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LOS ANGELES-Hypothetical: Borrower secures a non-recourse loan to acquire a commercial office building and concurrently leases it to a cloud based internet start-up company. The loan is secured only by the real property but is subject to certain “bad boy” exceptions for borrower misconduct (including a stipulated “bad boy” act for the termination of the lease without lender consent). Borrower's principal enters into a full recourse “bad boy” guaranty. Two years into the loan, the tenant goes out of business, ceases paying rent and abandons the property. Borrower subsequently defaults on the loan, files for bankruptcy and assumes that its losses are limited to the lender foreclosing on the property. The lender, however, disagrees, forecloses on the property and sues the guarantor for the deficiency balance.

Is buyer or lender correct?

The answer is that it depends. Two state court decisions, one in California and one in Michigan, have reached different conclusions on how and when limited recourse guarantees will be interpreted as full recourse. 

California's Approach:

In GECCMC 2005-C1 Plummer Street v. NRFC NNN Holdings, 204 Cal.App.4th 998 (March 29, 2012), as modified on denial of rehearing (April 30, 2012), the California Court of Appeal, when presented with analogous facts, agreed with the buyer.

In its decision, the Court of Appeal analyzed the applicability of two statutes from the California Civil Code.  Section 1951.2(a) provides that “if a lessee of real property breaches the lease and abandons the property before the end of the term....the lease terminates.”  Section 1951.4(b) states that “[e]ven though a lessee of real property has breached the lease and abandoned the property, the lease continues in effect for so long as the lessor does not terminate the lessee's right of possession.”

Concluding that Section 1951.2 did not apply, the Court of Appeal relied upon the express language from the lease indicating that the lessee had no right to terminate the lease for any reason.  Relying instead on Section 1951.4(b), the court held that (i) under the lease, the lessor had the right to continue the lease in effect after lessee's breach and abandonment and recover rent as it becomes due and (ii) the borrower never gave any notice of termination to the lessee. 

Based on the provisions of the lease and these facts, the Court of Appeal determined that the lease did not terminate, and, therefore, the “bad boy” guaranty was never triggered.  In the absence of such misconduct, the sole security for the loan is the property, not the guaranty.

Michigan's Approach:

In Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership 493 Mich. 859 (September 26, 2012), the Michigan Court of Appeals, in a similar but not identical matter, sided with the lender.

Specifically, the court held that a borrower's violation of a loan facility's nonrecourse liability carve-out provision, which prohibited the borrower from becoming insolvent, resulted in the loan becoming fully recourse against the borrower. In reaching this conclusion, the court scrutinized the terms of the loan documents and expressly noted the requirement that the borrower remain solvent in order to maintain its SPE status.  Having admittedly become insolvent, the court concluded that the borrower violated the SPE requirements, resulting in the loan becoming fully recourse, which, in turn, triggered full recourse liability to the guarantor. 

Interestingly, after the case was decided, the Michigan Legislature changed the law to obviate the holding by passing the Nonrecourse Mortgage Loan Act.  (Michigan Senate Bill No. 992.)

Impact of These Cases:

While the California case has been controlling for close to a year and the Michigan decision is no longer good law, both continue to impact negotiations and structuring of non-recourse financings throughout the United States. Lenders, borrowers and guarantors remain sensitive to the potential risk of future case law and legislation, and the crafting of mutually acceptable “bad-boy” carve-outs remains an important issue in most structured finance negotiations. 

By Michael C. Polentz, Co-Chair of the Real Estate & Land Use practice at law firm Manatt, Phelps & Phillips LLP. The views expressed in this column are the author's own.