Liability In A Non-Recourse Loan: Michigan Case Stealing National Spotlight

A recent case in Michigan has sent shockwaves through the CMBS, (Commercial Mortgage Backed Security) real estate market. Borrowers claim that if the case is not overturned it will "create economic disaster for the business community in Michigan."

This case has a twist, reminiscent of a Paul Harvey "The rest of the story" radio program. The "twist," although possibly a safe haven for Michigan borrowers, may not protect borrowers in other states, which is why this case has potential national impact.

The borrower failed to make a loan payment and the lender foreclosed. Post foreclosure the lender filed an action to collect on the deficiency against the borrower and the guarantor.  In the case of WELLS FARGO BANK, NA, v CHERRYLAND MALL LIMITED PARTNERSHIP and DAVID SCHOSTAK, and SCHOSTAK BROTHERS & CO., INC.¹, the lender (Plaintiff) obtained judgment on a non-recourse loan, against the borrower and the guarantor, in excess of $2,000,000.00.

This type of loan was generally referred to as a non-recourse debt, yet contained certain provisions which would allow the lender to proceed against the borrower and possibly the guarantor. In this case the loan was also secured by a heavily restricted personal guaranty. 

CMBS loans are based upon asset isolation. Asset isolation contains two main provisions:  (i) separateness covenants (the "Separateness Covenants") and (ii) narrow limitations on the lender's general agreement not to pursue recourse liability (the "Limited Recourse Provisions") except under very limited circumstances.   The lender agrees not to pursue recourse liability directly or indirectly against the borrower or its owners, provided that the lender can comfortably rely on the assurance that the financed asset will be "ring-fenced" from all other endeavors, creditors and liens related to the parent of the property owner or affiliates. In addition the lender looks to the performance of the asset separate and insolated from any asset owned by such parent entity or affiliates. More specifically, it is not just the isolation of the real property asset, but the isolation of the cash flows coming from the  operation of the real property, from which debt service is paid on the mortgage loan and subsequently distributed to the holders of the securities issued backed by such mortgages.

This separateness is also referred to as Single Purpose Entity or SPE.  The Plaintiff argued that when Cherryland became insolvent (unable to pay its bills, not just the mortgage) which required cash from other endeavors, and the borrowers had taken a draw against the income of the property caused the entity to loose its SPE status. This status loss therefore allowed the lender to proceed.

Three separate theories were used in which to proceed under the guaranty and against the borrower for the deficiency:  The first sought a judgment against Schostak, as the guarantor, for the entire loan deficiency on the ground that Cherryland's insolvency constituted a failure to maintain its SPE status. The second also sought a judgment against Schostak as the guarantor for the entire loan deficiency, but on the additional ground that Cherryland had entered into unfair transactions with an affiliate, also an alleged failure to maintain its SPE status. The third sought a judgment against Schostak, again as the guarantor, for a distribution Cherryland made to its owners in 2010.

The note, mortgage, and guaranty which were somewhat "standard" CMBS documents all provide, in nearly identical language, that the loan debt becomes fully recourse with respect to the borrower (mortgage and note) or the guarantor (guaranty) in the event that Cherryland "fails to maintain its status as a single purpose entity as required by, and in accordance with the terms of the mortgage and guaranty." Plaintiff asserted that it was entitled to recover damages in the amount of the loan deficiency from both Cherryland and Schostak because Cherryland's insolvency constituted a failure to maintain its single purpose entity (SPE) status.

Any foreclosure would most likely be the result of the borrower becoming insolvent…, and therefore the Defendants argued to the court that by allowing a non-recourse loan and guaranty to become recourse based upon insolvency would create "economic disaster for the business community in Michigan."

The court denied the Defendants pleas and arguments and allowed the ruling to stand.  Judgment was entered, and upheld by the Michigan Appellate Court, against the borrower and the guarantor.

Because the loan documents were fairly standard, the borrowing community, upon getting wind of this case, began to pull out every CMBS loan documents to review these provisions.  Many law firms representing borrowers and guarantors began to take a second look at their position, and lenders began to start looking to borrowers and guarantors for recovery of deficiency amounts.

Many non-party entities filed Amicus Curiae briefs including Michigan Chamber of Commerce, the Michigan Attorney General, and the Building Owners and Managers Association International. What makes this case so interesting ("the rest of the story") is the reaction by the legislature to a statement contained in the courts ruling: 

"This case illustrates why this Court should frequently defer policy-based changes in the common law to the Legislature. When formulating public policy for this state, the Legislature possesses superior tools and means for gathering facts, data, and opinion and assessing the will of the public. . . ."

The judiciary, by contrast, is designed to accomplish the discrete task of resolving disputes, typically between two parties, each in pursuit of the party's own narrow interests. We are "'limited to one set of facts in each lawsuit, which is shaped and limited by arguments from opposing counsel who seek to advance purely private interests.'" We do not generally consider the views of nonparties on questions of policy, and we are limited to the record developed by the parties."

The ruling was issued December 27, 2011, by the Michigan Appellate Court and has been appealed to the Michigan Supreme Court.

And now...the rest of the story…

On February 29, 2012, two months after the ruling, a bill titled the "Non-Recourse Mortgage Loan Act" was introduced to the legislature. The bill, which became law 29 days later, made a "post closing solvency covenant” an "unfair and deceptive business practice and against public policy."²  The statue made such clauses "invalid and unenforceable". The law took immediate effect on March 29, 2012.

The statue also has retroactive effect, “This act applies to the enforcement and interpretation of all nonrecourse loan documents in existence on, or entered into on or after, the effective date of this act."³  which arguably would control on the Cherrywood case on appeal.

There are issues with the statue which have not yet been decided,  some of which are being briefed and argued in the Supreme Court case;  a) the affect on documents executed in or controlled by other state's law, b)  provisions in the mortgage loan documents where in statutory rights are waived. c) The statue may be unconstitutional on many grounds.

Borrower's in states other than Michigan are not protected by the Non-Recourse Mortgage Act. Borrowers may be subject to the logic as applied in the Cherryland Case, and lenders may be able to obtain judgment on what was generally assumed as non-recourse debt, or against a guarantor on a limited guaranty.  The ruling from the Supreme Court of Michigan may agree, disagree or change the analysis of the mortgage agreement.

Stay tuned to hear...the rest of the rest of the story.

1 Wells Fargo Bank, NA v. Cherryland Mall Ltd. P’ship, 295 Mich. App. 99, 106 (Mich. Ct. App. 2011)
2 MCLS  § 445.1591
3 MCLS § 445.1595