An appellate court decision threatens to turn many existing CMBS mortgages from non-recourse to recourse. It may take legislative action at each State level to fix it.
The commercial mortgage lending industry is abuzz over the December 27th, 2011 decision by the Court of Appeals of Michigan that confirmed a lower court ruling that Wells Fargo Bank as Special Servicer could pursue the warm-body guarantor of the non-recourse carve-outs for losses on a foreclosed conduit loan. The grounds? The failure to keep the borrowing entity, a special purpose entity (SPE) “solvent”.
Wait a second! Isn’t every borrowing SPE where the owner gives up and hands the lender the keys by definition “insolvent”? YEP! And, there was no argument on that fact in this case, by borrower, special servicer or judge. The judges finding: Standard CMBS documents have this SPE solvency carve-out and even though it makes no sense, the clause is not ambiguous. Be letting the loan go into default this carve-out was violated and the guarantor can be pursued for losses after foreclosure – despite the fact that both borrower and original conduit lender at the time the loan was created meant to enter into a “non-recourse” loan.
The loan in question was originated by Archon Financial (Goldman Sachs) and used standardized conduit documents. After successfully foreclosing on the property Wells Fargo Bank as special servicer brought suit to recover the deficiency under the non-recourse carve-outs. Amicus briefs supporting the borrower’s position were filed by the Mortgage Bankers Association, MBA, and the Commercial Real Estate Finance Council, CREFC. Even though this ruling will increase the recoveries on defaulted CMBS loans, it is bad news for the CMBS industry.
Scott Rogers, a real estate attorney at Rutan & Tucker, LLP, commented on the ruling:
"Cherryland may not only be bad for CMBS lenders, but bad for non-CMBS real estate lenders as well. The Court's strict and strained interpretation of some portions of the loan documents and not others resulted in an outcome that appears to defy common sense and defeat the parties' initial intent. Both lenders and borrowers must now be concerned that the implied intent of commonly understood provisions of their loan documents many years later may be wholly ignored or oddly reinterpreted by a court in unanticipated ways. This may lead to increased negotiation of loan documents, defensive drafting and yet further delay and expense in the closing process."
At Newmark Realty Capital, we’re seeing experienced borrowers becoming increasingly conduit-phobic. Many borrowers will only consider a CMBS loan execution if we demonstrate that we cannot solve their financing need with a loan from a life insurance company, bank or other portfolio lender. The Wells Fargo Bank vs. Cherryland Mall LP ruling will make these borrowers even more afraid to take a loan from a CMBS conduit.
CMBS loan closings will slow downLegal bills to close a CMBS loan will get even more expensive. Borrowers should not try to save money on their own counsel. Borrowers must remember when negotiating a CMBS loan that they need aggressive legal counsel who routinely negotiate these somewhat standardized but evolving CMBS loan documents. Unlike loans from portfolio lenders, borrowers with CMBS loans live and die by the loan documents: As shown in the Wells Fargo Bank vs. Cherryland Mall LP case, once the loan is securitized, common sense, the party’s common intent or reality will not trump the language in the loan documents.
So if this ruling could be bad for CMBS lending why did Wells Fargo Bank, a major player in the CMBS, file the case?Earlier this month, I attended the West Coast CREFC High Yield Debt Investment Conference (CREFC is highly geared toward the CMBS industry) and had the opportunity to ask the Special Servicing panel how frequently do they, as CMBS special servicers, take legal action against borrowers claiming non-recourse carve-out violations. Each panelist, representing LNR, CW Capital, PNC, KeyBank, Situs responded with “All the time!”
It seems a multitude of legal actions going at any point in time the norm for each of the firms. Specifically they all agreed that in the CMBS world it is the Special Servicer’s fiduciary duty to the trust’s investors, to find and enforce springing guarantees under the non-recourse carve-outs, as a means to maximize the recovery on a defaulted loan.
Newmark Realty Capital is involved in loan servicing for both life insurance companies and CMBS loan pools, and we see the CMBS world taking a very different approach to that taken for life insurance company mortgages, where lenders carve-out violations are used more as a threat versus a gotcha to get at springing recourse.
For more information...The decision on this case is quite readable; you can find it here: Wells Fargo v. Cherryland Mall LP.
Here are some highlights:
“Defendants (borrowers) have argued, in the alternative, that even if section 9(f) (the requirement that the borrowing entity be kept solvent) was an SPE requirement, it was not breached. Defendants assert that the provision was intended to prevent owners from removing all of the money from Cherryland (The borrowing entity) , thereby leaving it without assets sufficient to pay its debts. And, because the owners did -not remove any assets in the three years predating the default, Cherryland's insolvency was not created by the owners and, therefore, was not a violation of section 9(f).
First, defendants do not contend that section 9(f) is ambiguous; thus, there is no reason to resort to extrinsic evidence to interpret it. Second, the parties agree that Cherryland became insolvent. Cherryland's only basis for its contention that section 9(f) was not violated is that the insolvency was not based on its own actions, but the downward spiral of the market. Section 9(f), however, does not require insolvency to occur in any specific manner. Rather, any failure to remain solvent, no matter what the cause, is a violation. . . . .
We recognize that our interpretation seems incongruent with the perceived nature of a nonrecourse debt and are cognizant of the amici's arguments and calculations that, if accurate, indicate economic disaster for the business community in Michigan if this Court upholds the trial court's interpretation. Nevertheless, the documents at issue appear to be fairly standardized nationwide, and defendants elected to take that risk—as did many other businesses in Michigan and nationwide. It is not the job of this Court to save litigants from their bad bargains or their failure to read and understand the terms of a contract. . . . . .
In summary, based on the rules of contract interpretation and the persuasive authority of decisions of other courts that have interpreted nearly identical loan documents; we agree with the trial court that the mortgage, as incorporated into the note, unambiguously required Cherryland to remain solvent in order to maintain its SPE status. Having admittedly become insolvent, Cherryland violated the SPE requirements, resulting in the loan becoming fully recourse. “