Legislation Proposed in State of Michigan to Declare Solvency Covenants of Non-Recourse Loans Unenforceable: Finance, Insolvency & Restructuring Alert

A proposed bill entitled the Nonrecourse Mortgage Loan Act recently introduced to the Senate for the State of Michigan would regulate the use and enforceability of certain loan covenants in non-recourse commercial transactions. Presumably, the bill, Senate Bill No. 992 introduced on Feb. 29, 2012 and referred to the Committee on Economic Development, is in reaction to a recent decision of the Michigan Court of Appeals finding a guarantor liable for a deficiency claim notwithstanding the non-recourse nature of the loan. See Wells Fargo Bank, NA v. Cherryland Mall Ltd. P’ship, --- N.W.2d ---, 2011 WL 6785393 (Mich. Ct. App. Dec. 27, 2011).

A. The Cherryland Decision

In Cherryland, the borrower obtained a loan using real estate commonly known as the Cherryland Mall as collateral. After the borrower defaulted, the lender commenced foreclosure by advertisement which resulted in a multi-million deficiency. The lender subsequently commenced a civil action for, among other things, breach of guaranty against the guarantor, notwithstanding the fact that the loan was non-recourse or what is frequently referred to as a “bad boy” guarantee. The trial court held that guarantor was liable for the deficiency because the borrower had violated covenants in the loan documents regarding the solvency of the borrower as a “special purpose entity.”

On appeal, the guarantor contended that either the mortgage was unambiguously non-recourse and insolvency was not a violation of the borrower’s SPE status, or that the mortgage was ambiguous and the extrinsic evidence demonstrated that solvency was not required to maintain SPE status. After a thorough review of the loan documents, including the requirements to maintain SPE status in the mortgage, the court held that when the borrower became insolvent, the event of insolvency triggered full recourse against the borrower and the guarantor.

Recognizing that its decision potentially has national implications, the court succinctly stated as follows with respect to non-recourse loans and SPE status:

We recognize that our interpretation seems incongruent with the perceived nature of a non-recourse 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.

Cherryland, --- N.W.2d ----, 2011 WL 6785393 (Mich. Ct. App. Dec. 27, 2011).

B. Nonrecourse Mortgage Loan Act – Senate Bill No. 992

Approximately two months after the Cherryland decision, Senators Meekhof, Richardville, Hunter and Whitmer introduced the Nonrecourse Mortgage Loan Act. The Act, which has yet to be considered for enactment, proposes to regulate the enforceability of loan covenants in non-recourse commercial loan transactions.

In the event that the proposed Act is enacted in its present form, it will preclude a lender from obtaining a judgment for damages against a borrower or guarantor due to the failure of the borrower to remain solvent. Specifically, a “post-closing solvency covenant” in non-recourse loan documents could not be used to create a “non-recourse carveout” or “as the basis for any claim or action against a borrower or any guarantor or other surety on a non-recourse loan. The proposed legislation further provides that any post-closing solvency covenant that purports to provide the basis for a claim against a borrower or guarantor with respect to a non-recourse loan shall be "invalid and unenforceable."

Importantly, the proposed Act would apply to all non-recourse loans in existence, regardless of whether the loan was made prior to the enactment of the legislation. Moreover, the proposed Act would apply to any action pending on the effective date of the Act unless a judgment or final order has been entered and appeal rights exhausted or expired.

The proposed Act clearly raises many issues for lenders, borrowers and guarantors. It is clearly intended to prevent future decisions similar to Cherryland. However, whether the proposed Act is enacted or is even constitutional remains to be seen.