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Beware Expanding Non-Recourse Carve-Outs: Understanding the Bad Boy Guaranty

Life insurance companies and the larger national banks again are making non-recourse loans to borrowers, but are the loans really non-recourse?

These loans, which often are packaged as pools of loans and securitized (referred to as commercial mortgage-backed securities or CMBS), contain carve-outs or exceptions to the non-recourse nature of the loan. Non-recourse carve-outs are a list of actions or events that will result in the borrower or guarantor having partial or full recourse liability for the loan.

In most cases, the lender will require an individual who has control of or a controlling interest in the borrower to guaranty the loan to the extent of the recourse liability arising from the non-recourse carve-outs. This guaranty is commonly called the “Bad Boy Guaranty” because the events or actions that trigger recourse liability for the loan traditionally were limited to wrongful acts on the part of the borrower or guarantor.

More recently, the list of non-recourse carve-outs has expanded into events and actions that one would not consider wrongful. For this reason, it is very important to understand the scope of the “Bad Boy Guaranty” and have the carve-outs reviewed and negotiated by legal counsel.

Borrower and Guarantor Become Fully Liable

There are two types of non-recourse carve-outs. The first type results in the borrower and guarantor being fully liable for the loan. An example of such a carve-out is a borrower filing for bankruptcy or consenting to or facilitating an involuntary bankruptcy proceeding, receivership or the like.

Other examples that are more problematic include:

  • Violating the single purpose entity – bankruptcy remote covenants contained in the loan documents,
  • Failing to permit inspections of the property by the lender,
  • Failing to deliver financial information to the lender,
  • Allowing a voluntary lien to encumber the property, or
  • Transferring the property or an ownership interest in the borrower in violation of the provisions of the loan document.

Liability in the Event of Loss

The second type of non-recourse carve-outs includes acts or events that result in recourse liability only to the extent that the lender suffers a loss from such a carve-out event. Examples are:

  • Fraud or misrepresentation,
  • Gross negligence or willful misconduct,
  • Any environmental indemnification,
  • Misappropriation, misapplication or conversion of insurance proceeds, condemnation proceeds, rents or security deposits,
  • Failure to maintain required insurance,
  • Failure to pay real estate taxes
  • Waste at the property and
  • A borrower’s commission of a criminal act.

As one can see from the extensive exceptions to the non-recourse nature of the loan, it is critical that the non-recourse carve-outs are reviewed and negotiated.

Recommended Provisions

The following is a short list of some of the major provisions we try to negotiate on behalf of the borrower or guarantor:

  • All non-recourse carve-outs other than bankruptcy create recourse liability only to the extent of the actual loss incurred by the lender.
  • Waste and failure to pay real estate taxes should not create recourse liability if the property has insufficient cash flow to support payment of taxes and proper maintenance and repairs.
  • Required notice and cure periods before failure to permit inspections or deliver financial statements results in recourse liability.
  • Insolvency or the failure to pay debts as they come due does not trigger recourse liability.
  • Limit the scope of the recourse liability for improper transfers of the property. Negotiating this limitation may require revisions to the covenant and events of default contained elsewhere in the loan document, where the prohibited transfers are defined.
  • Distributions to the owners prior to an event of default are not subject to recapture.

Not all non-recourse loans are the same. More and more lenders are piling on non-recourse carve-outs that increase the likelihood that borrowers and guarantors may be liable for a deficiency judgment. Without careful attention to the non-recourse carve-outs and the “Bad Boy Guaranty,” a borrower and guarantor may be in for a not-so-pleasant surprise.

Larry Lerman is a commercial lending and real estate attorney at Lerch, Early & Brewer in Bethesda, Maryland who structures and documents complex commercial lending arrangements and represents parties who are buying, selling, leasing and financing commercial real estate. For more information on negotiation non-recourse carve outs, contact Larry at (301) 657-0163 or lglerman@lerchearly.com.

This content is for your information only and is not intended to constitute legal advice. Please consult your attorney before acting on any information contained here.

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