Real Estate and Land Use

A New Case Interpreting Limited Recourse Guarantees; This Time With a Different Result

Authors: Katerina H. Bohannon | Carl L. Grumer

Facts: Lender made a $44,000,000 loan to Borrower. Borrower purchased two commercial properties and leased them to Washington Mutual Savings and Loan (“Tenant”). The loan was a non-recourse loan, secured only by the real property and no other assets of Borrower, subject to certain “bad boy” exceptions for borrower misconduct. Guarantor entered into a full recourse “bad boy” guaranty that would be triggered by such misconduct.

Tenant went out of business, ceased paying rent and abandoned the property. Borrower defaulted on the loan payments. The Guarantor was sued for the full amount of the outstanding indebtedness.

Principal Issue in the Case
One of the stipulated “bad boy” acts under the guaranty was the termination of the Tenant leases without the Lender’s consent. The principal issue decided by the California Court of Appeal was whether Tenant’s ceasing to pay rent and abandoning the property “terminated” the leases, triggering full recourse and Guarantor’s duty to repay the loan.

Trial Court Decision
The Superior Court of Los Angeles determined that the leases had been terminated without Lender’s consent and therefore Guarantor was fully liable under the guaranty.

Court of Appeal
The California Court of Appeal concluded that the trial court erred and reversed its decision.

Why?
The California Court of Appeal determined that despite Tenant’s abandonment of the premises and its cessation of paying rent, the leases were not terminated.

Section 1951.2(a) of the California Civil Code provides that “if a lessee of real property breaches the lease and abandons the property before the end of the term....the lease terminates.” The Court of Appeal determined that this section does not apply to this case because the lease clearly stated that it “shall not be terminable for any reason by Lessee[.]...Any present or future law to the contrary shall not alter this agreement of the parties.” Thus, under the terms of the lease, neither the failure to pay rent nor the abandonment of the premises terminated the leases.

Further, Section 1951(a) is subject to Section 1951.4(b) of the California Civil Code, which states, “Even though a lessee of real property has breached the lease and abandoned the property, the lease continues in effect for so long as the lessor does not terminate the lessee’s right of possession.” In this case, Borrower never gave notice of termination to Tenant. In order for Section 1951.4 to apply, there must be a provision in the lease in substantially the following form: “The lessor has the remedy described in California Civil Code Section 1951.4 (lessor may continue lease in effect after lessee’s breach and abandonment and recover rent as it becomes due, if lessee has right to sublet or assign, subject only to reasonable limitations).” (Section 1951.4(a).) The Court of Appeal determined the leases complied with this requirement.

Based on the provisions of the leases and these facts, the Court of Appeal determined that the lease did not terminate, and, therefore, neither the loan provisions nor the “bad boy” guaranty was ever triggered. Both Borrower and Guarantor are fully liable under these provisions only if Borrower engages in specified misconduct, which did not occur. In the absence of such misconduct, the sole security for the loans is the property, not the guaranty.

Other Arguments, Other States
Lender argued that although the lease termination provision in the guaranty “superficially resembles a ‘bad boy’ guaranty,” in reality it works like an absolute guaranty because full recourse is triggered regardless of whether the lease is terminated by the Tenant or the landlord/Borrower, citing Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership (Mich.App., Dec. 27, 2011, No. 304682) N.W. 2d (2011 Mich. App. Lexis 2360, *38)[borrower’s insolvency triggered the guaranty even though insolvency was not the result of the borrower’s “bad boy act” because the guaranty “does not require insolvency to occur in any specific manner”]. Although the Court of Appeal ultimately decided the case on other grounds, certain language in the opinion appears to disagree with the Michigan Cherryland decision. The Court of Appeal in this case, unlike the Michigan court, looked at the intent of the parties, finding that recourse was intended only if the Borrower committed certain “bad boy acts.” The Court rejected the Lender’s reliance on Cherryland by stating that such argument fails on the facts of this case “even assuming that we would follow the Cherryland opinion.”  Interestingly, after the case was decided in Michigan, the Michigan Legislature changed the law to obviate the problem by signing into law the Nonrecourse Mortgage Loan Act, which applies retroactively.  Michigan Senate Bill No. 992

Impact of These Cases
This issue is likely to arise repeatedly in the future, given the similarity in structure and document forms used in structured finance transactions in recent years. In this decision the California Court of Appeal appears to signal that it is going in a different direction than the Michigan court. It remains to be seen how this area of law will develop. Stay tuned.

GECCMC 2005-C1 PLUMMER STREET OFFICE LIMITED PARTNERSHIP, Plaintiff and Respondent, v. NRFC NNN HOLDINGS, LLC, Defendant and Appellant 2012 Cal. App. LEXIS 366