In a 2007 decision, a Massachusetts Federal court found that a borrower’s transfer of a $2-million settlement award violated the terms of its loan documents with a securitized lender and triggered the recourse liability provisions of the note and mortgage. With this finding, the court held that the borrower and loan guarantors were liable to the lender for the full amount of the loan—more than $17 million. Blue Hills Office Park, LLC v. J.P. Morgan Chase Bank as Trustee, etc., 477 F. Supp.2d 366 (D. Mass 2007), was the first reported case enforcing the non-recourse carve-outs in a conduit or “securitized” mortgage loan. The case provides several important lessons to parties entering into agreements to borrow:

• Borrowers and guarantors must take seriously the promises they make to their lender in loan documents, for those promises will be enforced;

• The definition of “property” in a mortgage often extends far beyond the typical “dirt” and building put upon it;

• A “non-recourse loan” does not always insulate a borrower and its principals from personal liability; and

• The courts are willing to give a broad interpretation to the language of loan documentation and enforce it strictly.

In times when financing is readily available, many borrowers prefer to deal with lenders who offer “non-recourse” loans on the understanding that such financing limits the personal liability of the borrower and its principals, who usually serve as partial guarantors of the loan. A non-recourse loan is one in which, following a default, the lender’s sole recourse is to the property secured by the mortgage. Generally, with such loans, the lender cannot look to the assets of the borrower or guarantors. In order to ensure that the borrower does everything it should to protect the property, however, lenders typically provide that in certain situations they will seek personal liability against the borrower and/or the personal guarantors.

These exceptions, “non-recourse carve-outs,” also known as “bad boy acts,” impose personal liability if the lender suffers a loss due to wrongful acts committed by the borrower or its principals. Examples of typical non-recourse carve-out items include fraud or misrepresentation, misapplication of insurance or condemnation proceeds, losses related to environmental matters and misapplication of rents. Generally, conduit or securitized loans have more specific carve-outs than loans made by a local bank or smaller lender.

The nature and extent of carve-outs often expand or contract with the market. Standard non-recourse carve-outs can sometimes be narrowed by the borrower’s negotiation with the lender when the loan commitment or loan application is under review. There are two types of recourse liability in loans with a securitized lender: “Carve-out liability,” which provides for reimbursement of losses incurred by the lender in connection with a specific list of defaults by the borrower; and conversion of a “non-recourse loan” to a “full recourse loan” upon the happening of certain specified events of wrongdoing. For example, bankruptcy or insolvency of the borrower or related parties, unauthorized transfer of the property or shares or interests in the borrower or violation of the single purpose covenants frequently imposed by a conduit lender are all events that could convert a non-recourse loan to full recourse.

It was the unauthorized transfer of the “property” and a violation of the single-purpose entity covenants that resulted in the very large judgment against the Blue Hills borrower and guarantors. The Blue Hills decision resulted from a lawsuit by a borrower, Blue Hills Office Park, LLC (“Blue Hills”) against its lender, Credit Suisse First Boston Mortgage Capital, LLC (“Credit Suisse”) under a theory of lender liability.

In 1999, Blue Hills had refinanced an office building in Canton, MA with Credit Suisse. The loan was a non-recourse, securitized loan which Credit Suisse assigned to JP Morgan Chase Bank as trustee (“JP Morgan”). The loan had the lender’s “standard” carve-outs, and as is often the case, those carve-outs were also guaranteed by the two principals of Blue Hills. The office building in question was occupied by a single tenant, Boston Equiserve LP (“Tenant”).

Several years after the loan closing, Blue Hills became aware that the Tenant intended to relocate and purchase an adjacent building once its lease with Blue Hills expired. At the same time, the owner of the adjacent building applied to the municipality for permission to build a parking garage. Blue Hills objected to construction of the garage, partly, it appeared, as a strategy to delay construction and keep the Tenant from vacating the Blue Hills building.

Shortly after the appeal was filed, Blue Hills, the neighboring owner and the prospective purchaser of the adjacent property (an affiliate of the Tenant), entered into a settlement agreement under which Blue Hills received $2 million. In exchange, Blue Hills agreed to drop its objections to the zoning permit for the parking garage. Ultimately, the garage was built and the Tenant relocated to the new building, leaving Blue Hills with a vacant building. At that point, because Blue Hills was not able to re-rent the entire building, its property could not support the JP Morgan mortgage. Eventually, Blue Hills defaulted on the mortgage and foreclosure action followed. Blue Hills thereafter filed a separate action against the lender, alleging lender liability claims.

When it entered into the $2-million settlement with its neighbor, Blue Hills did not consult its lender nor advise the lender of receipt of the settlement award. The funds were transferred to an account of an affiliate of Blue Hills and never appeared on Blue Hills’ books and records. As a result, the lender had no knowledge that this settlement had ever taken place until it was disclosed some time after the fact.

In its counterclaim against Blue Hills, the lender claimed that Blue Hills violated the terms of the mortgage by transferring a portion of the “mortgaged property” (i.e., the $2-million settlement award) without the lender’s consent, and by depositing funds belonging to Blue Hills into accounts other than those maintained by Blue Hills. In reviewing all mortgage documents and facts of the case, the court agreed with the lender’s position.

In finding in favor of the lender, the court used an analysis that broadly interpreted the meaning of the term “mortgaged property.” In the Blue Hills mortgage, the definition of “mortgaged property” reached beyond the physical real estate, building and improvements. This definition continued for several pages and included, among other things, “any cause of action related to or derived from the mortgaged property,” “proceeds” and “a payment made for any injury to or decrease in the value of the premises and improvements.”

In reviewing the facts of the case, the court determined that the $2-million settlement award that Blue Hills received directly related to Blue Hills’ property and therefore fell within the lender’s definition of “mortgaged property.” As such, the settlement award became part of the lender’s collateral. The court held that, at the very least, Blue Hills should have notified the lender about this settlement award and obtained its consent to the settlement. The court went further to note that the lender may have been entitled to retain the award.

The court also ruled against Blue Hills on a more technical aspect of the loan documents, relating to transfer of the settlement proceeds to an account maintained by an affiliate of Blue Hills. Under the loan documents, Blue Hills was required to maintain its own bank accounts, books and records, to use only those accounts and have its records reflect everything relating to the property. The court concluded that transfer of the settlement award through the affiliate’s account was a violation of the mortgage.

In its analysis, the Court also found that Blue Hills failed to abide by other covenants and agreements it had made regarding its status as a single-purpose entity. While not specifically relevant to the court’s finding regarding the settlement award, it is important to note that the court analyzed all of Blue Hills’ actions following the default and determined that Blue Hills repeatedly failed to live up to its obligations under the loan documents.

Lessons learned: If an owner of real estate desires to enter into a loan with a securitized or “conduit” lender, they should be aware of potential pitfalls and understand that the term “non-recourse” does not, in all situations, mean there will be no personal liability. In fact, Blue Hills and its guarantors ended with the costliest result—full personal liability for the entire amount of the loan. If nothing else, the Blue Hills case teaches the following:

1. A property owner should be sure to review the term sheet and commitment letter for a new loan with their attorney before signing it, to see if it is possible to narrow the list of required non-recourse “carve-outs.” If specific terms of the loan are not negotiated up front, it may be difficult to make any changes later.

2. The owner must understand that under certain circumstances, a “non-recourse” loan could lead to personal liability, including full liability for all losses incurred by the lender. Borrowers and any guarantors need to recognize and remain aware of situations where this could occur.

3. A borrower must also recognize that the term “collateral” or “mortgaged property” may include any and all rights related to the real estate, including money and damages awarded in litigation or settlement in circumstances where the case is related to the real property encumbered by the lender’s mortgage.

It is essential that a borrower understand what is contained in loan documents that they sign. Equally important is recognition that once the loan closes, it is not “over.” Borrowers and guarantors alike must recognize that they have continuing obligations to the lender under their loan documents, and these obligations cannot be ignored. Specifically, borrowers and guarantors must:

• Be familiar with covenants contained in the loan documents and be sure to adhere to them. For example, a borrower’s violation of the special-purpose entity provisions in a mortgage is commonplace. While lenders generally do not follow every detail about the borrower’s day-to-day activities in managing a property, nevertheless, the borrower’s failure to comply with the lender’s requirements may result in untoward consequences, as can be seen in the Blue Hills case.

• Be familiar with issues that require the lender’s prior consent and be sure to follow the proper procedures any time it is required.

• Before taking any action out of the ordinary, check the loan documents first to ensure compliance with the lender’s requirements.

• Be sure to review and acknowledge the lender’s role and rights with regard to any lawsuit or other proceeding affecting the property, the borrower or any guarantor.

As a general rule, the lender’s full and limited recourse carve-outs are designed to protect against wrongdoing by borrowers. Even when a loan goes bad, if the borrower has not run afoul of the lender’s rules, the borrower and the guarantors will find that their liability has been limited.

The language of loan documentation is generally so specific and inclusive, especially in securitized and conduit-type loans, that many times borrowers and guarantors find that they have inadvertently violated the lender’s prohibitions. This was the very costly lesson learned by Blue Hills and its individual guarantors. By following the recommendations we have outlined above, borrowers and guarantors can protect and reduce the risk of taking on personal liability, especially as a result of a technical or inadvertent loan default.

Robin F. Lewis is a partner in the law firm Mandelbaum Salsburg, West Orange, NJ. She can be reached at [email protected].

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