Jeffrey M. Verdon Law Group, LLP
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A Word of Caution...

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Not So Bad Acts That May Trigger Recourse Liability in Bad-Boy Guaranties

Dear Clients, Colleagues, and Friends,

Non-recourse loans have become more popular and desirable as a means for commercial real estate financing in recent years. There is a definite appeal in these types of loans due to the fact they do not require personal guaranties by the key principals of borrowers and their sponsors, limiting the liability for the loan to the real property collateral securing the loan, and not the personal assets of the principal.

Although these loans are favored for the limits they seem to set on liability, an article recently published in Orange County Business Journal entitled Staying Off the Hook - Managing the Evolving Bad-Boy Guaranty, shed light on some hidden triggers for liability in many non-recourse loans being offered today. We thought the information in the article would be useful to your continued business activities.

As you may know, most non-recourse loans include a "carve-out guaranty," more commonly known as a "bad-boy guaranty." These bad-boy guaranties list certain acts and occurrences that would cause the principals to be liable for either the actual losses incurred by the lender due to such acts and occurrences, or, in the event of certain acts and occurrences, the full amount of the loan. Classically, these acts and occurrences were limited to bad acts by borrowers and their key principals and executives, such as fraud, waste, commission of criminal acts, gross negligence and misappropriation. However, the article pointed out that as non-recourse loans have developed, many lenders have expanded the list of acts that can trigger increased recourse liability.1

While there are many benefits to non-recourse loans, the "bad-boy guaranties" that most lenders require are becoming broader these days to include more triggering acts. Originally, bad-boy guaranties contained a more limited list of certain acts and occurrences that would cause the principals to be liable for either the actual losses incurred by the lender or the full amount of the loan due to such acts and occurrences. Bad-boy guaranties now often contain questionable carve-outs for broader sets of acts and occurrences, including failure to maintain insurance and pay real estate property taxes, failure to deliver final statements and reports, certain transfers of the property or ownership interests in the borrowing entities, or termination of leases by tenants.

A major cause of concern with these broader sets of acts and occurrences is that many of them can be the result of an act by a third party and, therefore, the act which triggers liability may not even be in the control of the borrower and their principals. For example, another act commonly found in bad-boy guaranties that would trigger recourse liability is the commencement of involuntary bankruptcy proceedings against the borrower. In this situation, the involuntary proceedings are outside the control of the borrower.

However, the current favorable lending environment gives borrowers additional leverage to open negotiations on loan documents that may have previously been off limits for discussion. As a borrower, you should request to have these events removed from the listing of carve-outs, or at least limited to involuntary proceedings which you have consented to, acquiesced in, or orchestrated, bringing carve-outs back within your control. Also, be watchful for carve-outs which impose recourse liability for failing to pay real estate taxes on the property. As a borrower, you should look to negotiate to limit recourse to the amount of the lender's actual losses and only to instances of willful non-payment, and not instances where insufficient income from the property is the cause of the failure to pay.

When obtaining non-recourse loans in the future, be careful to read the language in newer bad-boy guaranties to ensure that only the bad acts that are typically defaults are included. Be especially watchful for included acts such as failure to meet financial reporting deadlines, failure of the borrower to stay solvent, any transfers of the property or ownership interests of the borrower, failure of the borrower to allow lender and their agents to inspect the property, and the recordation of any liens or encumbrances against the property. While some of these may have their place in the loan document, you should take the necessary steps to negotiate to limit the scope of the carve-outs to apply only to true bad-acts that are within the control of those signing the documents.

While the benefits of non-recourse loans still seem to outweigh the risks in most situations, it is important to proceed with caution, be mindful of the possible triggering events that may be included as carve-outs, and to make sure that only those true bad-acts within your control are included within the "bad-boy guaranty."
We hope you find this information helpful.

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