Commercial Mortgage-Backed Securities (CMBS) loans are on the rise and many familiar with the market are concerned with the relaxed underwriting standards. Interestingly, looser underwriting standards and increased loan volume are not the only issues. Lenders are also encountering statutory and legislative developments that may limit recourse remedies in these loans and the combination of these factors has potential for serious consequences.
Increasing Numbers and Sliding Credit Quality
The volume of CMBS loans is increasing and this trend is expected to continue. CRE Finance Council’s 2015 Market Outlook Survey suggests the number of CMBS loans will increase in 2015 due to loan maturities and economic optimism. There is also concern that higher volume means lower underwriting standards. Lenders of CMBS loans are facing increased pressure to provide more favorable terms to borrowers due to the influx of capital in the market. Private equity firms and hedge funds are aggressively pursuing borrowers and, according to Moody’s, issued more than 40 CMBS loan origination programs, 2014 alone. In today’s market, borrowers are again obtaining interest only loan with reduced debt service coverage requirement.
The “Limit” of Limited Liability
One of the primary advantages for a CMBS borrower is limited personal liability in the event of a default. Guarantees in securitized loans are typically only triggered in the event of certain non-recourse carve-outs intended to prevent “bad-boy” acts of the borrower or guarantors. The purpose of the non-recourse carve-out is to protect the lender’s investment while shielding the borrower from personal liability, except in cases of intentional misconduct, fraud, or misrepresentations to the lender. In December of 2011, the landmark case of Wells Fargo Bank, N.A. v. Cherryland Mall challenged that premise. In Cherryland , the Court of Appeals of Michigan interpreted a non-recourse carve-out for insolvency so broadly as to include insolvency as a “bad boy” act even when the cash flow from the project was insufficient to pay the mortgage debt. The Cherryland case received criticism on the basis that the “bad boy” carve-outs were intended to be for bad acts and not an unintentional insolvency. The case has of course, opened up potential opportunities for lenders to exercise remedies through the non-recourse carve-outs.
Lender’s Dwindling Recourse Remedies
Recent legislative actions and court decisions in Michigan and Ohio shed light on an emerging trend that has diminished Cherryland ’s impact. In March of 2012, Michigan enacted the Nonrecourse Mortgage Loan Act, which made post-closing solvency covenants unenforceable as a basis of a claim on a non-recourse carve-out. Just last month the United States Court of Appeals for the 6 th Circuit applied that statute retroactively in Borman v. Borman . Following Michigan’s lead, in March of 2013, Ohio enacted the Ohio Legacy Trust Act, which contained similar provisions.
Several recent New York cases have also limited the effect of non-recourse carve-outs that would not traditionally be considered “bad boy” acts. In December of 2013, in the unreported decision of U.S. Bank National Association v. Rich Albany Hotel, LLC , the New York Supreme Court held that recourse triggers could not be premised on non-payment of the loan debt but only on non-payment of debts to third parties. In that case, U.S. Bank argued that the borrower’s failure to pay its debt service payments under the loan was a triggering event because the loan documents included a carve out if the borrower “shall generally not be paying its debts as they become due.” The court held that to include the loan itself within the debts referred to in that provision would nullify the non-recourse structure of the loan and, as such, the borrower’s failure to pay its debt service payments on the loan did not trigger the non-recourse carve-out. Similarly, in April of 2014, the United States District Court for the Southern District of New York, in CP III Rincon Towers, Inc. v. Cohen, decided that involuntary liens imposed upon a borrower did not trigger a recourse carve-out, notwithstanding a contrary provision in the guaranty. The District Court held that the word “transfer” in the loan documents was intended to refer only to voluntary transfers, notwithstanding a different provision in the guaranty that would have triggered the recourse carve-out for involuntary liens.
Note that because loan documents are often governed by the law of the state in which the lender resides, these developments can affect borrowers across the country and not only in Michigan, New York, and Ohio.
What It All Means
In two words, increased risk . Loan quality is going down while the volume of loans is going up. At the same time, lenders may not be able to rely on the same recourse remedies that they did in 2011, or at least not with the same confidence. Of course, the recovering commercial real estate market could help buffer some of this risk. Even so, lenders and investors should take notice of the trend and be on the alert for updates in this area, and evaluate the impact of these developments in their underwriting and purchasing decisions.