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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