Solvency Covenants in Non-Recourse Loans on Shaky Ground?

June 14, 2013 Stephen Aron Benson Real Estate Law

A Michigan case in which a solvency covenant within the “bad boy” provisions of a non-recourse loan was ruled unenforceable could affect lender lawsuits in other states

Many commercial real estate loans made in the past 15 years or so – especially those that became part of commercial mortgage-backed security (CMBS) pools – were non-recourse (i.e., no personal liability, limited to a foreclosure remedy upon default) on their face, but usually came with a set of non-recourse carve-out provisions or “bad boy” clauses.

Essentially, the lender would be saying to the borrower and any guarantor of the loan: “Okay, the loan has no personal liability, except that if you do something ’bad,’ we reserve the right to come after you personally.”

When the non-recourse/bad boy approach began, the list of carve-outs was fairly short. For example, burning down the building and absconding with the insurance proceeds, or banking the rents and not paying the debt service, were among the earliest provisions. Over the years, the creative attorneys on Wall Street and in Charlotte kept expanding those provisions, until borrowers sometimes began to wonder whether the loan was truly non-recourse (hey, we’ve been on both sides of these deals!). In our view, as the list grew longer, the chance that a court would decline to enforce one or more of the provisions grew larger. The bad boy covenant for the failure to maintain status as a single-purpose entity or for the borrower to resort to bankruptcy protection always seemed to be potentially problematical.


The series of Michigan Cherryland court decisions (Wells Fargo Bank, N.A. v. Cherryland Mall Ltd. Partnership) have been an interesting adventure, with a loan default triggering the bad boy provisions and making the loan a potentially recourse loan. In the Cherryland matter, the borrower defaulted on a non-recourse CMBS loan secured by a shopping mall when it failed to make the loan payments. The lender foreclosed and then sued the borrower and the guarantor for the loan balance deficiency of approximately $2.1 million on the basis that the borrower triggered one of the non-recourse carve-out provisions (essentially making the loan a recourse loan) by failing to remain solvent when the value of the property dropped below the outstanding loan balance. The solvency covenant was likely buried in a separate document provision relating to single-purpose entity issues.

The trial court held in favor of the lender, Wells Fargo, awarding an approximately $2.1 million deficiency judgment, plus attorneys’ fees and costs. On appeal, the Michigan Court of Appeals upheld the judgment, reasoning that, although its interpretation of the loan documents “… seems incongruent with the perceived nature of a non-recourse debt […] it was not the court’s job to […] save litigants from their bad bargains.”

Many commentators felt that this issue (i.e., the solvency of the borrower and the value of the property) was simply a market risk issue and not a “bad act” on the part of the borrower – in effect turning a non-recourse loan into a recourse loan through no “bad act” of the borrower.

Following the Michigan lower court decisions (given the abbreviated analysis just given you, and perhaps for other reasons), the Michigan legislature passed the Nonrecourse Mortgage Loan Act (NMLA), which, in effect, retroactively made the use of a post-closing solvency covenant as a non-recourse carve-out unenforceable as an unfair and deceptive business practice and against public policy. The Michigan Supreme Court subsequently remanded the case to the Court of Appeals for reconsideration in light of the passage of the NMLA. Back at the lower court, Wells Fargo argued that the guarantor had waived that defense, that the Act was unconstitutional, and that it should not be applied retroactively in any event, and made other public policy arguments as well.


At least so far, Wells Fargo has lost all of its arguments, and that particular provision (i.e., insolvency or the loss in value being a bad boy act) seems to be unenforceable, at least in Michigan. We are not aware that other states have legislatively addressed this issue, but one might suppose that, in light of the recent “great recession” – where values commonly dropped below mortgage values through no fault of the borrower – this issue is being litigated all over the country.

In states, such as Arizona, that do not have the type of statute enacted in Michigan, the borrowers and the guarantors will be relying on public policy positions. We are not aware of any pending cases in Arizona discussing this issue but wouldn’t be surprised if that occurred.