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CRE Finance World, Autumn 2013

Bad Boy Guarantees Strictly Construed A publication of Autumn issue 2013 sponsored by CRE Finance World Autumn 2013 49 eal estate finance transactions typically involve nonrecourse mortgage loans to single asset special purpose entities (SPEs). In these situations, the lender’s recourse is limited to the mortgage property, rents, deposit accounts and other assets affixed to or derived from the operation of the property upon non-payment of the loan. Recent court decisions addressing the scope and extent of the liability limitations indicate that parties signing bad boy guarantees need to be very clear and detailed in the documents supporting the agreement so as not to be caught off guard by the exposure they will undertake. The owners of the SPE/borrower are not personally liable for the non-recourse loan, unless the lender required the execution of a non-recourse carve-out guaranty, commonly referred to as a “bad boy” guaranty. The owners who sign these guarantees agree to repayment obligations in the event of specified acts or violations of the loan documents. Courts in recent decisions out of various states have strictly construe bad boy guarantees to impose liability for the entire loan balance irrespective of the nature of the damages to the lender arising from the breach. The case of Princeton Park Corporate Center v. SB Rental I, 410 N.J. Super 114 (App. Div. 2009) is illustrative. Here, the mortgage loan documents executed in 2001 prohibited secondary financing without approval by the mortgage lender. A subordinate loan was obtained in 2004 without the lender’s knowledge or approval, and it was paid off in just seven months. Nonetheless, when the first mortgage loan went into default in 2006, the lender foreclosed and immediately thereafter sued the signers of the bad boy guaranty for the full deficiency of $5 million. The lender won at both the trial court and on appeal. The appeals court held that even though the lender was not actually damaged by the second lien loan (that had been paid off before the default), the absence of direct damages was not relevant. In this regard, the court stated, “having freely and knowingly negotiated for the benefit of avoiding recourse liability generally, and agreeing to the burden of full recourse liability in certain specific circumstances, defendants may not now escape the benefit of their bargain.” The obligors in the Princeton Park case did not contest the foreclosure action, but in the separate suit to enforce the carveout guaranty they did defend with the argument that the lender was not harmed at all by the subordinate loan that was repaid in full before the default. The defendants asserted that the carve-out clause was a liquidated damages provision and that to allow the lender to recover under such circumstances would effect a penalty that should be unenforceable as a matter of law. The New Jersey courts, at both the trial and appellate levels disagreed. At the appellate level, the Court observed that the clause at issue was “not a liquidated damages provision,” that it operated “principally to define the terms and conditions of personal liability, and not to affix probable damages,” and that it did not matter that the obligors “eventually cured the breach … and that no harm accrued to the plaintiff as a result thereof.” Id., 410 N.J. Super at 121-123. What did matter to the New Jersey courts was that the carve-out was sought by the lender to afford some special protection in the otherwise non-recourse context, and that the carve-out provision was “freely and knowingly” agreed to by the obligors in return for the benefit of avoiding recourse liability generally. Id at 124. Another example — this one from Michigan — is Wells Fargo Bank v. Cherryland Mall, 812 N.W. 2d 799 (Mich.Ct.App. 2011), where both the trial and appellate courts found the non-recourse carve-out guarantor liable for the full deficiency after the SPE/borrower became insolvent in violation of the loan covenant requiring that the SPE remain able at all times to pay its debts and liabilities from its assets as the same became due. The Court of Appeals in Michigan characterized the solvency covenant as one of the “Separateness Covenants” customarily included within the recourse triggers under typical CMBS non-recourse transactions involving an SPE as this one was. The operative covenant of the Note read as follows: Notwithstanding anything to the contrary in this Note or any of the Loan Documents, ... the Debt shall be fully recourse to Borrower in the event that ... Borrower fails to maintain its status as a single purpose entity as required by, and in accordance with the terms and provisions of the Mortgage.... Id., 812 N.W. at 806. The operative covenant of the Mortgage read as follows: Mortgagor is and will remain solvent and Mortgagor will pay its debts and liabilities including, as applicable, shared personnel and overhead expenses) from its assets as the same shall become due. Id. at 808. R Michael Viscount, Esq. Partner Fox Rothschild LLP


CRE Finance World, Autumn 2013
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