On March 14, 2007, the first case in Massachusetts to enforce a non-recourse carve-out in a commercial real estate loan, Blue Hills Office Park v. J.P. Morgan Chase Bank, contradicted significant assumptions in real estate lending about the liability of borrowers and guarantors under carve-out provisions of non-recourse loans. The stark warning: “don’t mess with the collateral.” It was issued in the form of a $17.5 million liability judgment against an individual where a limited liability company (Blue Hills Office Park, the borrower) defaulted on its commercial loan secured by a mortgage. The loan was non-recourse but for certain so-called carve-outs, which, if violated, triggered the guarantee in the full amount of the loan. The carve-outs prescribed that the debt would become fully recourse if the borrower did “sell, convey alienate, mortgage, encumber, pledge or otherwise transfer the mortgaged property or any part thereof without the prior written consent of [the lender].” Additionally, the borrower was prohibited from “commingl[ing] the funds and other assets of the mortgagor with those of any affiliate or constituent party, and guarantor.”
The borrower defaulted on the mortgage by failing to pay property taxes for the month of Aug. 2004, due to its sole occupant relocating when its lease expired in July 2004. The borrower remained unable to pay property taxes and principle and interest on the loan, and the lender promptly foreclosed on the property. Through foreclosure, the lender discovered that the borrower brought an appeal to an adjacent property owner’s permit to construct a parking garage in an attempt to prevent its sole tenant from relocating when the lease expired. The borrower settled the appeal for $2 million to compensate for the diminished property value that would result from the tenant relocating to the adjacent property, and waived all future rights of appeal. The borrower brought and settled the appeal without notifying the lender or obtaining its permission.
Non-recourse loans exonerate borrowers from personal liability in the event of default, leaving foreclosure of the mortgaged property as the creditor’s only recourse. Carve-outs are often used to prohibit actions by borrowers that pose special risks to the property, and generally impose full recourse liability on borrowers if any of the prohibited acts are committed. One common carve-out, prohibition against transferring the mortgaged property without the consent of the lender, was included in the Blue Hills mortgage. Upon discovery that the borrower had received the $2 million settlement and deposited the entire amount into an account held by its two guarantors and their lawyer, the lender claimed the borrower transferred the mortgaged property and commingled the funds in violation of the prohibition.
The borrower disagreed and argued that “mortgaged property” included only real property, although the term’s meaning could vary depending on context. Massachusetts District Court Judge William Young admonished the assumption as “unreasonable and unpractical.” Because the property was the lender’s only recourse in the case of default, the lender had an interest in preserving the property value and included language in the mortgage to that effect. The court proceeded to interpret the mortgage far more broadly than just defining “mortgaged property” as the real property.
The sweeping granting clauses of the contract defined “mortgaged property” as inclusive of “causes of action related to, derived from, and used in connection with the mortgaged property,” thus including the zoning appeal. The $2 million settlement, which was a “proceed” of the zoning appeal, was also mortgaged property because a similarly sweeping clause incorporated “all proceeds, products, offspring, rents and profits from any of the foregoing, including, without limitation, those from sale, exchange, transfer, collection, loss, damage, disposition, substitution or replacement of any of the foregoing.”
Borrowers and guarantors must be careful to heed Judge Young’s warning. Violating carve-out provisions that affect the value of the collateral can lead to full recourse liability, including legal costs such as attorney’s fees. Therefore, all interested parties to a mortgage must be absolutely sure what the mortgage defines as the collateral and what the borrower may and may not do with it.
