Daily Development for
By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of
Of Counsel: Blackwell Sanders Peper Martin
Kansas City,
prandolph@cctr.umkc.edu
The reporter for this item is Jack Murray of First American
Title Insurance. I've edited the report
heavily, however. I do include two of
Jack's comments interspersed with my own, and after this post will post an
article by Jack dealing generally with some of the issues discussed here.
MORTGAGES; DEFICIENCIES; NON-RECOURSE CLAUSES;
CARVEOUTS: Carveout
provision imposing general deficiency liability when specific, quantifiable
injuries to security occur is enforceable, and should not be evaluated as a
liquidated damages clause.
Heller Financial, Inc. v. Lee, Case No. 01 C 6798, 2002
Lee and VanWhy, along with others,
formed a
The Note contained a nonrecourse
provision, which provided that no maker would be personally liable to pay the
Loan or to perform any obligation under the Loan documents, and that the holder
of the Note would look solely to "the Assignments and any other collateral
heretofore, now, or hereafter pledged by any party to secure the Loan." The
Note further provided, however, that notwithstanding the nonrecourse
nature of the Note, each maker (except for one individual maker, Robert Ahnert) would be personally liable, jointly and severally,
for repayment of the Loan "and all other obligations of Maker under the
Loan Documents" in the event of any breach of certain covenants in the
Loan Agreement "pertaining to transfers, assignments and pledges of
interests and additional encumbrances in the Property, the Partnership or the
Corporation."
One of the specific covenants in the Note triggering carveout liability stated that each of the makers would
not, without the prior consent of the lender, "grant or permit the filing
of any lien or encumbrance on the Project, the Collateral or the general
partnership interest of the Corporation in the Partnership," other than
those created by the senior loan documents and certain personal property
leases; provided that Royal Plaza could contest the validity or amount of any
asserted lien if (1) it gave prior written notice to Heller, (2) such contest
stayed the enforcement of the contested lien, and (3) the contested lien was
bonded or insured over by the title insurance company or Royal Plaza posted
security in a manner acceptable to Heller.
After the purchase of the Hotel by Royal Plaza, six liens
(in the form of tax liens and mechanic's liens) were placed against the Hotel,
none of which was consented to by Heller or of which Heller was notified, and
none of which was bonded over or insured by the title insurance company. As a result of these liens, Heller declared a
default under the Loan and informed Lee, VanWhy,
Lee and VanWhy argued that they
were not responsible for, and had no knowledge of, the liens placed against the
Hotel because it had been managed "with the knowledge and agreement of
Heller" by a separate management company unrelated to
The court stated that under Illinois law (which all the
parties agreed governed the loan transaction), a loan would be deemed to be nonrecourse where the borrower "is not personally
liable for the debt upon default, but rather, the creditor's recourse is solely
to repossess the property granted as security for the loan" (citations
omitted). Under this definition, the
court ruled that the loan from Heller was a nonrecourse
loan. The court noted, however, that
lenders commonly create certain carveouts to nonrecourse provisions in loans to "provide the
protection that lenders require, personal liability, to insure the incentive to
repay the loan and maintain the viability of the loan."
The court concluded that the carveout
language was unambiguous and clearly provided for personal liability on the
whole loan upon the occurrence of any of the enumerated exceptions to nonrecourse, including the placing of liens against the
Hotel. The court noted that the carveouts had been negotiated and agreed to by all parties,
as evidenced by the fact that one of the makers of the Note, Ahnert, had been exempted from any personal liability for
violation of the carveouts. As the court succinctly
summarized, "[i]t is painfully clear that the nonrecourse loan from Heller to
The court noted that because the Loan was secured by the
equity interests of the entities that purchased the Hotel and not the Hotel
itself, Heller was especially concerned about the operation of the Hotel due to
the direct impact on the value of the collateral securing the Loan.
Lee and VanWhy argued that the carveouts were actually liquidated damages provisions and
were unenforceable as penalties. They
pointed out that the "trigger" for the invocation of the carveout was the imposition of liens in unspecified amount
against the hotel, while the consequence was exposure to a significant
liability in connection with a $10 million loan. The court rejected this argument, finding
that the section of the Note dealing with the nonrecourse
carveouts was not a liquidated damages provision
because it provided for only the recovery of actual damages incurred by Heller,
i.e., the amount of the unpaid Loan indebtedness at the time of the default.
Therefore, according to the court, "[t]his amount is the actual damages to
Heller based on Lee and VanWhy's breach. Since [the carveout section of the Note] involves actual damages it
cannot be a liquidated damages provision."
Reporter's Comment 1: With respect to the argument that carveouts from nonrecourse
provisions are unenforceable liquidated damages provisions, the court stated
that, at least in
The six liens placed on the Hotel property were for an
aggregate amount of approximately $820,000, and occurred over a five-month
period of operation of the Hotel. Although the amount of the unpaid balance due
on the Loan at the time of default is not stated in the court's opinion, the
court noted that as a result of the violation of the covenant not to place
liens against the property, there had been a public sale of both the Hotel and
"the equity interest in Royal Plaza and Maddlee,
which had been pledged to Heller as security for the Heller loan," Even
though Heller received proceeds from the sale covering a portion of the debt,
it is conceivable that the "actual damages" of approximately $820,000
(which clearly were quantifiable) were in fact less than the outstanding
balance due on the Loan after application of the sale proceeds.
Editor's Comment 1: In response to Jack Murray's comment
above, it was also possible that, due to the circumstances of the foreclosure
sale, the liability of the borrowers would have been considerably greater than
the $820,000. It is not clear that
payment of the $820,000 would have been an acceptable "cure" of the
default once acceleration had occurred and foreclosure was proceeding. Consequently, the borrowers did have a point
that they could be viewed as being penalized.
But the court answers this with the response that the bank's
collateral was only in the equity interest in the hotel, so that the liens
against the hotel itself were not truly "junior" to the bank's lien,
and could in fact have devalued it. This justifies the bank's special concern
here supporting acceleration.
Editor's Comment 2: Note that the consequence of the language
stating that the borrowers would be liable if they "permitted" the
filing of certain liens against the property was that they assumed to
obligation to monitor and prevent those liens from being filed. Of course, the fact that the liens were of
public record did not mean that the borrowers would be notified of them. But, in the view of the court, it was up to
the borrowers to devise a scheme under which they would be notified or
otherwise become aware of and prevent such liens from arising.
Reporter's Comment 2:
It certainly is hard to argue with the court's decision in Heller based
on the facts of the case. However, the precedential
value of this decision may be somewhat limited, at least with respect to the
validity and enforceablity of carveouts
to nonrecourse provisions in mortgage loan documents.
As the court stated, "the loan was secured by the equity interests of the
entities that purchased the Hotel, and not by the Hotel property itself. This
means Heller is concerned with the successful operation of the Hotel since it
affects the value of the collateral that secured the loan. Any lien on the
property compromises the equity interests of
Readers are urged to respond, comment, and
argue with the daily development or the editor's comments about it.
Items in the Daily Development section
generally are extracted from the Quarterly Report on Developments in Real
Estate Law, published by the ABA Section on Real Property, Probate & Trust
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