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A recent case illustrates how a borrower can be misled by so-called “nonrecourse loans.” “Nonrecourse” generally means that if a borrower defaults, the lender has rights to sell or repossess the mortgaged real estate or other collateral in order to recover on the loan but not other unrelated assets of the borrower. CARVE-OUTS It’s rare when these types of loans are available to residential borrowers. However, they are frequently available in commercial deals — often with strings attached. These strings make the borrower personally liable for certain “bad acts,” such as improper transfers, unauthorized encumbrances, misappropriating funds, permitting environmental problems and a variety of other defalcations. Lenders that provide nonrecourse loans need these types of carve-outs from nonrecourse liability to discourage borrowers from committing these “bad acts.” In Heller Financial Inc. v. V. Lee, Case No. 01C 6798, 2002 U.S. Dist. LEXIS 15183 (N.D. Ill., Aug. 16, 2002), the borrower found himself liable for the full balance of what he viewed as a nonrecourse loan. In that case the borrower, along with other parties, co-signed an equity loan agreement and a promissory note in connection with a $10 million loan needed to purchase a hotel in Orlando, Fla. The note contained a nonrecourse provision, which, on its face, purported to exculpate all makers from personal liability and left the lender to look solely to the collateral pledged to secure the loan. Lee’s downfall proved to be the carve-out provision in the note, which stated that despite the nonrecourse language, each maker would be personally liable for repayment of the loan upon a breach of certain covenants in the loan agreement concerning “transfers, assignments and pledges of interests and additional encumbrances in the Property, the Partnership or the Corporation.” The note specifically stated that each of the makers would not permit the filing of any lien or encumbrance on the collateral. After Lee’s partnership purchased the hotel, several tax liens and mechanic liens were filed against the partnership. As a result, Heller declared a default under the loan, sold the hotel and then came after Lee for the deficiency between the loan balance and the amount received. Lee defended on the grounds that he had no knowledge of the offending liens that were placed against the hotel because it had been managed “with the knowledge and agreement of Heller” by a separate management company unrelated to the borrower. The court rejected this defense, stating that the borrower was the one that had contracted with Heller for the loan, and not the manager. Also, ignorance of the liens was not a defense since they were a matter of public record. UNENFORCEABLE ‘PENALTY’ Lee then raised an issue that will attract the attention of borrowers and lenders around the country. He argued that the carve-out was a liquidated damages provision that was unenforceable as a “penalty.” In Illinois and many other states, the courts tend to permit parties to recover only damages that are actually sustained. The court stated: “The common law principle is that a liquidated damages provision is enforceable when it appears in advance that it would be difficult at the time of breach to compute actual damages and the liquidated damages provision is a good faith attempt to estimate what actual damages would be. … However, in interpreting provisions which affix the amount of damages in the event of a breach, courts lean toward a construction that excludes the idea of liquidated damages and permits the parties to recover only damages actually sustained.” Under the Heller case carve-out, the maker could become fully liable for the balance of the $10 million loan, merely for permitting liens to be placed against the property. In this case, the aggregate amount of the liens was approximately $820,000, and apparently that was significantly less than the outstanding balance due on the loan after application of the sale proceeds. Therefore, the borrower argued that the personal liability was a “penalty” because it could be substantially more than the damages triggered by the prohibited liens. The U.S. District Court rejected the borrower’s arguments and sustained the carve-outs that had been negotiated and agreed to by the parties. It pointed out that one of the makers of the note had exempted himself from any personal liability for violation of the carve-outs, but Lee had not done so. The court agreed with Heller’s arguments that since the loan was secured only by the equity interests of the entities that had purchased the hotel and not the hotel itself, Heller was especially concerned about liens. Those liens could affect the operation of the hotel and directly impair its security for the loan. While the court didn’t spell this out, a judgment creditor with a loan against the real estate could exercise a priority right against hotel income and interrupt the cash flow needed to pay the Heller loan. The court also rejected the penalty argument because the carve-out provided for only the recovery of Heller’s actual damages, i.e., the amount of the unpaid loan indebtedness at the time of default. Therefore, according to the court, “[t]his amount is the actual damages to Heller based on Lee and VanWhy’s breach. Since [the carve-out section of the note] involved actual damages it cannot be a liquidated damages provision.” On the other hand, the borrower’s position has some merit. If the borrower could have cured the problem by putting up $820,000 and satisfying the liens, or by paying that to Heller to pay the liens, why isn’t that the proper measure of “actual damages”? The decision is not surprising based on the facts of the case. In the Heller case, the loan was only secured by equity interests in the entities that purchased the hotel and not even by the hotel itself. Heller had agreed to nonrecourse liability only because the borrower had agreed to personal liability if any of the listed “bad acts” occurred that could diminish the value of the property or divert cash flow from it. In addition, if one views the so-called “penalty” as merely an obligation to pay back a loan that benefited Lee and his corporation, the result does not seem harsh. Many people who are not steeped in the custom of nonrecourse loans, including some judges, are suspicious of them anyway. There is a general feeling that a borrower must have taken advantage of some special relationship with a lender when it makes a deal to borrow money and to be excused from any personal responsibility to pay that money back. A judge I know once asked me how favored borrowers are able to make these special deals with lending officers. He queried, “How come they can get that kind of deal, but when I borrow money on my house, I can’t?” All of this should serve as a lesson to borrowers who are promised nonrecourse loans in mortgage commitments. They should read the carve-outs very critically before they accept these loans, and compare them with other nonrecourse loans that are being offered. Most of all, they should try to avoid springing liability that makes them liable for the full loan, even though the defaults may trigger damages that amount to only a small fraction of the loan balance. Harris Ominsky is a partner in Philadelphia’s Blank Rome Comisky & McCauley (www.blankrome.com).

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