The Post-Closing Solvency Covenant as a Carveout in Nonrecourse Commercial Mortgage Loans

Many commercial loans secured by real estate include a nonrecourse provision as to the borrower, with a carveout for "bad acts" that would trigger a full recourse provision. Such loans are often guaranteed by a collectible guarantor, who would be liable in the event a "bad act," as defined in the loan document, is committed. Typical examples of "bad acts" are misappropriation of rents, failure to pay real estate taxes, or failure to keep adequate books and records.

A "single purpose entity" covenant is often included. This covenant is important to the lender because it would not want the borrower entity to own other assets or to engage in other businesses that could create a risk of the borrower's solvency and/or a breach of the borrower's payment obligations on the loan. A breach of the single purpose entity covenant results in the loan becoming fully recourse to the borrower. Many guarantees provide that the guarantor will be liable for the full amount of the debt in the event the borrower fails to maintain its status as a single purpose entity. A provision requiring the borrower to remain solvent and to pay its debts and liabilities as they become due, in order to maintain its single purpose entity status is also often included. If so, can the lender claim that the borrower's failure to make payments on the loan itself is a breach of the solvency requirement, and therefore a violation of the single purpose entity covenant, and that therefore the guarantor is fully liable?

This issue has taken some dramatic twists and turns following the December, 2011 decision by a Michigan Court of Appeals in the Cherryland Mall Ltd Partnership¹ case. In that case, to the consternation of many in the commercial real estate industry, the Court of Appeals affirmed the trial court's decision in favor of the lender, by reading the loan documents literally, and holding that the borrower's failure to make payments on the loan itself constituted a violation of the borrower's single-purpose entity status, and therefore, the guarantor was fully liable. The court acknowledged that its holding would "indicate economic disaster for the business community in Michigan", but that the court's job "was not to save litigants from their bad bargains or their failure to read and understand the terms of a contract." The court noted that if the contract should not be enforced because it was against public policy, it was up to the Legislature to address the matter.²

While the borrower's appeal to the Michigan Supreme Court was pending, the Michigan Legislature reacted quickly in enacting its Nonrecourse Mortgage Loan Act³ (NMLA) stating that a post-closing solvency covenant shall not be used, directly or indirectly, as a nonrecourse carveout or as the basis for any claim or action against a borrower or any guarantor or other surety on a nonrecourse loan, and that such a provision in the nonrecourse loan documents is invalid and unenforceable.⁴

Upon remand from the Michigan Supreme Court, the Court of Appeals issued a new decision published on April 9, 2013⁵, and in upholding and applying the newly-enacted NMLA, decided the case inversely from its 2011 decision. The lender challenged whether the NMLA, which was enacted while the appeal was pending, was constitutional, and especially whether it could be applied retroactively to change the outcome of the case. After all, as argued by the lender, the Constitution generally prohibits states from enacting ex post facto laws or laws impairing the obligation of contracts⁶, and it also argued that applying the new law retroactively would violate its 14th amendment right to substantive due process, as well as the separation of powers clause of the Constitution.

In the court's analysis, there has been movement away from an absolute bar to contract impairment, and a balancing approach should be used, weighing the degree of the impairment of the contractual rights against the justification for the impairment as an act of the state's police power to implement legislation for a legitimate public purpose. The court concluded that there was a significant and legitimate public purpose for the NMLA, and that the remedy provided by the Legislation was reasonable and appropriate. Even though the law was being applied retroactively, the concerns about commercial developers not being able to qualify for financing to pursue continued economic development in the state, affecting tax revenues, and increasing foreclosures, all during a period of economic recovery in the state, resulted in the court finding that the NMLA and its retroactive application had a rational basis that was not effectively rebutted. The court also disposed of the separation of powers argument in holding that the NMLA did not interpret the contract or dictate the outcome of the particular case, but merely declared that the post-closing solvency covenant is invalid, unenforceable, and against public policy.

The State of Ohio, mirroring Michigan's NMLA, enacted legislation⁷, effective March 27, 2013, invalidating post-closing solvency covenants as a nonrecourse carveout or as the basis for any claim or action against a borrower, guarantor, or other surety on a nonrecourse loan. Therefore, for now, the issue seems clear in Michigan and Ohio. However, in the absence of a similar statute, other states could adopt the reasoning of the first Cherryland decision, and interpret the loan documents strictly as written.

It is not yet known whether the lender will appeal the new Cherryland decision back to the Michigan Supreme Court. Ultimately, an appeal to the U.S. Supreme Court could be possible.

For a copy of the April 9, 2013 Cherryland case, go here.

¹ 295 Mich App 99; 812 NW 2d 799
² Id at 125
³ MCL 445.1591 et seq
⁴ MCL 445.1593
⁵ Grande Traverse Circuit Court LC 2010-028149-CH
⁶ US Const 1963, art 1, Sec. 10
⁷ ORC 1319.07 and 1319.08