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Lenders, Be Wary When Extending Credit on Rental Income Stream

Commercial Lending Bulletin

A recent 7th U.S. Circuit Court of Appeals case reminds lenders that it is incumbent upon the lender to verify the income stream before extending credit based on rental income. In Wells Fargo Equipment Finance Inc. v Titan Leasing, Inc., the bank extended non-recourse credit (a loan secured only by collateral) to a manufacturer of locomotives relying on the income stream from a specific lease executed by the borrower and its lessee for a locomotive. The borrower presented a fully executed copy of the lease to the bank as evidence of the income stream. The borrower warranted in the loan documents that the locomotive was delivered and accepted by the lessee and that the lessee acknowledged the locomotive’s receipt and acceptance.

Despite these warranties, the lessee returned the locomotive for repair during the loan closing because it was damaged during delivery. The lessee rejected the locomotive after it was returned several months later, and never made a payment on the lease. While the bank took possession of the locomotive to recover the amounts owed, it also sued the borrower alleging breach of warranties under the security agreement—namely, that the borrower’s representation and warranty that the locomotive was received was untrue.

Lenders Should Verify the Lease with the Lessee and Include “Bad-Boy Carve-Outs”

While the note was non-recourse, meaning that the borrower was not personally liable, the loan documents contained certain warranties that, if breached, would subject the borrower and any guarantor of those warranties to recourse liability. The original trial court ruled in favor of the borrower. However, the Court of Appeals reversed and remanded the case to the trial court. The court awarded a judgment in favor of the bank because the borrower had breached the warranties in the loan documents.

Although the court eventually found for the bank, there are two important takeaways for lenders to remember. First, had the lender verified with the lessee at the time of the loan closing that the lease was in full force and effect and there was no default under the lease (commonly accomplished through an estoppel certificate), the loan may not have closed or funded until the repaired locomotive was delivered and accepted by the lessee. By merely relying on the borrower’s representation, the bank was forced to repossess the collateral and sue to collect sums owed at an additional cost and expense. Second, whenever a lender makes a non-recourse loan, it should always include the “bad-boy carve-outs,” (read more about “bad-boy carve-outs” at "Beware Expanding Non-Recourse Carve-Outs: Understanding the Bad Boy Guaranty") that reserve recourse liability on the borrower and guarantors if certain representations or covenants are breached.

Alison Rind is a commercial lending attorney at Lerch, Early & Brewer in Bethesda, Maryland who represents lenders in loan transactions and other commercial matters, including handling asset-secured loans. For more information about non-recourse loans, contact Alison at (301) 657-0750 or awrind@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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