided that debt was to be fully recourse against the borrower, in the event that the borrower did not maintain its status as a SPE. 
Next, the defendants advanced several arguments based on contract interpretation.  The defendants argued that the terms of the mortgage were unambiguously non-recourse; and that failure to remain solvent did not constitute a violation of SPE status.  To support the latter argument, the defendants pointed out that "SPE" was never defined in the mortgage. 
The Court therefore scrutinized the terms of the mortgage.  It noted that the requirement that the borrower remain solvent was included under the heading "Single-Purpose Entity/Separateness."  Therefore, it concluded that the "natural and logical" conclusion was that solvency was a condition necessary to maintain SPE status. 
Further, the Court observed that accepting the defendants' arguments would mean that the mortgage provided that there was nothing that the borrower must do to maintain SPE status.  As the loan documents stated in numerous places that a failure to maintain SPE status would result in the loan becoming fully recourse, the Court stated that the defendants' interpretation was unreasonable. 
Therefore, the Court held that "[h]aving admittedly become insolvent, Cherryland violated the SPE requirements, resulting in the loan becoming fully recourse." 
In reaching that conclusion, the Court acknowledged that its interpretation of the contract "seems incongruent with the perceived nature of a non-recourse debt," and further acknowledged the contention of various amici that its holding could "indicate economic disaster for the business community in Michigan."  Nevertheless, the Court maintained that it was not its job to "save litigants from their bad bargains," nor to address matters of public policy. 

Ralph T. Wutscher
McGinnis Tessitore Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
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