Daily Development forWednesday, July 5, 2007
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

Another Jack Murray contribution - as edited, of course.

MORTGAGES; NOTES; NONRECOURSE; ENFORCEABILITY OF CARVEOUTS: First reported decision in which a court has enforced recourse of "bad boy" carveouts in a nonrecourse securitized loan.

Blue Hills Office Park, LLC v. J.P. Morgan Chase Bank, 477 F. Supp. 366 (D. Mass. 2007)

The borrower appealed a decision of the town board of zoning appeals that allowed the adjacent property owner to erect a parking garage on its property. The borrower subsequently withdrew the appeal in return for a cash payment of $2 million, without notice to or approval of the lender. The court ruled that the settlement was part of the "mortgaged property," which, as described in the loan documents, included "[a]wards or payments . . . with respect to the Premises . . . for any . . . injury to or decrease in value of the Premises." The nonrecourse provision in the mortgage (which obviously was carefully negotiated) specifically provided that if the borrower diverted funds from the mortgaged property that belonged to the lender, the borrower's and guarantors' liability would become recourse for the entire loan balance of the loan (certain other borrower acts and defaults, such as fraud, intentional physical waste, or removal and disposal of mortgaged property after default, would

 result only in limited liability of the mortgagor and guarantors for actual damages).

The court held that when the borrower settled a zoning appeal against the adjoining landowner (in this case for $2 million) and failed to disclose the settlement to the lender or seek its consent (as required by the mortgage loan documents) and diverted the funds to itself, the borrower (and the guarantors) lost their nonrecourse protection and became liable for the full amount of the loan and related costs (upwards of $20 million), and not simply the restitution amount of $2 million. (The high bidder at the lender's foreclosure sale, instituted after the borrower defaulted on its loan payments, was a single-purpose entity created by the lender, which later sold the property to a third party.)

The court castigated the attorneys for the borrower and the guarantors. Apparently these attorneys assumed that since litigation in this area is so rare, they could assume a very aggressive litigation posture and the matter would be worked out later to their satisfaction. But the moral of the Blue Hills case is that carveouts to nonrecourse loans mean what they say and will be strictly enforced (even if the borrower and guarantors rely on advice to the contrary from their counsel)! (See John C. Murray, "Carveouts to Nonrecourse Loans: They Mean What They Say!" http://www.firstam.com/listReference.cfm?id=5574.)

After the court's judgment, the guarantors fired their attorneys and put them on notice of a malpractice claim. The borrowers and guarantors subsequently appealed from the judgment, but the appeal was dismissed and $17.25 million (98.5% of the judgment) was paid to the lender to settle the case. (Blue Hills Settlement and Release Agreement.) As Judge Young so succinctly stated during the trial, "don't mess around with the collateral. . . . "[I]f you mess around with the collateral, that's when you'll be liable for the entire amount of the deficiency." 10/13/06 Blue Hills Case Trial Transcript at 47.

The court also found a second violation of the nonrecourse carveouts – the borrower had violated single-member and single-purpose-entity requirements in the loan documents by commingling the $2 million settlement payment with monies of its member and by failing to maintain a participating independent director. Although the borrower had named as the "independent director" an individual who once worked as a paralegal or secretary at the borrower's law firm, the court stated that "it is clear that she did not participate in the management of Blue Hills in that capacity," Id. at 383, and that she "was not involved in the discussions concerning the $2,000,000 settlement payment." Id. Therefore, the court held, the borrower had violated a specific mortgage covenant because it had failed to "cause there to be" an independent director and had failed to maintain its status as a single-purpose entity. See In re Kingston Square Associates, 214 B.R. 713, 721 (Bankr. S.D.N.Y. 1997) (finding fo

r plaintiffs partially on basis that "[the "independent director"] seems not to have taken any interest at all in the properties. He testified that as a director he never reviewed any documents regarding any of the Debtors including rent rolls, judgments, or state court decisions").

Reporter’s Comment 1: Since the mid-1980's, lenders have been qualifying and restricting nonrecourse provisions in commercial real-estate loans by making exceptions for certain "bad acts" by borrowers. In recent years, many lenders have expanded the scope of such "carveouts" to include risks of exposure to the property's economic deterioration or neglect. Some nonrecourse provisions provide that the borrower is liable for the specific damages resulting from the violation or breach of a carveout, while others state that the entire loan becomes recourse tgthe borrower if anygf (or certain of) the excepted acts occurs. In some cases the exceptions have virtually swallowed the rule; i.e., the clause is drafted so that the borrower has personal liability for virtually all defaults except the failure to pay the principal and interest due on the loan. There has been relatively little case law regarding the validity and enforceability of such carveouts, and these provisions have rarely

been challenged by borrowers. However, recent court decisions such as Blue Hills, supra, and Heller Financial, Inc. v. Lee, Case No. 01 C 6798, 2002 U.S. Dist. LEXIS 15183 (N.D. Ill., August 16, 2002) (where the court rejected a challenge to the enforceability of a specific exception to the nonrecourse provision in the note executed by the borrower) may provide some needed guidance in this area.

Reporter’s Comment 2: The court summarily rejected the borrower's bogus lender liability claims (alleging that the special servicer had wrongfully denied its request to access reserve accounts to make the loan payments and real estate tax payments, and that the lender had breached the "implied covenant of good faith and fair dealing" by failing to meet with the borrower in an effort to work out the loan). The court held that the lender was perfectly within its rights in failing to meet with the lender after the occurrence of an acknowledged loan default and was under no obligation to transfer funds from special reserve accounts to make scheduled payments of principal and interest on the loan.

Reporter’s Comment 3: As noted above, the court endorsed an expansive definition of "mortgaged property," as broadly defined in the mortgage's granting clauses, to include non-real estate assets only indirectly related to the mortgaged real estate, i.e. a lawsuit brought by the borrower and its settlement proceeds. But might this type of action also be characterized, under somewhat similar circumstances, as a security interest in a tort claim under Article 9 of the Uniform Commercial Code? Could there be a potential conflict? See Prof. Daniel Schecter, Proceeds Resulting from Settlement of Zoning Appeal Are Part of Mortgaged Property and Belong to Mortgage Lender. Blue Hills Office Park LLC vs. J.P. Morgan Chase Bank, 2007 comm. fin. news 26 (April 2, 2007) (Comment):

I wonder whether under a different set of facts, the characterization of the settlement proceeds as "mortgaged property" might create a potential priority conflict with Article 9 of the UCC, which (under some circumstances) permits secured parties to take security interests in commercial tort claims. Suppose, for example, that a borrower's shopping center is injured because a neighboring entity is emitting unpleasant odors thus constituting a nuisance. If the borrower brings a suit against the neighbor on a nuisance theory, that tort recovery might belong to the Article 9 lender with a security interest in the borrower's commercial tort claims. At the same time, the same recovery might be characterizable as part of the "mortgaged property" belonging to the mortgage lender. (Even if there were a potential conflict, the best solution would be a timely intercreditor agreement between the two lenders.)

Reporter’s Comment 4: The issue may well be the distinction between the grant of a security interest and the perfection of the security interest in the collateral. The granting clause in a mortgage may be sufficient for attachment as meeting the security interest requirement of 9-203(b)(3)(A) of the UCC. But the filing of a mortgage cannot perfect a security interest in personal property other than fixtures. For example, the granting clause in a mortgage could not define trucks located on the property as "mortgaged property," then try to perfect a security interest in certificated goods through recordation of the mortgage. The correct reasoning undoubtedly is that "mortgaged property" must ultimately be actual real property (or fixtures). A UCC filing clearly would be necessary where a mortgage loan is secured by equipment, personalty or contract rights. Although a mortgage that also constitutes a fixture filing will create and perfect a valid security interest in the fixtures, t

here is a chance that what the secured party believes are "fixtures" are in fact just equipment. Section 9-102(a)(4) of the UCC (which defines fixtures) should be studied carefully. If the described collateral is not in fact "fixtures," then a fixture filing -- or a mortgage that serves as a fixture filing -- will not perfect a security interest in the collateral. Comment 6 to UCC 9-503 states, in part:

“In some cases, it may be difficult to determine whether goods are or will become fixtures. Nothing in this Part prohibits the filing of a "precautionary" fixture filing, which would provide protection in the event goods are determined to be fixtures. The fact of filing should not be a factor in the determining whether goods are fixtures.”

Therefore, when in doubt it may make sense for the secured party to take the conservative approach and also file a regular UCC financing statement in the "location" of the debtor, with a collateral description of any collateral that may potentially be deemed to be personal property.

Editor’s Comment: The editor believes that the lesson here is that “bad boy” clauses may mean what they say, and that therefore lawyers counseling borrowers and guarantees should so assume.  But the editor is not convinced that the courts have totally abandoned the notion that provisions creating a penalty for default are not enforceable. 

Consider, for instance, if the sole violation in this case had been the appointment of the paralegal as the independent director.  Assume that, after the lender complained about this appointment (which of course was a callous disregard of the spirit of the independent director requirement), but before any ill consequences had occurred, the borrower agreed to appoint a true independent director.  Later, if a default occurs, would the court conclude that the “bad boy” clause operated to destroy the nonrecourse protection?  The editor believes that in such cases - harmless or relatively harmless violations or cured violations - even deliberate and callous - the courts may view the loss of nonrecourse protection as a penalty.  He’s certainly not willing to assume otherwise after just one case. 

The Reporter for this case was Jack Murray of the Chicago office of First American Title Insurance Company. 

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