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Real Estate Guarantors Beware: Acts of ‘Bad-Boy’ Borrowers Can Trigger Personal Liability
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(This article first appeared in the March 19, 2008, New York Law Journal.)
May 5, 2008
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By Jeffrey B. Steiner and Zachary E. Samton
Thelen Reid Brown Raysman & Steiner LLP
The recent credit crunch has led many industry prognosticators to predict a potentially significant increase in workouts and foreclosures affecting the commercial real estate market. In anticipation of such problems, many lenders and borrowers are re-examining their loan documents and analyzing their options and remedies. Both lenders and borrowers, however, should avoid making the mistake of reviewing only the loan agreement or mortgage affecting their property. Proper preparation for the resolution of a problem loan also should include a close look at the other loan documents, especially the guarantees.
The most prevalent commercial mortgage loans for the last decade have, despite being defined as "non-recourse," included a guaranty from either a principal or well-capitalized parent entity ensuring that the borrower will not undertake certain prohibited acts. Such a guaranty is commonly referred to as a "non-recourse carve-out guaranty" or a "bad boy guaranty."
The principal or parent entity of a property owner that might otherwise be loath to issue a more standard payment guaranty often can be comfortable issuing a non-recourse carveout guaranty because the prohibited acts are under the control of the borrower and are not subject to market fluctuations or simple bad luck. Normally, the proscribed "bad boy" acts under such a guaranty include: fraud and intentional misrepresentation, gross negligence, willful misconduct, waste, wrongful removal or destruction of any part of the property, misappropriation or conversion of any insurance proceeds, condemnation awards, rents paid more than one month in advance or security deposits, filing for bankruptcy (and other bankruptcy-related acts), failure to provide financial information, failure to maintain the borrower's status as a single (or special) purpose entity ("SPE"), sometimes as a bankruptcy remote entity, failure to obtain consent for any additional indebtedness encumbering the property and for a transfer of the collateral.
Depending on the prohibited act, the guarantor can be liable for losses or, in certain instances, the entire principal balance of the loan.
While it may seem easy to avoid committing a "bad boy" act and, therefore, to prevent any possible liability under such a guaranty, desperate borrowers have been known to commit desperate (and prohibited) acts to avoid foreclosure or to otherwise pull all possible cash out of a property before foreclosure or deed-in-lieu. In the current economic climate, however, guarantors should be especially vigilant not to violate the terms of a "non-recourse carve-out" guaranty. If a lender already is concerned that a loan is significantly under-collateralized, the lender may not hesitate to hold a guarantor liable for violation of a guaranty, including a non-intentional violation such as failure to strictly adhere to single-purpose entity covenants.
Although the case law is limited, the few courts that have made decisions concerning violations of a non-recourse carve-out guaranty generally have ruled in favor of the lender and held the guarantor(s) personally liable under the guaranty.
SPE Status
Most recently, a court determined that a borrower's diversion of a $2 million payment from the settlement of an appeal of a zoning board decision to an account benefiting an affiliate of the borrower without the consent of the lender violated the non-recourse carve-out guaranty. Blue Hills Office Park LLC v. JPMorgan Chase Bank, 477 F.Supp.2d 366 (D.Mass. 2007). The court held that this diversion of funds violated the prohibition against a transfer of the property (the $2 million payment was determined to be additional collateral and part of the mortgaged property) as well as the requirement that the borrower be a single-purpose entity. The court found that by transferring the settlement payment to an account containing other funds held for the benefit of an affiliated entity, the borrower co-mingled the funds and thereby breached the single-purpose entity covenant. The borrower's failure to maintain its single-purpose entity status created liability in the full amount of the deficiency between the amount recovered at the foreclosure sale and all amounts due under the loan. In the end, the guarantor paid (literally) a very hefty price for diverting funds and violating the SPE covenants.
Although most borrowers would not commit such a blatant violation of the single-purpose entity covenants, less obvious violations could be damaging. Typically, there is a three- to four-page list of single-purpose requirements, including that the single-purpose borrower maintain its own books and records separate and apart from affiliates, file its own tax return (unless required to file a consolidated tax return) and use separate stationery, invoices and checks bearing its name. Whether a borrower's failure to comply with a seemingly unimportant requirement such as using separate letterhead or checks would be held to violate the terms of a non-recourse carve-out guaranty has not been tested. However, following the logic of Blue Hills, such a mistake could trigger a guarantor's liability. It is important to note that the court in Blue Hills did not base its decision on the significant amount of the funds that were diverted but on the diversion itself.
Filing for Bankruptcy
In at least two cases, guarantors were held personally liable under a bad-boy guaranty for violating a non-recourse carve-out that prohibited the filing of a bankruptcy claim by or against the borrower. In First Nationwide Bank v. Brookhaven Realty Associates, 223 A.D.2d 618, 637 N.Y.S.2d 418 (2d Dept. 1996), the borrower and lender entered into a non-recourse mortgage with a guaranty making individual partners of the borrower, as guarantors, personally liable if a bankruptcy was filed by or against the borrower and was not dismissed or resolved within 90 days of the filing. The borrower defaulted on the loan and filed a bankruptcy proceeding that was not dismissed until after the 90-day cure period expired.
After the bankruptcy proceeding was dismissed, the lender sought a determination in the foreclosure action that it was entitled to a deficiency judgment against the borrower and guarantors based on the borrower's bankruptcy filing. The borrower and its partners argued that the bankruptcy default clause was unenforceable under the Bankruptcy Code, which prohibits the enforcement of "ipso facto" clauses in executory contracts. The court, however, rejected this argument and concluded that once the bankruptcy case had been dismissed, the enforceability of the bankruptcy default clause was governed by state law and not bankruptcy law. The court further concluded that the "ipso facto" prohibition did not apply in such a circumstance because the bankruptcy court's policy of providing a borrower/debtor with an opportunity to reorganize and start anew was not present in foreclosure proceedings.
In Federal Deposit Insurance Corp. v. Prince George Corp., 58 F.3d 1041 (4th Cir. 1995), a lender was entitled to pursue a deficiency judgment against the borrower and its joint venture partner, as guarantor, pursuant to a non-recourse mortgage note if the borrower: 1) voluntarily became part of a suit that suspended, reduced or impaired the lender's recourse rights to the collateral; or 2) engaged in "any act, omission or misrepresentation" that had the same effect.
The borrower defaulted on the loan, and the lender initiated foreclosure proceedings. The borrower then filed a bankruptcy suit, which stayed the lender's foreclosure. The bankruptcy suit later was dismissed, and the lender filed a suit for a deficiency judgment. The court rejected the borrower's argument that the guaranty provision was a waiver of the right to bankruptcy protection and void as against public policy. The court concluded that the note did not prevent the borrower from filing for bankruptcy but rather required the joint venturer, as guarantor, to become personally liable for payment of the loan if such action was taken. The court upheld the lender's right to sue the joint venturer for a deficiency judgment pursuant to the "non-recourse carve-out" provisions in the note.
Bad Faith Waste
The lender's expectation is that the inclusion of a recourse carve-out prohibiting tortious waste will discourage a borrower from failing to pay its real estate taxes and insurance in order to divert funds to equity holders or obtain leverage to force a workout. See, “Nonpayment of Taxes as Tortious Waste in Nonrecourse Mortgage Loans,” 19 Cal. Real Prop. J. 21 (2001).
However, when such a provision does not act as a sufficient deterrent to borrowers, lenders can turn to the courts, which have held that a guarantor may be personally liable for a borrower's deliberate failure to maintain the value of the property. For example, in Nippon Credit Bank, Ltd. v. 1333 North Carolina Boulevard, 86 Cal.App. 4th 486, 496-497 (2001), the court upheld a lower court decision that a borrower committed bad-faith waste by failing to pay real estate taxes while the non-recourse loan was delinquent and held that the lender could recover for waste when its security was "substantially impaired" by such failure to pay taxes. The court held that a jury could have determined that the borrower's sole aim in defaulting on the taxes was to divert money from the project and that evidence showed that the project had sufficient funds to pay the taxes.
As it has been observed that the degree to which borrowers maintain and preserve their property diminishes significantly in times of financial duress if their loans are limited recourse as opposed to full recourse, the court also may require lenders to show that a borrower's actions differed from how it would have behaved if it had been a full recourse loan and that the lender would have suffered less of a loss if the borrower had acted in a different manner. In addition, the court may consider whether the borrower acted in a manner that went beyond the usual activities to which a lender generally is deemed to have agreed. See, 55 Wash & Lee L. Rev. 1207, 1256.
Encumbrances on Property
In Heller Financial, Inc. v. Lee, 2002 U.S. Dist. LEXIS 15183 (N.D.Ill. 2002), in connection with a mezzanine financing, the loan documents made the guarantor personally liable if any lien was placed on the collateral or property without the written consent of the lender. Six liens were placed on the property without lender's consent, and the lender declared the borrower to be in default under the loan. The lender foreclosed and sold its equity interests in the project and brought a claim to hold the guarantor personally liable for the deficiency. The borrowers argued that such a provision was a liquidated damages clause, but the court determined that the non-recourse provision provided for actual damages, not liquidated damages, and upheld the personal liability of the guarantor for the deficiency.
Although case law generally suggests that courts will respond favorably to holding a borrower/guarantor personally liable for a deficiency claim based on violations of a nonrecourse guaranty, it is important to note that in one extreme case, Acorn Properties, Inc. v. East 7th Realty Associates, 238 A.D.2d 279, 656 N.Y.S.2d 274 (1st Dept. 1997), the court denied lender's claim for a deficiency judgment because lender's claim was not timely and because the lender failed to present evidence of the alleged violations (fraud and waste) during the foreclosure proceedings or on a motion for a deficiency judgment.
Conclusion
From the perspective of either a borrower or lender, non-recourse carve-out guarantees should be carefully reviewed and analyzed when a commercial mortgage loan goes bad. There are numerous ways a borrower can trigger recourse liability, and in the current climate, a foreclosing lender may have a significant financial incentive to enforce such a guaranty. As the courts have not hesitated to impose such recourse liability on guarantors for bad-boy violations, borrowers should be proactive to avoid either simple imprudence or avaricious acts that may lead to personal liability far in excess of anything anticipated.
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For more information about the issues covered in this report, please contact Jeffrey B. Steiner in our New York office at 212-603-2260 or at jsteiner@thelen.com or Zachary Samton in our New York office at 212-603-6534 or zsamton@thelen.com or contact your Thelen attorney. For more information about Thelen’s Construction and Government Contracts Department, click here.
(Reprinted and excerpted with permission from the March 19, 2008, edition of the New York Law Journal. ©2008 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.)
©2008 Thelen Reid Brown Raysman & Steiner LLP
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