Real estate loans are typically divided into two categories, recourse and nonrecourse. With recourse loans, guarantors are personally liable for the loan whereas, with nonrecourse loans, lenders’ sources of recovery are typically limited to the mortgaged property.
While nonrecourse loans limit liability in many respects, there are significant exceptions known as “nonrecourse loan carve-outs” that can result in personally liability for losses and, in some cases, trigger full personal liability for an entire loan.
Guaranties that trigger personal liability for losses as a result of “bad acts” are known as “bad boy” guaranties. Guarantors typically will not balk when required to deliver these guaranties as, at first glance, it seems fair to be on the hook for losses if certain “bad acts” are committed.
However, the actual terms of these guaranties may go way beyond the typical bad-boy carve-outs for gross negligence and willful misconduct. It is imperative that these guaranties are carefully negotiated to not only limit liability to “bad acts,” but to also restrict the carve-outs to events that borrowers control. Against that backdrop, below are some key carve-outs that guarantors should seek to limit:
- Failure to Pay Taxes, Insurance and Other Charges – Often guarantors are responsible for losses resulting from the failure to pay taxes, insurance and other charges. While this initially seems reasonable, it is crucial to limit these types of carve-outs because the failure to make these payments may not by itself be the result of a “bad act.” In some instances, there just may not be sufficient cash flow to make these payments if a property is underperforming. As a result, these carve-outs should be limited to situations in which “there then existed sufficient cash flow from the operation of the property to make the required payments.” In addition, liability resulting from these and other carve-out events should be cut off after the tender of a deed in lieu of foreclosure or, if earlier, when a lender forecloses or takes title to the property. Otherwise, lenders (or their successors and assigns) may go after guarantors/borrowers despite the fact that the borrower no longer owns the property.
- Breach of Key Documents – Sometimes guarantors are responsible for losses resulting from the breach, termination or modification of documents that are essential to the operation of the property (such as reciprocal easement agreements or condo documents). At a minimum, liability for these carve-outs should not be triggered unless the events have a material adverse effect upon the property and until notice and an opportunity to cure is given.
- Waste and Misrepresentation – These carve-outs should be limited to a “materiality” threshold and, if possible, restricted to “intentional” acts. Also, there should not be any liability for “waste” if outdated or worn property is replaced.
In addition to liability for losses, some lenders require guarantors to be liable for entire loans upon the occurrence of other carve-out events. Below are some critical carve-outs that guarantors should negotiate if they are even willing to agree to full recourse liability at all.
- Breach of Single Purpose Entity (SPE) Provisions – CMBS loans require compliance with SPE provisions, including the maintenance of separate bank accounts, records and financial statements — as the belief is that the SPE provisions help protect the borrower against the insolvency of its affiliates. A breach of these SPE provisions should not trigger full recourse liability unless the breach actually results in the pooling together of the assets and liabilities of a borrower with another party (known as substantive consolidation) and that breach is cited as a factor in a court’s consolidation decision.
- Transfers – While it is reasonable for certain transfers to trigger liability, the loan documents should permit family and estate planning transfers as well as transfers of interests not exceeding an agreed upon threshold. In addition, death and incompetency of members, guarantors and control parties should not trigger liability as those events are outside of anyone’s control. Finally, there needs to be a mechanism for allowing the substitution of a replacement guarantor that is reasonably acceptable to the lender.
- Bankruptcy – Bankruptcy carve-outs should be limited to voluntary bankruptcy so that bankruptcy petitions filed by third parties (including lenders) don’t result in full recourse liability.
- Liens – Involuntary liens, such as those filed by suppliers of labor or materials, should not trigger full recourse liability as these types of liens may not result from “bad acts,” but may be the outcome of a good faith dispute. If this type of carve-out is necessary, then liability should not be triggered if borrowers bond or arrange for payment within a reasonable period following notice of such lien. In these cases, notice is key because it would be unfair to impose liability if borrowers are unaware of the liens.
Negotiating nonrecourse loan carve-outs can often be complex and, if not carefully navigated, may expose guarantors to significantly more liability than anticipated. Each carve-out should be scrutinized to ensure that the interests of guarantors and borrowers are being met. Savvy borrowers represented by experienced counsel will always maintain a competitive edge in the market by applying best practices to limit their liability in these critical negotiations.
The opinions expressed in this article are not intended to create an attorney-client relationship and do not constitute legal advice. Neither the transmission of the information contained within this article nor the use of the information or communication with A.Y. Strauss creates an attorney-client relationship with A.Y. Strauss.