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In a commercial real estate loan, the borrower’s liability for repayment of the indebtedness can be broadly characterized as either recourse or nonrecourse. If the debt is a nonrecourse obligation, the loan documents, by their terms, limit the borrower’s liability for repayment to its interest in the collateral that is mortgaged or pledged as security for the loan. Upon the occurrence of a default, the lender can proceed only against the mortgaged property and cannot seek to recover a deficiency from the borrower even if the proceeds from the sale of the collateral are insufficient to repay the loan. If the debt is recourse, there is no such limitation of liability. The loan is a personal obligation of the borrower, and the lender can subject to execution sale any property of the borrower, whether or not it was pledged as security for the loan. Upon a sale of the mortgaged property, the borrower remains liable for repayment of any deficiency, provided that the lender complies with the requirements of applicable deficiency judgment law. In actual practice, many commercial real estate loans are hybrid obligations, falling somewhere between full recourse and full nonrecourse status. In a hybrid loan, the lender’s recourse is limited to the borrower’s interest in the property for certain types of defaults; other defaults, however, give rise to recourse liability against the borrower and guarantors. Those actions or events that give rise to recourse liability are frequently referred to as “carveouts” because they delineate an area of personal liability within the otherwise nonrecourse status of the loan. Carveouts generally impose personal liability on the borrower and guarantors for what might be characterized as the bad acts or misconduct of the obligors. For example, the carveouts may impose personal liability for waste; misapplication or conversion of rents, security deposits, insurance or condemnation proceeds; fraud or material misrepresentation; breach of single-purpose-entity covenants; or willful violation of specific covenants such as sale of the property without the lender’s consent. In addition to bad acts carveouts, the loan documents may also impose personal liability on the borrower and guarantors in the event of a bankruptcy filing or for environmental clean up obligations. There are two types of carveout liability – specific- or compensatory-carveout liability, and broad- or punitive-carveout liability. In the case of specific-carveout liability, the loan documents impose recourse liability to the extent of the actual harm caused by the borrower’s bad acts. For example, a borrower who misapplies insurance proceeds would, in the case of specific liability, be personally liable for the funds that are misapplied. In the case of general liability, the borrower or guarantor becomes liable for the entire amount of the loan, regardless of the harm caused. The bad act has the effect of converting the loan in its entirety from a nonrecourse obligation to a recourse obligation. It is a much more severe remedy than specific carveout liability. Lenders typically seek specific-carveout liability for things like waste, misapplication of funds and environmental matters, all of these being situations in which there is a specific, quantifiable loss. Broad liability is generally applied to conduct that goes to the core of the transaction such as fraud or material misrepresentation, breach of single purpose entity provisions, filing for bankruptcy, or transfer of the property without the mortgagee’s consent. With these concepts in mind, we turn to the case of Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, decided March 14 by the Massachusetts Federal District Court. Blue Hills Office Park was a single-purpose Delaware limited-liability company formed to acquire and own a property located at 150 Royall St., Canton, Mass. On Sept. 14, 1999, Credit Suisse made a nonrecourse loan to Blue Hills in the amount of $33.149 million, secured by a mortgage on the property. Credit Suisse later assigned the loan to J.P. Morgan. Blue View Corporate Center owned an adjacent office building, 250 Royall St., which it intended to sell to DST Realty Inc. In April 2003, Blue View applied to the Canton Zoning Board for a special permit to construct a parking garage at 250 Royall St. Blue Hills objected, but the zoning board granted the special permit over Blue Hills’ objections. Blue Hills filed an appeal of the zoning board’s decision in the Massachusetts Superior Court. On Aug. 5, 2003, Blue Hills entered into a settlement agreement with Blue View and DST Realty, pursuant to which Blue Hills withdrew its appeal in return for a payment of $2 million. J.P. Morgan never approved or even had notice of the settlement or payment. DST Realty was an affiliate of Boston Equiserve Limited Partnership, which occupied 96 percent of the building at 150 Royall St. The initial term of Equiserve’s lease at 150 Royall St. had an expiration date of July 31, 2004. Equiserve had the right to renew the lease for an additional five-year term, but on May 14, 2003, Equiserve gave notice that it was not going to renew the lease, and instead was moving to the office building owned by its affiliate at 250 Royall St. As a result of Equiserve’s nonrenewal, Blue Hills did not have sufficient funds to pay either the real estate taxes or debt service, and the loan went into default. The lender accelerated the loan, created a single purpose entity to which it transferred the loan, and foreclosed on 150 Royall St. The lender’s single purpose entity purchased the property at foreclosure sale, and then sold it to One Beacon Insurance Group for $23 million. This resulted in a deficiency on the loan with respect to principal alone in excess of $10 million. The plaintiff in Blue Hills was actually the borrower, which alleged that the lender violated the loan contract, breached the implied covenant of good faith and fair dealing, and violated Massachusetts statutory consumer-protection laws. The lender asserted various counterclaims against Blue Hills and the guarantors, seeking to hold all of them personally liable for the full amount of the deficiency under the broad carveout liability provisions contained in the loan documents. The Massachusetts U.S. District Court rejected the borrower’s claims for lender liability and upheld the lender’s counterclaims against the borrower and guarantors for the deficiency. Though the loan was generally nonrecourse, the carveouts in the mortgage provided that the debt would become fully recourse to the borrower if, among other things, the borrower transferred the mortgaged property or any interest therein, without the lender’s consent. Similarly, the guaranty provided that the guarantors would become liable for the full amount of the debt if the borrower transferred the mortgaged property in violation of the mortgage. The court first considered whether the zoning appeal process and the $2 million payment were part of the mortgaged property, and whether there was a transfer in violation of the mortgage. It answered both questions in the affirmative, relying on both the specific language of the mortgage and general principles of commercial reasonableness. In a nonrecourse loan, the court said, “the lender looks entirely to the value of the mortgaged property for security. Merely to protect the real property itself from transfer would be unreasonable and unpractical.” The zoning appeal was a cause of action “related to, derived from, and used in connection with the mortgaged property.” Its settlement had a twofold impact on the value of the collateral. First, the basis of the zoning appeal was that the proposed parking structure would be in the sight line of the property and obstruct views, and was therefore detrimental and offensive. More importantly, however, the zoning appeal was a strategy to keep Equiserve as a tenant so that the borrower could continue to pay debt service. Settlement of the zoning appeal meant that the garage would be built and Equiserve would vacate Blue Hills’ property, which ultimately resulted in the payment default. Since the settlement of the zoning appeal and the receipt of the $2 million constituted a transfer of the mortgaged property without the consent of the lender, the borrower and the guarantors were jointly and severally liable under the carveout provisions of the mortgage and guaranty for a deficiency which included approximately $11 million of principal, $4.5 million of default interest, and $2.5 million of attorney fees. The court in Blue Hills was careful to point out that in this case there was a close relationship between the bad act that violated the carveout provisions and the payment default. The settlement of the zoning appeal contributed to the termination of Equiserve’s tenancy, which in turn brought about the payment default. The appeal of the zoning decision was Blue Hill’s “strategy to keep its sole tenant and to maintain its cash flow and ability to service the debt. . . . With the zoning appeal settled, the garage would be built and Equiserve would vacate the Blue Hills property.” It is interesting to conjecture how the court would have ruled in Blue Hills if the lender’s assertion of personal liability were predicated upon a bad act that was unrelated to nonpayment of the loan. Would the decision have been the same if the termination of Equiserve’s tenancy, which caused the payment default, had nothing to do with settlement of the zoning appeal? In the case of broad-form carveout liability, there exists the possibility of a disconnect between the harm caused by the bad act and the extent of the borrower’s recourse liability. This arises where the bad act is unrelated to the payment default. For example, there may be a breach of single purpose entity covenants or a misrepresentation by the borrower that is wholly unrelated to the event that caused the payment default. While it is unlikely that a lender would declare a default and accelerate the loan based solely on a “technical breach” of the carveout covenants, if the asset is otherwise nonperforming the lender might very well seek to establish personal liability based on an unrelated breach of the carveout covenants. The borrower might argue that in such a situation recourse liability is a punitive remedy and should not be enforced; however, there is a strong counterargument. Nonrecourse status is a contractually conferred benefit, and the parties should be free to determine the requirements, conditions and limitations of that benefit. The loss of nonrecourse status is not a penalty, at least not in the usual sense. Even if there is no connection between the breach and the harm caused, the lender is seeking only actual compensation for its losses (assuming that there is a payment default in addition to a default in the performance of the carveout covenants). If the concept of recourse liability does not violate public policy in the first place, it is difficult to see why public policy would be violated by the conversion of a nonrecourse loan to a recourse loan upon the occurrence of certain conditions. It remains to be seen how a court would rule in a case where the payment default is unrelated to the borrower’s violation of the carveout provision. MARTIN DOYLE and DAVID FELDER are members of Saul Ewing’s real estate department in the firm’s Philadelphia office. Both have worked on a number of major real estate transactions and have been involved in all aspects of real estate development, sales, finance and leasing. Doyle received a law degree, cum laude, from the University of Pennsylvania Law School. Felder received his J.D. degree, cum laude, from Harvard Law School.

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