THE INTRODUCTION of commercial mortgage-backed securities (CMBS) financing in the 1990s ushered in a period of spectacular growth in the U.S. commercial real estate market. Between 1995 and 2005, total outstanding commercial real estate loans increased by 158 percent from $1.014 trillion to $2.618 trillion.1 In 2005 alone, over one-third of new loan issuances were CMBS. A key trait of CMBS loans is that they are nonrecourse, which means that the borrower is not personally liable for the loan upon a default. Instead, the lender’s sole recourse is to repossess the property pledged as collateral for the loan.2 To address the moral hazard of borrowers operating properties recklessly and using nonrecourse provisions as a shield against personal liability, lenders have historically included exceptions in loan documents so that the commission of certain intentional acts within the borrower’s control (commonly referred to as “bad boy acts” or“ nonrecourse carveouts”) would trigger personal liability. These exceptions represented the “fundamental bargain” of nonrecourse lending: so long as a borrower does not intentionally harm the lender’s collateral, the lender will look solely to the collateral, and not to the borrower’s personal assets, for recovery.
The flood of liquidity caused by the rise of CMBS precipitated the Great Recession. As commercial real estate values plummeted, taking CMBS loans down with them in the process, lenders scrambled to preserve their collateral and deter moral hazard. Their concerns were often well-founded. In the fog of war resulting from the adversarial postcrash environment, many borrowers neglected their properties, wasting them away while misappropriating whatever income remained. Lenders naturally looked to nonrecourse carveouts for relief, and an unprecedented flurry of CMBS-related litigation ensued. Never before had practitioners and courts scrutinized these carveouts so heavily.
In the wake of the recession and accompanying litigation came the advent of “CMBS 2.0,” a new lending environment in which credit underwriting standards tightened and the use of nonrecourse carveouts expanded. This expansion revealed two major side effects for borrowers. First, lenders pursued aggressive and often novel legal theories to exploit ambiguities in existing nonrecourse carveouts. Second, lenders became far stricter in documenting nonrecourse loans by requiring new carve outs not seen in CMBS 1.0. Taken together, these side effects substantially broaden the scope of carveouts from traditional bad boy behavior to more innocuous acts, culminating in a thorny financing environment. Borrowers must now be vigilant not to unintentionally trigger personal liability for carveouts in their existing loan documents while ensuring that any new carveouts are narrowly tailored and in the spirit of nonrecourse financing.
Historically, real estate finance practitioners were in general agreement (or so they thought) as to what types of bad boy acts would lead to personal liability. Acts constituting intentional malfeasance—such as fraud, misappropriation, transferring mortgaged property, filing for bankruptcy, and violating singlepurpose entity (SPE) covenants and risking substantive consolidation—were in disputable nonrecourse exceptions. For the most part, any violation of these carveouts automatically resulted in personal liability for the entire amount of the loan (i.e., “springing liability” or “full recourse”) without the need for the lender to show that it incurred actual losses.
During the early years of CMBS lending, these generally accepted carveouts were included in form loan documents but rarely tested in court. Practitioners blithely assumed that they understood the scope and potential ramifications thereof. However, to the dismay of borrowers (and to paraphrase Inigo Montoya from the movie The Princess Bride), the carveouts they kept using did not mean what they thought they meant. Indeed, catastrophic and unintended results stemmed from breaches of two such carveouts related to SPE covenants and transfers.
The inclusion in loan documents of SPE (or separateness) covenants is intended to separate the assets of a borrower so that, if an entity affiliated with the borrower files bankruptcy, the borrower’s assets (i.e., the lender’s collateral) are not “substantively consolidated” with those of the bankrupt entity. Customary loan documents contain over 30 such covenants, some of which are material—e.g., prohibiting the borrower from combining its assets with those of another entity—while others are not so at all—e.g., requiring the borrower to have its own letterhead. In the aggregate, however, these covenants serve a lender’s legitimate interest in preventing substantive consolidation. If a court ultimately consolidates the assets of a borrower with those of a bankrupt entity based on breach of an SPE covenant, the borrower would be hard-pressed to argue that such a breach is not tantamount to its own voluntary bankruptcy filing, which unquestionably triggers full springing personal liability.
Absent a substantive consolidation, however, a typical borrower may justifiably doubt that a seemingly innocuous breach of a single SPE covenant would result in the same recourse penalties as a voluntary bankruptcy. After all, who really cares if a borrower does not have its own letterhead? In 2011, in the oft-cited Wells Fargo Bank, N.A. v. Cherry – land Mall Ltd. Partnership case, the courtrelied on precedent in ruling that each individualSPE covenant is equally importantand any breach thereof triggers full springingrecourse. What was wholly unprecedentedwas the court’s determination that the borrower’sfailure to have sufficient funds topay its mortgage constituted a breach of thecovenant to “remain solvent.” This insolvencybreach did not cause a substantive consolidation of the borrower’s assets, nor didit arise from any intentional bad boy actsaken to harm the collateral. Rather, it wascaused solely by deteriorating market conditionsoutside of the borrower’s control.
By essentially requiring the borrower to personally guarantee the repayment of the loan (and to contribute an unlimited amount of capital beyond the value of the property to avoid a payment default), the court abandoned the fundamental bargain of nonrecourse lending and in essence converted the loan from nonrecourse to recourse. Suffice it to say that the decision created shockwaves in the real estate finance community.
Strictly interpreting individual SPE covenants in a vacuum, and not as a whole in the context of substantive consolidation, other courts have rendered seemingly unjust and, at times, absurd decisions. In addition to solvency covenants, courts have said that breaches of SPE covenants prohibiting acquisition of additional property, 10 admission in writing of an inability to pay debts,11 and amendment of a borrower’s organizational documents12 would all trigger full springing recourse, even if the breaches caused no actual harm.
For example, in LaSalle Bank N.A. v. Mobile Hotel Properties, LLC, the borrower agreed to a form SPE covenant not to amend its organizational documents. It later did so, however, simply changing the company’s stated business purpose from the “ownership…of a hotel” to “[engaging in] any lawful activity.” This benign change did not cause either a substantive consolidation of the borrower’s assets or any other harm to the lender. Yet it did trigger personal liability, with the court stating uncompromisingly that the plain language of the carveout “means what it says.” Because typical CMBS loan documents contain over 30 SPE covenants, many of which are insignificant if considered individually (for example, failing to “correct a known misunderstanding about its separate identity”), borrowers face a real risk that, in the CMBS 2.0 universe, innocuous and immaterial breaches of any given SPE covenant will be enforced vigorously by lenders and interpreted strictly by courts.
Another carveout under which borrowers thought they understood their risks, but by which they ultimately got burned in unanticipated ways, involves a prohibition on transfers of property. On its face, this prohibition seems reasonable and indeed essential to the fundamental bargain of nonrecourse loans. Under a plain-English interpretation of a “transfer,” a borrower might reasonably assume that the intent behind the carveout is to prevent the unpermitted sale of a mortgaged property. Given that such a sale is by definition an intentional bad boy act that harms the collateral, it follows that the remedy is full springing personal liability. Due to the expansive definitions of “transfers” and “mortgaged property” found in customary CMBS loan documents, however, CMBS 2.0 borrowers have incurred springing personal liability in scenarios that most CMBS 1.0 practitioners would have thought implausible.
Specifically, the term “transfers” generally includes not only sales but also any voluntary or involuntary liens, encumbrances, pledges, assignments, easements, covenants, and other dispositions of any direct or indirect interests in a mortgaged property. And likewise, the term “mortgaged property” generally includes not only land and improvements but also easements, covenants, rights to commence or defend legal actions, leases, licenses and permits, accounts, and other types of tangible and intangible property. Allowing lenders to exploit the breadth of these definitions, courts have upheld full personal liability for triggers as disparate as property tax liens, involuntary mechanic’s liens, terminations of parking licenses, and waivers of potential legal actions.
An extreme example of the nonintuitive nature of the transfer carveout is Blue Hills Office Park LLC v. J.P. Morgan Chase Bank. In that case, the borrower’s neighbor applied for a permit to build a garage. The borrower objected to the permit application but later withdrew its objection. Over a year later, the lender foreclosed and commenced an action to recover a $10.7 million deficiency personally from the borrower based on the transfer carveout. The court ruled that the borrower’s withdrawal of its objection to the neighboring development—despite not having any causal link to the actual default that led to the foreclosure, the $10.7 million deficiency, or indeed to any loss the lender incurred—constituted a violation of the carveout. Given cases like Blue Hills, and the seemingly endless ways to mix and match the definitions of “transfer” and “mort gaged property,” the practical risks to borrowers of unintentionally tripping the transfer carveout are almost inconceivable.
A second major side effect of CMBS 2.0 is the requirement of new carveouts that did not exist in CMBS 1.0. Lenders, stung by the losses they suffered in the Great Recession—including those they believed were caused by the nefarious acts of borrowers—invented carveouts to address matters for which the traditional remedy was nonrecourse default and foreclosure. For example, in response to borrowers’ intransigence and delay tactics during loan workouts, lenders now impose personal liability for failure to permit property inspections, deliver financial statements, appoint a new property manager, or cooperate in transferring licenses upon a foreclosure. In most of these cases, the purported bad act in question does not rise to the malfeasance level of traditional carveouts like fraud, misappropriation, or bankruptcy.
Further, in the new world of CMBS 2.0, lenders more often require certain catch-all carveouts (such as gross negligence and willful misconduct), which do not involve any specific bad acts or covenant breaches. This lack of specificity exposes borrowers to unpredictable and subjective risks, as opposed to traditional bad boy clauses that enumerate proscribed acts. In CMBS 1.0, these types of carveouts were either not required at all or routinely negotiated out by borrowers without much resistance.
One of the most controversial new carveouts imposes personal liability on a borrower if it interferes with or hinders a lender’s exercise of remedies. The reason for this carveout is clear, as during the recession borrowers often asserted lender liability claims in an effort to protect themselves from liability or foreclosure. Lenders in turn created an in terrorem effect to deter such claims. For borrowers, this new carveout presents an obvious dilemma: abandon good-faith defenses to a lender’s foreclosure and lose the property, or fight to keep the property under the threat of springing personal liability.
For example, in Bank of America, N.A. v. Freed, the borrower obtained a mortgage loan to finance its project, which later encountered financial difficulty. One of the springing full recourse carveouts in the loan documents required the borrower not to “contest, delay, or otherwise hinder” the lender’s exercise of remedies. The loan workout discussions became contentious, the lender filed a petition to appoint a receiver to wrest control of the project, and the borrower duly contested the appointment. The contest was shortlived, as just 30 days later the court appointed the receiver. Nevertheless, under a strict interpretation of the nonrecourse carveouts, the court rejected the borrower’s defenses and enforced full personal liability.
Given the courts’ strict interpretation of nonrecourse carveouts, often producing draconian and unanticipated results, borrowers have cried foul and looked to equitable defenses for protection. Among other things, borrowers have claimed that penalizing them with springing personal liability if the lender has suffered no actual harm is inequitable, unconscionable, and unenforceable. For example, the developer in Freed argued that its “hindrance” of the lender’s appointment of a receiver for a mere 30 days did not warrant a judgment for $206 million. The office owner in Blue Hills argued that its “transfer of property”—in actuality withdrawing its objection to a neighboring development—was not the type of bad boy conveyance that should merit a $10.7 million judgment. The apartment owner in Pineridge Associates, L.P. v. Ridgepine, LLC, argued that its transfer of property—in actuality incurring a mech anic’s lien that was wiped out in foreclosure—did not warrant full personal liability under its loan. In all of these cases, the borrowers’ arguments were rebuffed by the courts.
Indeed, the vast majority of cases reflect an unwillingness to entertain, much less adopt, the equitable defenses of borrowers. In those cases, neither the immateriality of the breach, the disparity between the judgment amount and the loss, nor the absence of any loss at all has persuaded the courts otherwise. The opinion in CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC— a case in which the borrower placed a $400,000 subordinate mortgage behind a $13 million senior loan and repaid the subordinate loan one year before the senior lender’s foreclosure—best sums up the common theme in the reasoning employed by many courts: “It matters not, as defendants argue, that they eventually cured the very breach that triggered their personal liability and that no harm accrued to plaintiff as a result thereof…defendants may not now escape the consequences of their bargain.” Undoubtedly, the SB Rental decision leaves many nonrecourse borrowers wondering what happened to their fundamental bargain.
CMBS debt surged in 2015 and, while the final numbers are still coming in, projected issuances totaled over $100 billion—more than in any other year in history except for the 2005–2007 peak. Because this surge coincides with rising commercial real estate values, there has been less distress in the markets and less litigation over nonrecourse carveouts. As history has taught, however, the surging market will not last forever, and the next black swan event could be just around the corner. When a market correction occurs, it will be impossible to predict what types of seemingly innocuous events will trigger springing personal liability.
Imagine making a deal with a neighbor that allows the use of the neighbor’s drinking fountain—would giving up that right constitute a transfer of property? How about objecting to that neighbor’s new paint color and then realizing you actually like neon green—by dropping your objection have you transferred property? And what if you legitimately dispute a lender’s foreclosure—did you improperly hinder the lender’s remedies? Or if you text the lender that you might not make your next mortgage payment—did you admit your inability to pay debts?
While lenders (and at times borrowers themselves) may consider the above examples as absurd instances of lawyers being persnickety, case law suggests otherwise. As borrowers navigate their way through CMBS 2.0 and beyond, it would behoove them to meticulously review their existing loan documents, identify overbroad nonrecourse carveouts that could trigger personal liability in unanticipated ways, and calibrate their behavior accordingly. In negotiating new nonrecourse loans, borrowers should ensure that any springing carveouts are narrowly drafted to encompass only intentional bad boy acts that are within the borrower’s control and will actually cause material harm to the lender’s collateral.