Rincon, Non-Recourse Carveout Guarantees and New York Law

Is Cherryland Still Relevant?

By:      Michael Pollack, Of Counsel, Ballard Spahr LLP[1]

-and-

Andrew E. Walsh, Of Counsel, Ballard Spahr LLP[2]

Introduction

On April 7, 2014, the United States District Court for the Southern District of New York decided CP III Rincon Towers, Inc. v. Richard Cohen[3].  The question before the court was whether or not real estate owner’s association (“REOA”) and mechanic’s liens triggered full recourse under a non-recourse carveout guaranty.  Concluding that these were involuntary liens, the court found that these liens did not result in full recourse under the guaranty.  The court also found these items did not trigger loss recourse as a violation of the loan documents’ SPE covenants.

As many loan documents are governed under New York law regardless of the location of the mortgaged property, the Rincon decision is a significant decision.  In one context, it has already been cited as authority directing courts how to identify contractual ambiguities[4].  Viewed in the context of “bad boy” guarantees and CMBS loans, Rincon sheds light on whether courts are going to subscribe to the line of analysis adopted by the Court of Appeals of Michigan in its 2011 decision in Wells Fargo Bank, N.A. v. Cherryland Mall [5]. In this latter context, Rincon suggests that the shadow cast by the Cherryland decision, already limited by legislative action in two states, may also be limited in judicial consideration of similar issues.

The Cherryland Backdrop

In December of 2011, the Court of Appeals of Michigan rendered its seminal decision in the Cherryland case.  The court found a guarantor responsible for full recourse for a deficiency judgment exceeding 2 million dollars for violating an SPE covenant that the borrower remain solvent and pay its debts as they become due.  When the market deteriorated in 2009, the Cherryland borrower stopped making payments under the loan and was rendered insolvent.  The borrower’s solvency covenant was unconditional.  Without finding an overt “bad boy” act by the borrower or its principals as the underlying cause, the court found the solvency covenant to have been breached and the guarantor fully responsible under its guaranty.  As the court stated “…any failure to remain solvent, no matter what the cause, is a violation.”[6]

For those who viewed Cherryland in its most disruptive form, the implication was that a Borrower faced with an unconditional solvency covenant must bring fresh capital to a project when the cash flow no longer supports its debt service.  The alternative is to confront liability under the guaranty.  Either way, the obligation would be difficult to quantify and this would prevent investors from being able to gauge their financial commitment to a project.  Market participants feared the pall such uncertainty would cast over real estate investments going forward.

Rincon

Rincon is one of the first clarifications of New York law regarding non-recourse guarantees since CherrylandRincon involved a $110 million dollar loan on a 320 unit high-rise apartment building to be constructed.  The defendant, Richard Cohen, was the President of the borrower and the non-recourse carveout guarantor.  The plaintiff, CP III Rincon Towers, Inc., was a special purpose entity formed to purchase the debt originated by Bear Stearns in 2007.

From 2008 to 2012, several REOA liens and mechanic’s liens were filed against the property.  Under the loan documents, it appeared there were four avenues of potential recourse against Cohen.

Full recourse could have been triggered under three separate provisions on the basis that the Borrower:

  1. placed a voluntary “Lien” against the property;
  2. failed to obtain the lender’s consent to a “Transfer”; and
  3. placed “Indebtedness” on the property without the lender’s consent.

The fourth potential avenue was that loss recourse could have been triggered under an SPE covenant prohibiting liens “of any nature”.

The loan documents defined the terms “Lien”, “Transfer” and “Indebtedness”. The term “voluntary” was not defined. In the course of negotiating the loan documents, the reference to mechanic’s liens had been deleted from the loss recourse provisions, but mechanic’s liens were still included in the definition of “Lien”. The court was left to resolve the internal inconsistencies in the loan documents and attempted to avoid rendering any of them superfluous.

Voluntary vs. Involuntary Liens

The court applied analysis from federal bankruptcy law in determining that the mechanic’s liens and REOA liens were not voluntary because they are liens created without the debtor’s consent. The loan documents did not require the borrower to obtain the lender’s consent before becoming part of the REOA or before retaining contractors. Once these events occurred, the court viewed the resulting liens as having been “imposed” and not voluntary[7]. Since the guaranty provided that only “voluntary” liens triggered full recourse, these liens did not trigger full recourse.

Transfer

Having found the liens not to be voluntary, the court still had to determine if they constituted a “Transfer” leading to full recourse. The court found the transfer provisions of the loan documents to be ambiguous and therefore looked to the history of negotiations between the parties to discern their intent. Ultimately, the court found the deletion of references to mechanic’s liens from the loss recourse provisions evidenced an intent that there not be any liability under the guaranty for the mechanic’s liens and REOA liens.

The court stated that a “Transfer” (and by extension, a breach) under the loan documents could occur without an affirmative act of the Borrower[8] . Such a construction of the loan documents appears consistent with a Cherryland approach even though the court did not refer to Cherryland in its analysis. Despite its statement, the court found that the liens did not constitute a “Transfer” as doing so would render the voluntary lien provision of the guaranty meaningless. The court interpreted the deletion of the references to mechanic’s liens from the loss recourse provisions as demonstrating an intent to exonerate the guarantor from liability absent an affirmative act[9].

Indebtedness

The court similarly found that the borrower had not violated the provision that it not incur any “Indebtedness” without the lender’s prior written consent. The court distinguished between incurring Indebtedness and the timely failure to pay Indebtedness. The court seemed to view the act of entering into the REOA and securing contractors as the acts of “incurring” Indebtedness. Since the loan documents did not prohibit the borrower from incurring the REOA fees or securing contractors, the loan did not require the borrower to obtain the lender’s consent before the property became encumbered with the REOA liens and mechanic’s liens[10].

Loss Recourse

Partial recourse still would have been possible based on a violation of the SPE provisions which prohibited liens “of any nature” had the court chosen to enforce this provision separately. Adopting such an approach would have been consistent with the approach in Cherryland. Instead, the court analyzed this in the context of the prohibition against “Transfer” without consent and relied upon a general rule of contract construction that the specific references to Liens and Indebtedness for full recourse controlled over the general SPE provisions for loss recourse[11]. The court did not expressly refute Cherryland but this approach seems to tacitly reject it.

Cherryland’s Legacy Outside New York

In the three years since the decision, subsequent history has shown a mixed reaction to Cherryland. While one Georgia court followed Cherryland, two state legislatures have enacted laws stating that public policy in their states dictates otherwise.

The Michigan legislature acted quickly to effectively overrule Cherryland by enacting the Nonrecourse Mortgage Loan Act of 2012[12]. The NMLA provides that a post-closing solvency covenant can not be used as the basis for a claim under a nonrecourse loan. When Wells Fargo challenged the constitutionality of this law, the same Michigan Court of Appeals that issued the Cherryland decision in the first instance upheld the statute as a valid declaration of public policy[13].

Also in 2012, the Ohio General Assembly acted to prevent ambiguity as to how postclosing solvency covenants would be fare in their state. Not to be outdone by their Michigan counterparts, and despite (or perhaps due to) a paucity of case law addressing the subject in that state, the Ohio General Assembly enacted the Legacy Trust Act[14]. This law is similar to the NMLA and provides that postclosing solvency covenants are unenforceable in Ohio after March 27, 2013.

Ohio and Michigan are the only states to address this subject legislatively. In the absence of legislative direction, the courts applying the laws of other jurisdictions must determine to what extent they view the decision in Cherryland as effective guidance. Given how closely the enactment of the NMLA and Legacy Trust Act followed the Cherryland decision, not many courts have given consideration to the effect of the decision. In 2012, a Georgia court was asked to interpret an SPE covenant which also required the Borrower to “be solvent and pay its liabilities from its assets…as the same shall become due.” and to “maintain adequate capital for the normal obligations reasonably foreseeable in a business with its size and character.”[15] The Georgia court, citing Cherryland favorably, enforced the full liability provisions of the loan documents and did not read any meaning into the phrases “from its assets” or “obligations reasonably foreseeable”. To date, the Guarantor in Mitchell’s Park has not been similarly rescued by the Georgia legislature.

CONCLUSION

Given the prevalence of reliance on New York law in loan documents, the view of the New York courts on Cherryland will be particularly telling. In Rincon, the Federal District court applying New York law did not rely upon, or even cite, Cherryland in its decision. The Rincon court relied heavily upon the particular facts of that case so it is difficult to draw any broad conclusions from that decision. The decision is also so recent that it is still subject to appeal and bears further monitoring. The fact driven nature of the Rincon decision underscores the need for careful review, negotiation and drafting in the loan documents to accurately and precisely manifest the parties’ intent.

However, Rincon does suggest, as the Michigan and Ohio legislatures before it, that the New York court too is distancing itself from the Cherryland line of analysis. This result should temper enthusiasm and anxiety among those who believed that Cherryland would lead to sweeping changes in the interpretation and enforcement of non-recourse guarantees in New York.

[1] Michael Pollack is Of Counsel in Ballard Spahr’s New York office at 425 Park Avenue, New York , New York 10022 (tel. 212-223-0200; email: pollackmv@ballardspahr.com)

[2] Andrew E. Walsh is Of Counsel in Ballard Spahr’s Washington , D.C. office at 1909 K Street, NW, Washington, D.C. 20006 (tel. 202- 661-2200; email: walsha@ballardspahr.com)

[3]  ____ F. Supp. 2d ___, 10 Civ. 4638 DAB, 2014 WL 1357323 (S.D.N.Y., April 7, 2014)

[4] In Gramercy Advisors, LLC v. Ripley, 13 Civ. 9070 VEC, 2014 WL 4188099 (S.D.N.Y, Aug. 25, 2014), the court recited the language from Rincon for the principle that in attempting to determine whether or not an ambiguity exists between competing contractual provisions, the courts ‘need not determine which is the more likely interpretation,’ but instead ‘merely decide whether each is sufficiently reasonable to render the clause ambiguous.’ Gramercy, at p. 9, quoting Rincon at p. 10

[5] 295 Mich.App. 99, 812 N.W.2d 799 (Mich.Ct.App., 2011)

[6] 295 Mich. App. at 125

[7] Rincon at p. 8

[8] Rincon at p. 11

[9] Rincon at p. 13

[10] Rincon at p. 15

[11] Rincon at p. 11

[12]  M.C.L.A. § 445.1593.

[13] Wells Fargo Bank, N.A. v. Cherryland Mall (on Remand), 300 Mich.App. 361, 835 N.W.2d 593 (Mich.Ct.App., 2012)

[14] Ohio Revised Code § 1319.07-09

[15] See Wells Fargo Bank, N.A. v. Mitchell’s Park, LLC, 1:10 Civ. 3820 TWT, 2012 WL 4899888 (N.D. Ga., Oct. 11, 2012).

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