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In a recent Massachusetts federal court case, a borrower’s settlement of a zoning appeal and transfer of the $2 million settlement proceeds to a hidden account of an affiliate, without informing the lender and obtaining its consent, triggered carve-outs in a non-recourse CMBS loan. The result: a $17.5 million full recourse judgment against the borrower entity and its individual guarantors. The lesson: both broad definitions of mortgaged property and carve-out provisions in non-recourse securitized commercial real estate loans mean what they say and will be enforced to the letter.

The March 14, 2007 opinion of Judge William G. Young of the U.S. District Court in Massachusetts resolved a case involving a $33 million non-recourse securitized real estate mortgage loan. Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, as Trustee for the Registered Holders of Credit Suisse First Boston Mortgage Securities Corp., Commercial Mortgage Pass-Through Certificates, Series 1999-C1, and CSFB 1999–C1 Royall Street, LLC.

After a nine-day bench trial, the Court first rejected a $15 million lender liability claim that the borrower had brought against the lender to start the lawsuit. On the lender’s counterclaim, the Court found the borrower and individual guarantors fully liable for a $10.77 million foreclosure deficiency based on violations of two separate so-called “bad boy” carve-outs. First, without informing the lender, the borrower had transferred part of the mortgaged property – the $2 million settlement proceeds of the borrower’s zoning appeal of a special permit granted to the adjoining property owner. Second, the borrower, a limited liability company, had violated single purpose entity covenants by commingling the $2 million settlement payment with monies of its member and by failing to maintain an independent director. With prejudgment interest and attorneys’ fees, the total judgment against the borrower and guarantors was $17.5 million.

The Blue Hills Case is significant in several respects. It is the first reported decision in the nation addressing and enforcing carve-outs in a non-recourse securitized loan. By imposing full recourse liability, not just requiring restitution and return of the transferred $2 million, the case underscores the power and reach of carve-out clauses. In addition, the case enforced an expansive definition of mortgaged property, typical of non-recourse loans, to include non-real estate assets related to the mortgaged real estate but not traditionally considered part of mortgaged property, i.e., a lawsuit brought by the borrower and its proceeds.

The decision also rejected a lender liability theory similar to one that prevailed in the widely reported 2005 California case, 1601 McCarthy Blvd. v. GMAC Commercial Mortgage Corp.¹ The Blue Hills Case provides a cautionary tale for borrowers and their counsel who are tempted to take aggressive positions with collateral, assuming that if challenged they will be able to negotiate a work out and escape the day of judgment merely by restoring the collateral.

The Facts of the Blue Hills Case

In 1999, Royall Associates Realty Trust, the owner of the Blue Hills Office Park at 150 Royall Street in Canton, Mass., refinanced its mortgage via Credit Suisse First Boston Mortgage Capital. The loan was non-recourse, but had full liability carve-outs making the borrower and two individual guarantors liable for the full amount of the loan upon certain defaults, including an unconsented-to transfer of the mortgaged property or any part thereof, and a failure to maintain the borrower’s status as a single purpose entity.

After the loan closed, the loan was assigned to a securitized loan pool for which J.P. Morgan Chase Bank eventually became the trustee, Wells Fargo Commercial Mortgage Servicing the master servicer and LNR Partners the special servicer pursuant to a Pooling and Servicing Agreement.

The Zoning Appeal

The single tenant in the office park was Boston Equiserve Limited Partnership, which had a five-year lease set to expire on July 31, 2004, with a five-year option to extend. In April 2003, Blue Hills became aware of Equiserve’s intention to relocate to and purchase a building on the adjoining property at 250 Royall Street after its lease expired in 2004. Also in April 2003, the owner of 250 Royall Street applied to the Town of Canton for a special permit to build a parking garage, the construction of which was a condition to Equiserve’s purchase of 250 Royall Street. The Town’s Zoning Board granted the permit over the objections of Blue Hills.

As a strategy to keep its sole tenant, Blue Hills in June 2003 appealed the issuance of the special permit, alleging that the proposed parking structure would be a detriment to the mortgaged property by blocking sight lines and views. Blue Hills had standing to bring the zoning appeal only because it owned the mortgaged property.

The Zoning Appeal Settlement

Two months later, however, without notifying or seeking the consent of the lender, Blue Hills entered into a settlement agreement with the owner of 250 Royall Street and with an affiliate of Equiserve that would be purchasing 250 Royall Street. Under the terms of the settlement agreement, Blue Hills received a payment of $2 million and waived all further rights of appeal of the Zoning Board decision. With the zoning appeal settled, the garage would be built and Equiserve would vacate Blue Hills’ property.

On August 8, 2003, the $2 million settlement payment was wired to a client account at Blue Hills’ law firm. The account was in the name of Royall Associates, the member of the borrower, and was controlled by its principals, the loan’s guarantors. Blue Hills never notified the lender of its receipt of the settlement payment. The transfer was accounted for on the borrower’s financial statements as a reduction in basis and as a transfer to the borrower’s member, Royall Associates.

Default and Foreclosure

In August 2004, the sole tenant Equiserve moved out, and Blue Hills then defaulted on its loan payments. The servicing of the loan was transferred from Wells Fargo to LNR. In September 2004, LNR sent the borrower a notice of default. An October 2004 foreclosure notice and November 2004 foreclosure sale followed, producing a $10.77 million loan deficiency.

Subsequent Events

In February 2005, the $2 million settlement proceeds were transferred again pursuant to an agreement between the principals of Royall Associates, splitting the settlement proceeds between the two principals/guarantors. The lender learned of the zoning appeal and settlement payment from a real estate broker only after the foreclosure sale of 150 Royall Street when an LNR asset manager visited the property.

In February 2005, Blue Hills filed a lender liability claim against the lender. The borrower accused the lender of wrongful foreclosure, alleging that the special servicer had wrongfully denied requests to access reserve accounts to make principal and interest and real estate tax payments after Equiserve moved out, causing payment defaults and forcing it into foreclosure. The borrower also alleged that the lender had breached the implied covenant of good faith and fair dealing by refusing requests to meet with the borrower after Equiserve moved out and by not cooperating with efforts to work out the loan.

The lender counterclaimed, seeking full recourse liability against Blue Hills based on an unconsented to transfer of part of the mortgaged property, namely, the undisclosed settlement of the zoning appeal and transfer of the settlement proceeds. The lender also asserted a third party claim against the guarantors, asserting full recourse liability on the same basis.

The Court’s Decision in the Blue Hills Case

The Court first rejected the borrower’s wrongful foreclosure claims, stating that the borrower had no right under the loan documents to access the loan reserves for payments of taxes, or of principal and interest after an event of default. The Court also found that the lender had no obligation to meet with or cooperate with the borrower to work out the loan after the borrower defaulted. The lender had not breached the implied covenant of good faith and fair dealing because it had done nothing to use its contractual rights as leverage to obtain some advantage to which the loan documents did not entitle it.

The Court then turned to the lender’s claim that when Blue Hills transferred part of the mortgaged property without the prior written consent of the lender, it breached the loan documents and became liable for the full amount of the deficiency. The Court agreed that the zoning appeal and the $2 million settlement payment made to the borrower were part of the “Mortgaged Property” as broadly defined in the mortgage’s granting clauses.

The Court rejected the borrower’s defense that “Mortgaged Property” in the transfer restriction of the mortgage referred only to transfers of real estate. The Court emphasized the importance of maintaining the value of all of the mortgaged property as security for repayment in the context of a non-recourse loan.

The Transfer of Mortgaged Property Made the Borrower Fully Liable

The Court next determined that Blue Hills transferred mortgaged property in violation of the parties’ agreement when it transferred the settlement payment to an account in the name of its member under the control of the member’s principals.

The take away from this part of the decision? The lender has a right to control any collateral defined in the mortgage, even if not traditionally considered part of mortgaged real estate. A borrower should carefully consult its loan documents before settling any lawsuit or disposing of any other asset.

The Transfer of Mortgaged Property Made the Guarantors Fully Liable

The transfer also made the guarantors liable for the full amount of the loan deficiency under the plain language of the full liability carve-outs of the guaranty. The second paragraph of the guaranty provided that the guarantors would be liable for the full amount of the “Debt” in the event that “Borrower fails to obtain Lender’s prior written consent to any assignment, transfer, or conveyance of the Mortgaged Property or any interest therein if required by Section 10 of the Mortgage.”

The guarantors relied on the guaranty’s limited liability carve-outs, which provided for liability limited to actual damages upon the occurrence of certain events, such as misconduct, fraud, intentional physical waste, or removal or disposal of mortgaged property after default. The guarantors contended that, if anything, their acts fell within those subparagraphs, triggering only limited liability. They argued that the acts triggering limited liability were more egregious than the transfer of the zoning appeal settlement payment. While the Court agreed that the misconduct giving rise to limited liability was more egregious than the conduct at issue, that did not override the plain language of the guaranty making the guarantors fully liable in the event of an unconsented-to transfer of any interest in the Mortgaged Property.

In a ruling from the bench that preceded his written opinion, Judge Young put it plainly: “The second full paragraph [of the guaranty] is, this is too glib but accurate, don't mess around with the collateral. . . . [I]f you mess around with the collateral, that's when you'll be liable for the entire amount of the deficiency.”

Violation of Single Purpose Entity Covenants

The Court found that an independent ground for full recourse liability under the guaranty was that the borrower failed to maintain its status as a single purpose entity. The guaranty contained a carve-out making the guarantors fully liable in the event that “Borrower fails to maintain its status as a single purpose entity, as required by, and in accordance with, the Mortgage.” Among the SPE covenants in the mortgage was that the mortgagor would not commingle its funds with those of any affiliate or guarantor. The borrower violated this covenant when it transferred the $2 million settlement payment to an account in the name of its member, Royall Associates.

SPE covenants are often honored in the breach. This part of the decision shows that borrowers ignore them at their peril.

Prejudgment Interest and Attorneys’ Fees

The Court awarded prejudgment interest to the lender at the contract’s 13.49% default rate from the August 8, 2003 date of the settlement payment. The prejudgment interest exceeded $4.5 million. Pursuant to an attorneys’ fees provision in the loan documents, the Court also awarded the lender every penny of its actual attorneys’ fees and costs of over $2 million, incurred both in pursuing its claims and in defending against the borrower’s lender liability claims. The guarantors, as well as the borrower, were liable for these amounts, which constituted parts of the “Debt” for which they were fully liable. Total judgment entered in the amount of approximately $17.5 million.

Postscript and Moral of the Story

Following trial, the borrower and guarantors appealed the judgment. Shortly thereafter, however, the appeal was dismissed, and $17.25 million (98.5% of the judgment) was paid to the lender to settle the case.

The moral of the story is clear. The plain language of mortgaged property definitions and of carve-outs controls in non-recourse CMBS loans. Borrowers and guarantors will be held to their agreements, even if they rely on contrary advice from their counsel. Borrowers who take a chance with the collateral expecting that if discovered and challenged they will work things out and escape the day of judgment are playing with fire because their loan agreements will be enforced to the letter. As Judge Young warned from the bench, “Don’t mess around with the collateral.”

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¹Case No. CGC-03-425848, California Superior Court

Originally published in the Real Estate Finance and Investment on July 22, 2007.