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U.S. District Court Decision Points Out Potential Risks in Non-Recourse Loans
September 27, 2007
Borrowers and Guarantors Urged to Negotiate Clear, Defensible “Bad-Boy Provisions” That Limit Liability
Earlier this year, in a decision handed down in favor of a commercial mortgage lender, the United States District Court for Massachusetts offered a clear warning to careless borrowers. The case, Blue Hills Office Park LLC v J.P. Morgan Chase Bank (477 F.Supp 2d 366 (D.Mass. 2007), demonstrates:
- the importance of carefully negotiating the terms of non-recourse loans, and
- the value of limiting borrower and guarantor liability — and lender recourse — to appropriate levels and specific situations.
This decision is particularly important, since there are relatively few cases that deal with the enforceability of “non-recourse carveouts” (also known as “bad-boy carveouts”) and the lender’s ability to take advantage of overly broad terms to accelerate foreclosure and recover the full amount of a loan.
An Overview of the Case
In 1999, Blue Hills Office Park LLC (“Blue Hills”) negotiated and closed a $33 million non-recourse mortgage loan with Credit Suisse First Boston Mortgage Capital LLC (“Credit Suisse”). The loan was guaranteed by William Langelier and Gerald Fineberg, and secured by a first trust on an office building; J.P. Morgan Chase Bank (“J.P. Morgan”) was the trustee for the investors in the securitization trust that held the mortgage. The terms of the loan included typical carveouts from the non-recourse provisions, covering acts such as waste, fraud and other recourse triggers.
Blue Hills subsequently defaulted on the loan by failing to make two monthly payments of principal and interest. It also failed to notify the lenders of, or to obtain prior consent for, the settlement of a zoning dispute involving a neighboring building. Without disclosing the transaction to the lender, Blue Hills transferred the $2 million dollar settlement payment into an account held by the guarantors’ lawyers rather than into one of its own accounts.
When Blue Hills requested that the lender make the missed payments from the loan reserve, the lender refused. Without giving any notice or opportunity to cure, the lender accelerated the debt, foreclosed on the property, and commenced pursuing a deficiency claim of over $10 million.
Blue Hills sued J.P. Morgan and Credit Suisse, claiming that the lenders had breached the terms of the loan, had foreclosed wrongfully and had violated the Massachusetts Consumer Protection Act, among other claims. The lenders countersued, claiming that Blue Hills and two of its principals had breached the loan contract and some of the "bad boy" carveouts, and had violated an implied covenant of good faith and fair dealing. The lenders also claimed that the guarantors had made representations that violated Massachusetts General Laws.
The District Court found in favor of the lenders on all counts. Of specific interest to borrowers, the Court ruled that Blue Hills had failed several key obligations under the loan documents: the duty to have an independent director (the Blue Hills “director” was a former secretary at one of the borrower's law firms and did not participate in the business) and the duty not to commingle assets (which occurred when the borrowers deposited the $2 million settlement into the account held by the guarantors’ lawyers).
The Court found that the terms of the non-recourse mortgage loan were stated broadly enough that they allowed the lender to claim immediate default without requiring notice or an opportunity to cure. The language of the agreement also enabled the lender to pursue the full amount of the debt, as opposed to limiting recourse to the significantly lesser amount of damages or losses created by the specific breach.
“Non-Recourse” Does Not Mean “Without Recourse”
The decision in Blue Hills makes it clear that non-recourse loans do not mean that lenders are without recourse. In fact, when loan terms are written with overly broad carveout language, the unintended consequence is often that lenders have incredible latitude in pursuing foreclosure and seeking deficiency damages associated with alleged defaults.
Borrowers can attempt to mitigate these risks in several ways:
- Negotiating and documenting exceptions to non-recourse provisions ("bad-boy carveouts") in terms that describe potential causes of default clearly and specifically.
- Seeking to limit “springing guarantees” to material and intentional acts and "bad boy" carveouts as opposed to negligence, inadvertent mistakes, and the like.
- Limiting the recourse liability of guarantors under "springing guarantees" and "bad boy" carveouts to include only damages proximately caused by the act prohibited by the breached guarantee or liability, as opposed to triggering guarantor liability for entire debt or deficiency.
- Negotiating notice and cure periods that allow the greatest opportunity to take corrective action.