The recent progress of the economic recovery and increased investments in the commercial real estate market may lull developers, owners and lenders into assuming that a legal laissez-faire attitude exists when it comes to commercial mortgage-backed securities (CMBS) transactions.

For the most part, however, cases dealing with both “credit bubble” and post-downturn structured financing transactions, while not breaking new ground, have underscored three critical lessons learned from the economic downturn:

• You can’t avoid the law;
• Fairness counts;
• Details matter.

You Can’t Avoid The Law

Courts have stressed that while parties may craft their agreements in any number of ways, they don’t get to craft their way out of the law. Lenders in a highly publicized case in New York learned this lesson the hard way when a U.S. Bankruptcy Court judge denied their motions to dismiss the Chapter 11 filings of financing subsidiaries that were supposedly legally isolated from the parent company’s bankruptcy.

In April 2009, General Growth Properties Inc., the nation’s second-largest mall owner, declared bankruptcy, marking the biggest real estate failure in U.S. history. A few months later, a U.S. bankruptcy judge in New York ruled that a large group of General Growth’s subsidiaries should be allowed to stay in Chapter 11, despite lender claims that the cases were ineligible for bankruptcy.

The subsidiaries, known as special purpose entities (SPEs), are often used by borrowers in CMBS transactions and are structured to be “bankruptcy remote” financing vehicles so that lenders will not be caught up in a bankruptcy case involving the parent company.

The judge ruled, however, that more than 160 of General Growth’s bankruptcy-remote SPEs should be included in the bankruptcy case. In a strongly worded decision, the judge reminded them of the language and policy objectives of the Bankruptcy Code and held that those seeking to have the SPE cases dismissed – claiming they were filed in bad faith – were simply inconvenienced by the Chapter 11 filings. As the judge noted, “inconvenience to a secured creditor is not a reason to dismiss a Chapter 11 case.”

Fairness Counts

Courts have also gone out of their way to enforce contracts in a manner that the judge finds to be fair. For example, a New York judge did not look favorably upon defendants’ 11th hour attempt to sell their equity collateral in Stuyvesant Town–Peter Cooper Village, a financially ailing apartment complex on Manhattan’s East Side, after the plaintiffs had spent nearly a year and millions of dollars to foreclose the property smoothly.

In September 2010, a New York judge issued a preliminary injunction blocking a Uniform Commercial Code foreclosure sale of the apartment complex on the grounds that the venture formed for this purpose first had to repay $3.66 billion owed lenders from a senior mortgage. The judge’s decision, based on an inter-creditor agreement that he considered “unambiguous,” obligated the venture to “cure all senior defaults” before proceeding.  

Details Matter

Even though a judge’s view of fairness often drives the result, it’s better to get the details right than to hope that a judge successfully guesses the parties’ intent. For instance, in a 2011 Michigan case, a “non-recourse” carve-out guarantor was surprised to learn that he was liable for supposedly non-recourse loans.

After a foreclosure sale of the Cherryland Mall in Traverse City, Mich. resulted in a $2.1 million deficiency, Wells Fargo Bank sued the developer who had signed a non-recourse carve-out guarantee making him liable for any deficiency if a violation of certain of the loan covenants was found. The Michigan Appeals Court upheld a trial court ruling that the developer was liable as guarantor for the entire loan deficiency because insolvency was a violation of the mall’s SPE status.

The mortgage, as it was incorporated into the note “unambiguously required Cherryland to remain solvent in order to maintain its SPE status,” the appeals court held.

“It is not the job of this court to save litigants from their bad bargains or their failure to read and understand the terms of a contract,” the ruling stated.

The Michigan legislature subsequently closed the loophole, enacting legislation last year that prevents lenders from seeking damages against a borrower or guarantor due to the borrower’s inability to remain solvent.

Experience, Judgment Count

The legal landscape remains complex and full of contradictions. You put your real estate financing goals at risk if your structure is not consistent with the law, you try to act unfairly, or fail to pay attention to details.
Owners and lenders need to be cognizant of this and approach each transaction with attention to detail and thoughtfulness to ensure that their goals are achieved to the maximum extent possible in any given context.

Sander Ash is a partner in the real estate department of Sullivan & Worcester’s Boston’s office. Rick Goulding is a summer associate in Sullivan & Worcester’s Boston office.