Michigan Court Decision May Expand Lenders’ Recourse Options

April 24, 2012
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A recent court ruling in Wells Fargo, N.A. vs. Cherryland Mall Limited Partnership may impact single purpose entity borrowers who sign limited recourse loan contracts and become insolvent. Traditional limited recourse loan contracts protect borrowers and their loan guarantors from liability when they agree to maintain separateness and adhere to SPE covenants imposed by lenders. Under these contracts, lenders agree to look only to assets that were financed to recoup losses. However, violation of these covenants or “bad boy” clauses relating to fraud, misappropriation, voluntary insolvency or seeking protection under bankruptcy law or breach of separateness provisions, allow the lender to go after the guarantor for the total amount of debt owed, according to Lexology.com. In the case of Cherryland Mall Limited Partnership, the borrower took out a limited recourse mortgage loan from a Cherryland principal that stipulated it must maintain its status as an SPE entity to avoid the loan becoming full recourse. The loan was later transferred to Wells Fargo. Cherryland defaulted on its loan in 2009 after failing to make a mortgage payment, and Wells Fargo foreclosed on the property, resulting in a loss of $2.1 million for which it sued the borrower and guarantor, the news source reports. The bank argued that Cherryland breached its SPE status by failing to make the mortgage payment and remain solvent. The trial court found that the guarantor was liable for the entire loan deficiency due to Cherryland’s insolvency being a failure to maintain SPE status.  On appeal, Cherryland argued that the SPE definition was not clearly articulated and the provisions not defined as SPE covenants. It also argued that the company’s insolvency was not the result of a willful “bad boy” act, but poor market conditions. However, the Michigan Court of Appeals rejected this, finding that compliance with all of the SPE mortgage covenants were necessary to maintain SPE status.  In other words, compliance with each and every covenant, including the provision that required the company to remain solvent, was essential to meeting SPE status requirements. The case may have broad implications for borrowers in the future, as the court may treat the violation of a single covenant with the same severity it does for violating all covenants in regards to maintaining SPE status.