Client Alert: Guarantors May Face Unexpected Recourse Exposure
May 31, 2012

Recent judicial decisions could result in a big increase in guarantor exposure under “bad boy” or “non-recourse carveout” guaranties.

A common commercial loan structure involves a non-recourse loan made to a single-purpose entity (or “SPE”) borrower – that is, a borrower that owns just one property – with specific recourse “carveouts” that allow the lender to seek recourse beyond the collateral property. These carveout situations include fraud, misuse of funds, and committing waste on the property – all situations which typically involve a deliberate act by the borrower or its officers, and hence commonly called “bad boy” acts. Lender exposure under these so-called “bad boy” carveouts is commonly guarantied by one or more guarantors, who generally are the principals of the borrower or its managing member.

This non-recourse structure was particularly common in “CMBS” (commercial mortgage-backed securities) deals over the last decade, but lenders also used it in the past (and continue to use it today) in other secured loan contexts, such as retail centers and multi-family housing. Guarantors have been comfortable giving such recourse carveout guaranties because they believe that so long as they do not commit any affirmative bad acts, they will not have exposure and the lender will have to look only to the property for satisfaction of the debt.

However recent judicial decisions, including two in December, 2011, have imposed recourse liability on guarantors for acts beyond the guarantors’ control - and thereby have created significant uncertainty as to the potential exposure of all recourse carveout guarantors nationwide.

Recent cases create uncertainty

The two cases that most concern guarantors both arose in Michigan. In the first, 51382 Gratiot Avenue Holdings, the loan contained a covenant that the borrower would not “fail to pay its debts and liabilities from its assets as the same become due”. The associated guaranty covered, among other things, the breach of any of the covenants regarding being an SPE. With the economic downturn, borrower failed to make certain payments, and lender declared a default and sought full recovery under the guaranty. The borrower and guarantor argued that the borrower was only required to pay “from its assets”, and given the loss of value there was no breach. However the court found the loan language regarding payment “as they become due” to be clear and controlling, and held that the violation of the covenant triggered personal guarantor liability in excess of $12,000,000.

Just days later, another Michigan court in Cherryland Mall Limited Partnership reached a similar conclusion. In Cherryland the borrower had made a covenant that it would not “fail to remain solvent or pay its own liabilities”, and the guaranty specified that the loan became fully recourse if the borrower violated any of the SPE covenants. As in 51382 Gratiot Avenue Holdings, the economic downturn caused the borrower to become insolvent due to a decrease in property value. A default was declared, and the property was foreclosed by lender, with the lender seeking a deficiency judgment under the guaranty. The court determined that the SPE covenants had been violated, and hence even though the violation was not an affirmative act by the borrower or guarantor, full recourse liability existed under the guaranty.

Though these cases occurred in Michigan, similar cases have arisen in other states too - Louisiana, Massachusetts, and New Jersey to name a few. In all these instances, guarantors who thought they were only on the hook for things under their control - such as misuse of funds or fraud - suddenly found themselves on the hook for the entire loan amount due to general economic circumstances beyond their control.

Impact of these cases: increased uncertainty and risk

The potential impacts from these decisions are sweeping: loans thought to be non-recourse could essentially become fully recourse upon a lender election to declare a default and seek a deficiency judgment. Indeed, many of these loans across the country may already be de facto fully recourse loans, because borrowers may be violating net worth or insolvency covenants that were - deliberately or accidently - swept into non-recourse carveout language. In the end, guarantors and borrowers who believed they understood and controlled their exposure now find themselves on unstable ground, potentially at risk for millions of dollars of debt. Guarantors and borrower may find that they refrain from committing any “bad acts”, yet still face full liability.

Additional implications - domino effect, and tax consequences

The implications of these recent decisions are not limited to the impact on specific guarantors with respect to specific properties, either. Often the guarantors are principals of property management or development companies that are involved in multiple deals at any one time. If just one of these deals goes into default and recourse liability to the guarantor is triggered, the negative impact on the guarantor’s net worth could in turn trigger events of default under other loans with which the guarantor is connected. This domino effect could quickly collapse the financial standing of the company’s entire portfolio - and potentially those of its equity and investment partners as well.

Moreover, the conversion of a non-recourse loan to a recourse loan may have significant tax implications for borrowers and their owners. First, the implied conversion of debt from non-recourse to fully or partial recourse in nature may result in a deemed taxable exchange of old debt for new debt under Section 1001 of the Internal Revenue Code, with potential tax consequences especially when the fair market value of the debt is less than the loan’s outstanding principal. In addition, to the extent any of the debt is deemed recourse and then is waived or forgiven by a lender (such as in a negotiated workout, or in a deed-in-lieu of foreclosure), the cancellation of recourse debt could result also in ordinary income to the borrower. Moreover, if the borrower is a partnership for tax purposes, then the tax consequences of the foregoing actions are generally passed through to the partners of the partnership.

Borrower and guarantor responses

It is likely that little can be done to protect guarantors under existing loans. Amendments to clarify (and narrow) the scope of recourse carveouts would be an uphill climb for stressed lenders who now see a potential source of additional collateral - and modification of CMBS loans, with their fragmented ownership, could be almost impossible. If these issues can be identified in advance, though, borrowers and guarantors may be able to take actions to come back into compliance and thereby avoid a lender recourse demand.

For new loans, a more nuanced negotiation of recourse carveouts should help protect guarantors. Borrowers and their counsel need to make sure that separateness covenants are not blurred with “bad boy” recourse carveouts, as well as ensure that the latter are drafted narrowly to include only affirmative acts - not general market impacts or economy-wide changes.

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