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A Look at Recourse vs. Nonrecourse Debt
The commercial real estate market has been one of the hardest hit in the current depressed economy. Many issuers of debt that was securitised in the form of commercial mortgage-backed securities (known as CMBS loans) are currently or at the brink of facing payment and/or technical defaults. Most non-recourse CMBS loans require a limited guarantee with respect to specific "non-recourse carve-outs" contained in the loan documents whereby certain "bad boy" acts of the borrower may trigger full or partial recourse liability to the borrower/guarantor. Traditionally, the so-called bad boy behavior has been intentional or willful acts of the borrower that are specifically prohibited by the loan documents. A recent court decision in Michigan's Appellate Court may significantly bolster the CMBS lender's enforcement rights in certain non-recourse carve-outs if followed by other jurisdictions. Taxand US examines the issue of Recourse vs. Nonrecourse Debt by looking at a recent unprecedented court case.
In Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership, the Court of Appeals affirmed a lower court ruling that a non-recourse CMBS loan became full recourse to the guarantor as a result of the borrower's failure to keep the "single-purpose entity" solvent. The court's decision is alarming in this case because the insolvency of the borrower resulted purely from a market decline in the value of the property. Thus, the Court held that external factors unrelated to willful or intentional acts of the borrower may result in full recourse under a non-recourse carve-out guarantee.
Types of "Bad Boy" Carve-Out Provisions
Most non-recourse CMBS loan documents contain carve-out provisions that subject the borrowers and/or guarantors to full or partial recourse liability in the event of certain specifically enumerated "bad boy" acts. In general, there are two different types of non-recourse carve-out provisions:
- Full recourse, in which the guarantor is liable for the entire amount of the debt if the borrower commits certain acts (some examples include filing for bankruptcy protection, transferring the loan collateral without prior lender approval, failure to comply with single-purpose entity requirements in the loan documents); and
- Actual loss recourse, in which the guarantor must reimburse the lender for the actual loss resulting from certain borrower actions (some examples include the failure to pay taxes, the misapplication of insurance proceeds or condemnation proceeds, and the misapplication of rents).
The Cherryland decision highlights the fact that some CMBS borrowers may already be in a full recourse technical default position under their loan agreements. Though it is uncertain whether other jurisdictions will follow the ruling in this case, CMBS borrowers should proactively determine whether there is a lurking risk of default due to the violation of an SPE solvency covenant. To the extent that such an issue can be identified pre-emptively, there may be actions that can be taken to come into compliance prior to a foreclosure by the lender and/or a deficiency judgment.
In addition, any tax planning related to debt-financed property should consider whether any unintended shift of debt from non-recourse to recourse could:
- Result in adverse tax consequences, including a "deemed exchange" or a shift in partnership liabilities resulting in immediate taxation
- Alter the character of income on a transfer of property
- Provide an opportunity to exclude "phantom income" from current taxation under IRC Section 108.