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A recent case highlights how even so-called “nonrecourse” provisions in a mortgage loan may not protect the borrower against personal liability on the loan. As is common in much commercial lending, the borrower had negotiated a provision that limits its liability to the mortgaged collateral. However, that protection was not absolute. The negotiated provision in the mortgage provided that so-called specific “carveouts,” or exceptions, such as intentional physical waste, would trigger personal liability, but only to the extent of actual damage to the lender. In addition, the nonrecourse language provided for a much greater deterrent against diverting funds that should go to the lender. Then, both the borrower and the guarantors would become liable for the entire loan balance. As you might have anticipated, the validity of that deterrent was tested, and under a somewhat unusual set of circumstances. About four years after the mortgage closed, the owner of an adjoining property applied to the zoning board for a special permit to construct a parking garage. The borrower objected that the garage would block views of the office building and reduce its value, but the zoning board granted the special permit. The borrower appealed the decision and this led to a settlement with the neighbor paying the borrower $2 million in exchange for agreeing to dismiss the appeal. The borrower never notified its lender of the litigation or the settlement. Instead, it transferred the cash to an affiliated entity. $17 Million Liability At that time, the major tenant that rented almost all of the space in the office building decided not to renew its lease. After the lease expired, the borrower defaulted in paying loan installments, and a foreclosure by the lender yielded a deficiency of more than $10 million. Then, the lender asserted that when the borrower distributed the $2 million to its affiliates, it lost its nonrecourse protection and became liable for the full amount of the deficiency and other costs (eventually more than $17 million), and not simply the transferred $2 million. Also, it followed that the guarantors lost their nonrecourse protection. The Federal District Court of Massachusetts supported the lender’s claim and awarded judgment to it. Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, 477 F. Supp. 2d 366 (D. Mass. 2007). The mortgage had defined the “mortgaged property” as including “causes of action [related to] the use, operation, maintenance, occupancy or enjoyment” of the real estate and the “proceeds” of those causes of action. In light of that, the court found that the settlement payment was part of the mortgaged property and rejected the borrower’s argument that the mortgaged property consisted only of the real estate. Therefore, the borrower and its guarantors were fully liable for the deficiency. The court commented on the attorneys for the borrower and the guarantors, who were involved in structuring the ill-fated payment from the zoning settlement and the claim for the deficiency. It expressed “regret over the time, money and resources that necessarily have been expended to correct this faulty settlement structure.” In what appears to be a criticism of Blue Hills‘ lawyers, the court stated: “Here, one is left with the indelible impression that positions were taken and structures arranged with a view to salvaging something from a general wreck that would inevitably be ‘worked out’ rather than scrutinized by the full processes of careful trial and adjudication.” One of the lessons from this case is that carveouts to nonrecourse loans mean what they say and will be specifically enforced, even if borrowers rely on advice to the contrary from their attorneys. It is reported that after the court’s judgment, the guarantors fired their attorneys and put them on notice of a malpractice claim. The court also found a second violation of the nonrecourse carveouts. The borrower had violated single-member and single-purpose-entity requirements in the loan documents by commingling the $2 million settlement payment with monies of its member and by failing to maintain a participating independent director. This claim, which precipitated a careful, factual analysis, is obviously another way that nonrecourse carveouts can be triggered. Removing Timber Another way that a borrower can violate a mortgage is by permitting timber to be removed without consent of the lender. In another recent case, a trial court held that the borrower violated a mortgage by arranging with a timber buyer to cut and remove timber from the property for a payment of $13,500 to the borrower. In that case, a liability issue arose after the bank foreclosed, was awarded a deficiency and then brought action for waste against the timber buyer. The court found for the lender and held that timber was part of the secured property, even though the defendant had argued that the lender failed to perfect its security interest in cut timber under the Uniform Commercial Code. Feliciana Bank & Trust v. Manuel & Sessions LLC, 943 So. 2d 736 (Miss. Ct. App. 2006). Even though this case did not involve an attempt by the lender to exercise rights under a nonrecourse mortgage, the court held that the removal of the timber was an act of “waste” under the terms of the mortgage. This case illustrates another way that personal liability could be triggered under customary nonrecourse carveouts. Restitution and Penalties When negotiating nonrecourse provisions, borrowers’ attorneys should resist agreeing to those carveouts that trigger not only personal liability for restitution in the amount of the loss, but also could trigger the whole balance of the multimillion-dollar mortgage as occurred in the Blue Hills case. One could make a reasonable argument that a fair remedy for the lender would have been to receive the $2 million settlement plus an interest factor, rather than $17 million. Of course, the lender will negotiate for full liability because one cannot determine the extent of the economic detriment in diverting funds. For example, would the borrower have been able to hold off default on mortgage payments if the bank had received the $2 million zoning settlement? Perhaps that money could have been used to delay the foreclosure for months or even years, while the participants would have a chance to replace the lost tenant, or sell the building for a greater price than a premature foreclosure brought. In this case, the court’s characterization of the $2 million zoning settlement as mortgage collateral could theoretically have been influenced by evidence that the major tenant intended to buy the neighboring property and relocate there. The court states that the appeal of the zoning decision was a “strategy to keep its sole tenant.” In that light, the settlement sum seems more like a tenant-related payment than merely a settlement of a dispute over a neighbor’s zoning. It’s not clear from the Blue Hills decision whether the zoning appeal could have had any chance of succeeding, or whether reversing the zoning approval would have stopped the tenant from relocating, but this didn’t seem to influence the court’s decision. Some courts may view the loss of nonrecourse protection as an unenforceable “penalty.” This may be particularly true in situations where the triggering event turns out to have little economic relationship to the deficiency that the borrower and the guarantors will have to pay to the lender. For example, in the Blue Hills case, the court had held that the borrower failed to preserve its status as a single-purpose entity and to keep an independent director. Under certain circumstances, that failure could have few practical consequences to the lender, but under the mortgage language, that alone may have triggered full personal liability for the mortgage balance. Would some courts consider that an unenforceable penalty? Can it be said that merely enforcing full repayment of borrowed money is a “penalty,” even though the lender had agreed to limit liability only if the borrower had conformed to the accepted conditions for that special status? Lessons Even though the attorneys in the Blue Hills case may have thought that they had a good argument about why their clients had the right to pocket the $2 million settlement, with hindsight it appears that they might have taken a less aggressive position. Perhaps they could have sought a declaratory judgment on the issue of whether the settlement fee was part of the lender’s collateral, and whether the full recourse liability would be enforced. Other issues are raised by the broad definition of “mortgaged property” which included causes of action “related to the property.” Since the lender had rights to the zoning challenge against the neighbor, was the settlement enforceable without the lender’s approval? Suppose the borrower wants to settle the case, but the lender doesn’t? Who has the right to make that decision? Suppose the borrower decides that pursuing the case, or the appeal, would be throwing good money after bad. Can the lender force the borrower to continue to incur substantial costs and attorney fees? The scope of the definitions of mortgage property and the nonrecourse carveouts often take a back seat to other issues in negotiating a mortgage, such as interest payments, other collateral and prepayment rights. However, the Blue Hills case and the Feliciana Bank case highlight the importance of focusing on these somewhat neglected provisions in mortgage negotiations. Harris Ominsky is with the law firm of Blank Rome and is a former president of the board of the Pennsylvania Bar Institute.

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