Lender Whacked For $33M In Punitives

GMAC Commercial Mortgage Corporation, finding that GMAC breached its Security Agreement with its borrower, 1601 McCarthy Boulevard, LLC. The jury found GMAC guilty of breach of contract and conversion for refusing to release to the borrower money impounded as partial security for its loan.

Most of the cases reported in the pages of this and other publications are taken from the decision written by the Court of Appeal, following an appeal of the trial court decision or verdict. Today we have the opportunity to examine the outcome of the trial in the Superior Court, which may or may not be appealed.

The borrower, 1601 McCarthy Boulevard, is a limited liability corporation whose sole shareholders are a retired firefighter and his wife, who borrowed $8.8M from Wells Fargo Bank to purchase a $13M office building in Milpitas, California. The loan was transferred and eventually became part of a securitized loan pool in which Wells Fargo was the master servicer and GMAC was the special servicer.

Two years into the loan, in December 2002, the main tenant of the office building defaulted on its rent and expressed its desire to be released from its lease. As a result of this change in circumstances of the borrower, Wells Fargo, as master servicer, transferred the loan to the special servicer GMAC.

The loan documents anticipated the possibility of lease termination and provided that any lease termination payment must be deposited with the beneficiary [GMAC] in a pledged account until the space is re-rented, and then if the borrower is not in default the impounded money was to be returned to the borrower.

After weeks of negotiations 1601 McCarthy reached a tentative agreement with the defaulting tenant for termination of the lease whereby the tenant would pay $7.2M to be released from the remainder of its lease obligations.

1601 McCarthy promptly sought GMAC’s consent to the lease termination agreement, which was initially refused. GMAC, which had not originated the loan, purportedly said that “as it currently stands” the loan documentation was “terrible” and GMAC wanted to rewrite the loan documents. Efforts to agree on new documentation were fruitless, and 1601 McCarthy insisted on reverting to the original agreements. GMAC presented 1601 McCarthy with a Security Agreement and an Account Control Agreement that incorporated parts of the Deed of Trust and governed the impounding of the $7.2M lease termination proceeds in a pledged account controlled by GMAC.

In February 2003, 1601 McCarthy was able to secure a lease of some of the space with a former subtenant of the defaulted tenant, and in April secured another lease with a new tenant for the remainder of the space. 1601 McCarthy requested GMAC’s approval of the leases, which was granted. After completion of the tenant improvements and commencement of occupancy, 1601 McCarthy applied to GMAC for release of the $7.2M being held as additional security.

GMAC refused to release the $7.2M to the borrower, saying for the first time that its valuation of the property suggested a decline in the value that constituted a material adverse change in the financial condition of the borrower which was an event of default under the loan documents.

1601 McCarthy later contended at trial that GMAC had approved the new leases while knowing that in February it had prepared a “Confidential – Asset Resolution Strategy” plan that, undisclosed to 1601 McCarthy, provided that the lease termination impound funds would not be released to 1601 McCarthy unless the vacant space was re-rented at rates that would result in income equaling or exceeding the loan payments. The plan allegedly indicated that 1601 McCarthy was unlikely to be able to achieve this level of rent in the existing economic conditions.

For over three months 1601 McCarthy implored GMAC to release the $7.2M to it, but without success. In October 2003, 1601 McCarthy filed its original complaint, later amended, asserting causes of action for (1) breach of contract, (2) conversion, (3) breach of fiduciary duty, (4) unfair business practices in violation of Business and Professions Code § 17200, and (5) declaratory relief.

GMAC’s defense contended that at the time 1601 McCarthy requested the release of the funds GMAC had received a “preliminary verbal report” from an appraiser it had engaged, and together with its “own knowledge of what had happened to real property values in Silicon Valley” it believed there had been a material adverse change in 1601 McCarthy’s financial condition, constituting a default under the loan documents. GMAC never received a final appraisal from this appraiser, and ultimately retained another appraiser who completed an appraisal in October 2003, the same time as the lawsuit was filed.

GMAC asserted that (1) there had been a material decline in the primary asset of 1601 McCarthy, (2) the income was insufficient to service the debt, (3) the loan was non-recourse, (4) 1601 McCarthy was a single-purpose entity, and (5) there had been a loss of tenants and decline in the rental rates, all of which comprised a material adverse change in the financial condition of the borrower. One wonders how item numbers 2 and 3 had changed since the loan inception.

1601 McCarthy contended that GMAC refused to consider the $7.2M as its cash asset, and that when added to its balance sheet, as it properly should have been, 1601 McCarthy was in the same or better financial condition than it had been when the loan was originally approved, and in more than adequate condition to meet its present and future repayment obligations.

The jury returned a special verdict finding that GMAC breached its Security Agreement, that 1601 McCarthy met all conditions for release of the impounded funds, and that 1601 McCarthy was entitled to the return of its $7.2M together with $555,613 of lost investment income. The jury also found that GMAC acted with malice, oppression and fraud in committing a conversion of the impounded funds. In subsequent proceedings the jury awarded $33M in punitive damages to 1601 McCarthy Boulevard, LLC.

The trial lasted three weeks before San Francisco Superior Court Judge David L. Ballati. 1601 McCarthy was represented by Jon B. Streeter, Matthew M. Werdegar, and Yasmin Kok, of Keker & Van Nest in San Francisco, who graciously provided the pleadings and briefs from which this article was written, and whose work was exemplary.

Brewer Offord & Pedersen LLP represents lenders and borrowers in mortgage transactions. In the experience of our office dealing with commercial loans called on the basis of a material adverse change in the financial condition of the borrower as a result of the abrupt decline in real estate values following the dot-com crash, we have always been successful in reaching workout arrangements with, or on behalf of, the lenders. The lesson to be learned from this case may be that prudent lending practices suggest being more solution oriented and less dogmatic, and above all, do not harbor concealed intentions toward the borrower.

This article written and © Peter N. Brewer, Esq.

Brewer Offord & Pedersen LLP (www.BrewerFirm.com) serves the legal needs of homeowners, real estate and mortgage brokers, agents, brokerages, title companies, developers, investors, other real estate professionals and their clients. Mr. Brewer and his firm also represent clients in debt collection, breach of contract matters, and other litigation and transactional work. The firm’s client range from homeowners, brokers and lenders based in Santa Clara County, San Mateo County, San Francisco County, as well as throughout other counties in California.