Nonrecourse loans are popular among commercial real estate owners because the Lender agrees only to seek recourse against the real estate and other collateral securing the loan in a default or loss situation. Unless the loss is caused by a “bad boy act”, the borrower and/or principal will not be held personally liable. Bad boy acts, also known as nonrecourse carveouts, are actions or inactions by the borrower or principal that are fraudulent and/or that cause detriment to the property (e.g. environmental contamination, failure to insure the property, waste, transfer of the property, etc.). In nonrecourse loans, borrowers and principals agree to be personally liable for the lender’s loss arising from nonrecourse carveout events.
A new law went into effect on March 27, 2013 which impacts one type of nonrecourse carveout. New Ohio Revised Code sections 1319.07 through 1319.09 make invalid and unenforceable any “postclosing solvency covenant” as a nonrecourse carveout. New Section 1319.07(D) of the Ohio Revised Code defines a “postclosing solvency covenant” as:
“any provision of the loan documents for a nonrecourse loan…that relates solely to the solvency of the borrower, including without limitation, a provision requiring that the borrower maintain adequate capital or have the ability to pay the borrower’s debts, with respect to any period of time after the date the loan is initially funded.”
This new law is a response to the result in a 2011 Michigan appellate court case, Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership, which made a nonrecourse guarantor personally liable for a $2.1 million loan deficiency because the borrower’s insolvency violated a postclosing solvency covenant. The Ohio legislature, like some other jurisdictions, including Michigan, didn’t agree with the Cherryland result and therefore legislated accordingly. Many in the industry believe making a borrower or guarantor liable for a postclosing insolvency in a nonrecourse loan – based solely on economics or market circumstances – is the exception that swallows the whole (nonrecourse) rule. The Ohio General Assembly’s position is that the lender should take the risk of insolvency and postclosing solvency covenants are not only unfair but also a deceptive business practice that should be against public policy.
There are a couple important side notes regarding this new law. A voluntary bankruptcy filing or other voluntary insolvency proceeding is still a permitted nonrecourse carveout. In addition, this new law only affects nonrecourse commercial loans secured by Ohio real estate and it does not change the lender’s ability to realize on the collateral given to secure the loan. A solvency type covenant is still permitted in traditional recourse loans.
While this new law does provide some “big brother” legislative protection to commercial real estate borrowers, it still remains important for borrowers and their attorneys to review the nonrecourse carveouts as these are the events for which one may unintentionally find themselves personally liable on the loan or for the lender’s losses. This new law only makes one type of carveout unenforceable; many carveouts still remain valid and enforceable. Lastly, and equally as important, is for lenders and their attorneys to review the lender’s standard nonrecourse carveouts in light of this new law to make their documents are in compliance.