Daily Development for Monday, September 14, 2009
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Husch Blackwell Sanders
Kansas City, Missouri
dirt@umkc.edu

MORTGAGES; GUARANTIES; CARVE-OUTS; LIQUIDATED DAMAGES: Once a
Non-Recourse Carve-Out is triggered, it doesn't matter that is cured or
that its occurrence in the first place had no effect on the lender; the
borrower and each guarantor otherwise protected from liability for the
borrowed amount become liable for the entire outstanding loan; and the
amount thus collectable will not be characterized as liquidated damages.
CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC,
A-6307-07T2, 2009 WL 2431530. (N.J. Super. App. Div. 2009); August 11,
2009

The Appellate Division of the New Jersey Superior Court was asked
"whether a non-recourse carve-out clause in a mortgage note, providing
that [the borrowers] are personally liable to [the] lender for damages
resulting from violation of a particular loan obligation, is a
liquidated damages provision, and if so, whether it constitutes an
unenforceable penalty." A $13,300,000 mortgage loan was secured by a
guaranty of principal executed by the borrower's principals. Although
the loan was a non-recourse obligation, and the lender could not seek
recovery against the borrower or the guaranteeing principals in the
event of default, the note "contained a carve-out clause, providing that
the debt would be fully recourse if the borrower failed to obtain the
lender's prior written consent to any subordinate financing encumbering
the property." Under the guaranty agreement, the guaranteeing principals
were liable to the same extent as would be the borrower under that
provision.

During the term of the loan, the borrower obtained $400,000 in
subordinate financing secured by a second mortgage on the property
without first obtaining its first lender's consent. This triggered the
non-recourse carve-out provision of the loan documents and made the loan
fully recourse as to both the borrower and the guarantors. The $400,000
mortgage was satisfied seven months later, but was not discharged of
record. Beginning eighteen months later, the borrower stopped making
payments on its first mortgage loan. This triggered an uncontested
foreclosure action.

The property was sold by the sheriff's sale, leaving a deficiency of
slightly over $5,000,000. Based on the subordinate financing default,
the lender sought to collect this deficiency from both the borrower and
the guarantors. This was met with the argument that since the lender
"was not harmed by the added encumbrance on the property, the breach was
only related to any damages suffered by [the lender] and therefore the
non-recourse carve-out clause extracted an unenforceable penalty." The
lower court rejected this argument, "finding that the damages sought by
[the lender] were neither speculative nor estimated, but actual, ('equal
to the outstanding loan balance and nothing more') and fair, ('[t]he
defendants hav[ing] received the benefit of their bargain by receiving
and retaining the loan proceeds')."

The borrower and the two guaranteeing principals appealed, mainly
arguing "that the non-recourse carve-out clause [was] unenforceable as a
liquidated damages provision because the penalty extracted from the
borrower's breach of a covenant not to further encumber the mortgaged
property [bore] no reasonable relationship to any harm suffered by the
lender." This argument failed on appeal. Rejecting the arguments raised
by the borrower and its two principals, the Appellate Division first
cited the well-settled principle that a court's function is to enforce
contracts as written "and not to make a better contract for either of
the parties." It found the non-course language to be plain and capable
of legal construction, and no reason to avoid the clear meaning of that
language. Further, it felt that the applicable provision was
unambiguous.

The Appellate Division, and the lower court below, characterized this as
a "commercial transaction negotiated between business entities with
comparable bargaining power." It opined that the borrower and the
guarantors knew and agreed to the carve-out provision and knew that it
was a material term in acquiring the loan. On that basis, the Court held
the obligated parties "to the plain and clear language they chose."

The Court held that this carve-out clause was "not a liquidated damages
provision, much less an enforceable penalty. A clause is a liquidated
damages provision if the actual damages from a breach are difficult to
measure and the stipulated amount of damages is 'a reasonable forecast
of the provable injury resulting from [the] breach.'" Driving to the
heart of the matter, the Court further held that "[n]on-recourse
carve-out clauses like the one here are not considered liquidated
damages provisions because they operate principally to define the terms
and conditions of personal liability, and not to affix probable damages.
Generally speaking, because non-recourse loans may create issues of a
borrower's motivation to act in the best interest of the lender and the
lender's collateral, 'lenders identified defaults that posed special
risks and carved them out of the general nonrecourse provision.'"

In other words, "the non-recourse nature of [such a] loan operates as an
exemption, the carve-outs exist to implicate personal liability."

Another important reason behind the Court's decision was its belief that
the carve-out clause provided only for actual damages. This differed
substantially from the typical liquidated damages provision in that the
amount of damages is not fixed at the beginning of the loan, but reflect
only the actual damages incurred by the lender.

Lastly, it didn't matter to the Court that the borrower "eventually
cured the very breach that triggered" the personal liability and that
"no harm accrued to [the lender] as a result thereof." Even though the
encumbrance was only temporary, the borrower's action "had the potential
to affect the viability and value of the collateral that secured the
original loan." Further, the Court mused that it could not say with "any
certainty that the subordinate financing in this case was entirely
unrelated to [the] ultimate default." More formalistically, the Court
opined that "the fact that such potential may not have actualized [did]
not diminish the breach of obligation nor vitiate its contracted-for
consequences."

Reporter's Comment 1: WOW, wasn't that a surprise. Let's assume the
person negotiating the Non-Recourse provisions bargained intensely for a
provision that the borrower and guarantors would only be liable to the
extent the breach of the non-recourse provision resulted in a loss to
the lender.

Reporter's Comment 2: The court spent a great deal of time rejecting
claims made by the borrower and the guarantors that allowing the lender
to collect the entire debt and not be limited to whatever sale of the
property would realize would be an unenforceable penalty. The lender
only agreed to waive its claims to collecting the deficiency if certain
conditions were met. Those conditions were not met once the borrower
availed itself of secondary financing. Thus, the borrower simply didn't
qualify for the deficiency waiver.

Reporter's Comment 3: Did whoever undertook (or should have undertaken)
to have the second mortgage satisfied of record realize the consequences
of failing to do so. It is likely that the lender's foreclosure search
would not have reported the mortgage had it been satisfied.

Reporter's Comment 4: According to the New Jersey court, while this was
a matter of first impression in that state, courts in other states have
uniformly held that non-recourse carve-out provisions are valid and
enforceable. See: Blue Hills Office Park LLC v. J.P. Morgan Chase Bank,
477 F. Supp 2d 366 (D. Mass. 2007); First Nationwide Bank v. Brookhaven
Realty Assocs., 223 A.D.2d 618 (N.Y. App. Div); Prince George Corp. 58
F.3d at 1041 (4th Cir. 1995).

Editor's Comment 1: The editor believes that the reporter was tongue in
cheek with his "wow" in the first comment.  These were big boys who
signed clear waivers of non-recourse protections.  The nature of the
default, as the court points out, was such that a significant violation
might endanger the health of the company, and therefore it's ability to
repay the senior debt.  But the default itself was insignificant and
likely create such endangerment. 

Editor's Comment 2: Although one may argue about the exact defnition -
the clause, at least as applied - was a "bad boy" clause, and we have a
relatively clear court holding viewing such a clause as not a penalty
and not subject to liquidated damages clauses.  That's news. 

The Reporter for this item was Ira Meislik of the New Jersey Bar.


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