Law & Policy: Non-Recourse Carveout Liability

By Michael Hamilton and Jessica Fluehr

Commercial real estate loans have historically been structured to limit the liability of the borrower for deficiencies through the use of single-purpose entities and non-recourse provisions. However, the expanding list of non-recourse “carveouts,” and related mandatory carveout guaranties from creditworthy entities, has eroded the limited liability structure. This has become particularly relevant recently in the workout of troubled loans.

The following summary of case law is intended to underscore that potential carveout liability must be carefully examined by borrowers and guarantors because it is real, not always controllable and certainly not limited to really bad acts.

Bankruptcy: The carveout for a bankruptcy fi ling by the borrower is typically a full recourse liability. As demonstrated in the 2009 United States District Court of Ohio case 111 Debt Acqusition L.L.C. v. Six Ventures Ltd., bankruptcy carveouts are enforceable and not violative of public policy. In this case, the guarantors did not consent to, or assist, the borrower’s filing for bankruptcy, and the bankruptcy case was subsequently terminated, with no apparent adverse effect on the lender. Nevertheless, the guarantors remained liable for the full amount of the debt because liability was triggered simply by the filing. Similarly, in the widely cited 1996 case of First Nationwide Bank v. Brookhaven Realty Associates, the New York Appellate Court found that a springing bankruptcy carveout did not constitute an “ipso facto” clause—a clause whose effectiveness is triggered by a bankruptcy filing and which would typically be voidable under an executory contract. The “fresh start” protections that generally apply to debtors did not apply, and the carveout liability was enforceable against the borrower and its general partners.

Subordinate Financing: Recourse is also frequently triggered if a borrower enters into subordinate financing without the lender’s consent. In 2009, the New Jersey Appellate Court ruled in Princeton Park Corporate Center L.L.C. v. SB Rental I L.L.C. that a guarantor was fully liable for the debt owed to the lender as a result of the borrower’s entry into a subordinate financing in violation of the senior mortgage loan documents. The borrower repaid the second loan in full. Two years later, it defaulted on the fi rst mortgage loan. The court held that the mere entry into the subordinate financing triggered full recourse liability of the guarantors. Further, although the damages suffered as a result of the subordinate financing (zero) bore no resemblance to the guarantor’s liability under the guaranty (full recourse), the court enforced the guaranty.

Prohibited Liens: Non-recourse loans will often contain carveouts for imposition of any liens on the subject property. In Heller Financial Inc. v. Lee, the United States District Court in Illinois ruled in 2002 that a nonrecourse carveout provision triggered by tax liens was enforceable. Although the borrower contended that it had no knowledge of the tax liens because the property was being managed by an unaffiliated manager, the court did not find the borrower’s lack of knowledge of, or consent to, the liens relevant to its determination. The mere recordation of the tax lien was suffi cient to trigger recourse liability.

Single-Purpose Entity (SPE) Covenants: SPE carveouts were originally intended to discourage activities that would undermine the bankruptcy remoteness of the borrower. Over time, mere violation of any SPE covenant has become a sufficient recourse trigger. In 2004, the United States District Court in Louisiana held, in La Salle Bank N.A. v. Mobile Hotel Properties, that the borrower and guarantor were liable for the debt when the borrower amended the purpose clause in its organizational documents to provide that its purpose was no longer “solely … the acquisition, ownership and operation and management” of a hotel, but rather for “any lawful activity.” The court found that the amendment technically changed the status of the borrower from a “single purpose” entity and that was enough to warrant carveout liability.

Physical Waste: In 2009, the United States District Court of Alabama in Potomac Realty Capital L.L.C. v. Green held that physical waste on the mortgaged property triggered recourse for the losses sustained by the lender pursuant to a carveout guaranty. Although there was evidence that borrower sought to prevent the waste, the court found that the property’s condition suffi ciently worsened between the loan closing and foreclosure to warrant recourse.

Unpermitted Transfers: In the well-known 2007 case of Blue Hills Office Park L.L.C. v. J.P. Morgan Chase Bank, the borrower was involved in a zoning dispute with a neighboring property owner, which was settled for a $2 million payment from the neighboring owner. The court found that the dispute and its settlement constituted a portion of the “mortgaged property” under the loan, and the borrower’s subsequent “transfer” of the settlement payment to affiliates (without the lender’s consent) violated the transfer restrictions in the loan documents, thereby triggering full springing recourse liability.

Michael Hamilton and Jessica Fluehr are real estate and finance attorneys, who are based in the Los Angeles office of DLA Piper L.L.P. (US).