Client Alert: Blue Hills v. JPMorgan Chase

Jeffery D. Hoffenberg and Michael B. Manuel


May 22, 2008

A recent case, Blue Hills v. JP Morgan Chase, highlights several important lessons for commercial real estate lenders and borrowers, especially as financial pressures remain high in the real estate industry.  The borrower initiated this case asserting that the lender accelerated its loan and foreclosed on the mortgaged real estate in breach of the loan documents and the lender's duty to act in good faith.  The lender defended and also counterclaimed against the individuals who had signed the non-recourse carveout guaranty.   In a sweeping repudiation of the arguments made by the borrower and the guarantors, the court ruled that (1) the lender could rely on the strict language of the mortgage documents notwithstanding that words and actions of its agents were at variance with the mortgage documents, (2) the borrower ignored the strict language of the loan documents at its peril, and (3) the "springing" nature of the non-recourse guaranty was triggered when the borrower compromised a zoning dispute with its neighbor, as the compromise was an unpermitted "transfer" of a portion of the mortgaged property.

Claims Against The Lender:

This case originated with the borrower failing to make a quarterly tax escrow deposit of just over $150,000 as required by its loan documents.  When it came time to pay the real estate taxes, there was not enough money in the escrow account.  The lender advanced the shortfall, then declared an event of default, accelerated the loan and foreclosed, all in the space of approximately 60 days.  The borrower subsequently complained that the lender's actions violated the loan documents.

The property was originally occupied by a single tenant that paid real estate taxes pursuant to its lease.  Typically, lender accepted tax escrow payments directly from the tenant.  Occasionally, without declaring a default, the lender accepted late tax escrow payments from the tenant in consideration of a $500 fee paid by the tenant.  During the term of the loan, the lease expired and the tenant vacated the property.   Shortly before the lease expired, lender notified borrower of a deficiency in the tax reserve and requested borrower to deposit the necessary funds.  Instead of depositing the funds, borrower waited until the taxes were past due then requested that lender disburse the deficiency from a separate debt service reserve held by lender that had a balance in excess of Four Million Dollars.  The loan documents specified that disbursements from the debt service reserve were to be used solely for principal and interest payments.  The lender never responded to borrower’s disbursement request.  When the borrower failed to cure the tax deficiency, lender paid the real estate taxes and then declared a default which led to the foreclosure sale.

Borrower argued that the default declaration was premature because the lender had, by its conduct of accepting late tax deposits without declaring a default, modified the relevant provisions of the loan documents.  The court rejected the borrower’s claims.  The court noted that borrower had agreed in the mortgage that (i) the lender’s failure to insist on strict performance of any obligation under the loan documents would not be a waiver of the obligation and (ii) borrower would not be relieved of its obligations by lender previously extending  the time of payment of the tax deposits

Lender Bad Faith:

The borrower also complained that the lender acted in bad faith by ignoring and then not agreeing to, borrower's request to use the debt service reserve to satisfy the tax escrow deficiency. 

The court ruled in favor of lender for two reasons.  First, the loan documents clearly stated that funds in the debt service reserve were for payments of principal and interest and borrower could not cite any provision in the documents that would entitle borrower to use the debt service reserve to pay real estate taxes.  Second, disbursement from the reserve account was conditioned on no event of default being in existence.  Borrower requested the disbursement two days after the date the real estate taxes were due.  Borrower's failure to cure the escrow deficiency and to pay the real estate taxes when due, were both events of default and therefore a condition to disbursement was not met.   Thus, the court ruled that the lender, following the strict language of the loan documents, did not act in bad faith.

The Carveout Guaranty Claims:

The lender claimed that the guarantors became jointly and severally liable for the entire loan under the "springing" non-recourse guaranty when the borrower settled a zoning dispute with its neighbor without lender’s consent.  The court decided that the settlement was an unauthorized transfer of mortgaged property and so ruled in favor of the lender.

Over borrower's objections, the neighbor had obtained a special use permit to construct a parking garage.  Borrower discovered that its tenant planned to relocate to the neighboring property rather than renewing its lease with borrower.  Borrower filed an appeal challenging the permit presumably in an attempt to keep the tenant at its property.  Without notifying lender or seeking its consent, borrower settled its claims with the neighbor.  Borrower withdrew all objections to the special use permit in consideration of a $2 Million cash settlement. 

The court agreed with the lender that the settlement of the zoning appeal constituted an unauthorized transfer of mortgaged property.  The loan documents prohibited borrower from transferring any portion of the mortgaged property without lender’s consent.  The term, "mortgaged property" was defined to include (i) causes of action relating to or derived from the property and (ii) payments made with respect to the property for any decrease in value of the property. 

The court reasoned that the permit would allow a parking garage which, if built, would impair the view from borrower’s property.  Additionally, approval of the permit would allow borrower’s sole tenant to decide not to renew its lease with borrower and instead relocate.  When borrower settled its objections, the court saw a cause of action, the zoning appeal, being alienated and a payment for a decrease in value of the property, the cash settlement, being paid to borrower.  Since these elements were included in the definition of "mortgaged property" borrower violated the transfer restrictions. 

The carveout guaranty made the guarantors personally liable for all mortgage debt if the transfer restrictions were violated.  Thus, judgment was entered against the guarantors, two individuals, for a $10.7 million deficiency, $4.55 million in default interest and unpaid interest, plus $2 million in attorneys' fees and other collection costs.

Lessons:

In the current financial environment, there is an expectation that a material segment of the commercial mortgages in place will face some refinancing pressure.  Inevitably, borrowers and lenders will be looking at their situations and devising strategies that make the most sense and have the best chance of preserving the value of their respective investments.  The Blue Hills case reminds the real estate community of several fundamental points: 

• Even if the lender has not strictly enforced certain terms of the loan documents in the past, in the absence of a written amendment confirming such modification, borrowers should strictly comply with the terms of their loan documents.
  
• Lenders are entitled to rely on the express language of the loan documents regarding the obligations of borrowers thereunder, in determining whether a default has occurred.
  
• Modern commercial documents can be very broadly written.  Even the compromise of a dispute regarding how a neighbor may use its property can be covered by the definition of mortgaged property.
  
• "Springing" guarantees are enforceable.
  
• Lenders take great risk if the words and actions of their agents vary from the loan documents or are otherwise not fully documented.  Even though the lender eventually prevailed, the claims against the lender relating to the tax escrow went through a full trial causing the lender to incur in excess of $2 Million in legal fees.  The lender was fortunate that it could look to the springing liability under the guaranty, which arose from circumstances wholly unrelated to the tax escrow, to recover those fees.  Without recourse to the guarantors the lender would probably not have had any means of recovering its legal fees, as the value of the property was less than the outstanding balance of the mortgage.