Daily Development for Friday, August 6, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu

This is the second half of Jack Murray’s essay on this case (with my amendments. Ed.)

MORTGAGES; NON-RECOURSE; “CARVE OUTS;” “BAD BOY” CLAUSES: Louisiana District court upholds provision in securitized loan transaction stating that borrower will lose benefit of non-recourse protection if it alters its corporate structure so as to lose its “single purpose” status.

LaSalle Bank v. Mobile Home Properties, LLC, 2004 U.S. Dist. LEXIS 14401 (D. La., July 27, 2004)., discussed further under the heading: “Mortgages; Prepayment; Prepayment Premiums; Acceleration Trigger.”

Mobile Hotel executed a promissory note to the LaSalle Bank (as trustee for investors in the loan, which had been securitized), secured by a mortgage on a hotel in Mobile, Alabama, which was operated as a Ramada Inn. Mobile Hotel subsequently delegated the obligations under the loan to Mobile Hotel Properties ("MHP"), a limited liability company. To induce LaSalle to agree to the delegation, Columbus Hotel Properties ("Columbus,") as the sole member of MHP, guaranteed the loan.

Columbus then proceeded to make unauthorized cash advances (eventually exceeding $4 million, evidenced by an unsecured promissory note) to MHP, and ceased making mortgage payments under the loan. Making a bad situation worse, MHP then proceeded to amend its operating agreement (again in violation of a specific mortgage covenant) to provide that MHP was no longer a single-purpose entity and could engage in "any lawful activity." Having seen enough, LaSalle commenced a foreclosure proceeding (which was briefly interrupted by MHP's bankruptcy, which was subsequently dismissed).

LaSalle completed its foreclosure of the hotel - with the express consent of MHP and Columbus - with a winning credit bid of $6.9 million, and gave MHP a credit for this amount. (LaSalle eventually resold the hotel for $2.1 million.) LaSalle then demanded payment of a deficiency of approximately $3.1 million, which included "a yield maintenance premium and defeasance fee totaling $2,161,484.00." (The remaining amount included late fees, default interest, attorney's fees, and other costs and expenses.) [The defeasance fee issue is discussed in another item, as indicated above.]

MHP and Columbia sought a declaratory judgment that the change in MHP’s LLC articles of organization was not material and did not trigger a "full recourse" obligation under the loan documents as provided in the loan documents as a result of the unauthorized amendment.

The court ruled that although the loan was non-recourse to MHP, the carveout in the mortgage (and note) providing that the loan would become fully recourse to MHP if it failed to maintain its status as a single purpose entity was fully enforceable, as the result of MHP's breach of this covenant. The court ruled that the carveout language was specific and unambiguous (and not just "boilerplate"), and that the fact that MHP continued to "operate" as a single purpose entity was irrelevant. (The court found that MHP's motive for making the change was also irrelevant.) According to the court, "the language of the mortgage means what it says." Although LaSalle alleged that MHP had also breached several other warranties and covenants under the loan documents, the court found it unnecessary to discuss these additional violations because of its holding that the loan had become fully recourse because the breach of the "single purpose entity" covenant alone was sufficient to trigger the full -recourse provision of the loan documents.

Finally, the court summarily rejected the argument of Columbus, as guarantor of the loan, that it should not be held liable because it did not receive notice of MHP's default. The court pointed to the language in the Guaranty executed by Columbus whereby it "irrevocably and unconditionally" guaranteed the debt and all of MHP's obligations thereunder, which the court reasoned necessarily included MHP's obligation to maintain its SPE status. The further noted that the Guaranty stated that Columbus waived notice of any default or breach my MHP, and contained no right on the part of either MHP or Columbus to receive notice of a breach by MHP that would trigger the full-recourse obligations of MHP or Columbus.

Reporter’s Comment 1: The court's ruling in LaSalle on the borrower's violation of the SPE covenant is instructive, and comforting to CMBS lenders. The court in LaSalle noted that, "the defendant entity was originally formed for the purpose of acquiring, owning and operating the hotel property that secured the loan." The court also noted that there were "fourteen separate conditions, representations, covenants and warranties that describe and define the scope and limits of the single purpose entity and separateness requirements." The court had no trouble finding such covenants fully enforceable, including the language that provided for full recourse liability for breach of these covenants. The court noted pointedly that the change by MHP to the SPE language in the Articles of Organization was not "innocuous," regardless of the motives of MHP or its actual operation as an SPE after the change.

In recent years, many commercial mortgage lenders (especially in connection with multi-state, securitized, and structured-financing transactions) have required that the borrower be constituted as an independent bankruptcy-remote SPE, that is unlikely either to become the subject of a bankruptcy or to be substantively consolidated if a bankruptcy of a related person or entity occurs.

The SPE is often an intermediate holding company, which is separate from the borrowing entity that obtains the first-mortgage loan. To demonstrate the separate nature of the entities, a "non-consolidation" opinion is required along with assurance that the general partner (or member, if the borrower is a limited liability company) of a mortgage borrower is not liable for the debt.

Lenders and credit-rating agencies commonly require the following covenants in SPE organizational and loan documents:

(1) Prohibition against any business activity other than operation of the property and against owning any other property.

(2) Prohibition against any merger with another entity or acquisition of any subsidiary.

(3) Prohibition of any other debt other than lease financing, except for ordinary trade debt (fully subordinate financing may be permitted if the credit rating is not impaired).

(4) Separate SPE books and records, stationery, bank accounts, tax returns, and office space.

(5) Prohibition against contracts with affiliates, unless arms-length.

(6) Prohibition against commingling of assets with affiliates.

(7) Prohibition against the guarantee (or the pledge of assets to secure) the debt of an affiliate.

(8) "Independent director" approval of major decisions such as a bankruptcy filing, a change in the SPE organizational or governing documents, and transactions with affiliates.

(9) Disclosure, of any transfer of the assets from the borrowing entity to a new SPE, to the transferor's other creditors.

(10) A "lockbox" arrangement to monitor cash disbursements.

As mentioned above, in many current forms of real estate financing, a lender commonly requires that the borrower or developer be an SPE with no assets or operations other than the real estate project providing the security for the loan (usually a pass-through entity such as a business trust, special-purpose corporation, limited partnership, or limited liability company) is formed. The SPE then takes title to the property, either directly or by assignment of the purchase contract, constructs the building, and leases the property to the lessee/corporate user or its subsidiary.

Reporter’s Comment 2: The court in LaSalle was also correct in its ruling on the enforceability of the guaranty obligation by Columbus, finding that the Guaranty also "means what it says," i.e., the guarantor should not be able to weasel out of its obligations by ignoring the clear language of the guaranty agreement. As the court stated, "It cannot be said that the defendants were naVve or unsophisticated borrowers."

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