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CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC

410 N.J. Super. 114, 980 A.2d 1 (App. Div. 2009)

MORTGAGES; GUARANTIES; CARVE-OUTS; LIQUIDATED DAMAGES — Once a Non-Recourse Carve-Out is triggered, it doesn’t matter that it is cured or that its occurrence in the first place had no effect on the lender; the borrower and each guarantor otherwise protected from liability for the borrowed amount become liable for the entire outstanding loan; and the amount thus collectable will not be characterized as liquidated damages.

The Appellate Division of the New Jersey Superior Court was asked “whether a non-recourse carve-out clause in a mortgage note, providing that [the borrowers] are personally liable to [the] lender for damages resulting from violation of a particular loan obligation, is a liquidated damages provision, and if so, whether it constitutes an unenforceable penalty.” A $13,300,000 mortgage loan was secured by a guaranty of principal executed by the borrower’s principals. Although the loan was a non-recourse obligation, and the lender could not seek recovery against the borrower or the guaranteeing principals in the event of default, the note “contained a carve-out clause, providing that the debt would be fully recourse if the borrower failed to obtain the lender’s prior written consent to any subordinate financing encumbering the property.” Under the guaranty agreement, the guaranteeing principals were liable to the same extent as would be the borrower under that provision.

During the term of the loan, the borrower obtained $400,000 in subordinate financing secured by a second mortgage on the property without first obtaining its first lender’s consent. This triggered the non-recourse carve-out provision of the loan documents and made the loan fully recourse as to both the borrower and the guarantors. The $400,000 mortgage was satisfied seven months later, but was not discharged of record. Beginning eighteen months later, the borrower stopped making payments on its first mortgage loan. This triggered an uncontested foreclosure action.

The property was sold by the sheriff’s sale, leaving a deficiency of slightly over $5,000,000. Based on the subordinate financing default, the lender sought to collect this deficiency from both the borrower and the guarantors. This was met with the argument that since the lender “was not harmed by the added encumbrance on the property, the breach was only related to any damages suffered by [the lender] and therefore the non-recourse carve-out clause extracted an unenforceable penalty.” The lower court rejected this argument, “finding that the damages sought by [the lender] were neither speculative nor estimated, but actual, (‘equal to the outstanding loan balance and nothing more’) and fair, (’[t]he defendants hav[ing] received the benefit of their bargain by receiving and retaining the loan proceeds’).”

The borrower and the two guaranteeing principals appealed, mainly arguing “that the non-recourse carve-out clause [was] unenforceable as a liquidated damages provision because the penalty extracted from the borrower’s breach of a covenant not to further encumber the mortgaged property [bore] no reasonable relationship to any harm suffered by the lender.” This argument failed on appeal. Rejecting the arguments raised by the borrower and its two principals, the Appellate Division first cited the well-settled principle that a court’s function is to enforce contracts as written “and not to make a better contract for either of the parties.” It found the non-course language to be plain and capable of legal construction, and no reason to avoid the clear meaning of that language. Further, it felt that the applicable provision was unambiguous.

The Appellate Division, and the lower court below, characterized this as a “commercial transaction negotiated between business entities with comparable bargaining power.” It opined that the borrower and the guarantors knew and agreed to the carve-out provision and knew that it was a material term in acquiring the loan. On that basis, the Court held the obligated parties “to the plain and clear language they chose.”

The Court held that this carve-out clause was “not a liquidated damages provision, much less an unenforceable penalty. A clause is a liquidated damages provision if the actual damages from a breach are difficult to measure and the stipulated amount of damages is ‘a reasonable forecast of the provable injury resulting from [the] breach.’” Driving to the heart of the matter, the Court further held that “[n]on-recourse carve-out clauses like the one here are not considered liquidated damages provisions because they operate principally to define the terms and conditions of personal liability, and not to affix probable damages. Generally speaking, because non-recourse loans may create issues of a borrower’s motivation to act in the best interest of the lender and the lender’s collateral, ‘lenders identified defaults that posed special risks and carved them out of the general nonrecourse provision.’”

In other words, “the non-recourse nature of [such a] loan operates as an exemption, the carve-outs exist to implicate personal liability.”

Another important reason behind the Court’s decision was its belief that the carve-out clause provided only for actual damages. This differed substantially from the typical liquidated damages provision in that the amount of damages is not fixed at the beginning of the loan, but reflect only the actual damages incurred by the lender.

Lastly, it didn’t matter to the Court that the borrower “eventually cured the very breach that triggered” the personal liability and that “no harm accrued to [the lender] as a result thereof.” Even though the encumbrance was only temporary, the borrower’s action “had the potential to affect the viability and value of the collateral that secured the original loan.” Further, the Court mused that it could not say with “any certainty that the subordinate financing in this case was entirely unrelated to [the] ultimate default.” More formalistically, the Court opined that “the fact that such potential may not have actualized [did] not diminish the breach of obligation nor vitiate its contracted-for consequences.”

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