How to Negotiate Nonrecourse Carveout Guarantees

How to Negotiate Nonrecourse Carveout Guarantees

By Michael S. Kurtzon, Dykema

Reprinted with permission from the December 17, 2013 edition of Real Estate Law360

A nonrecourse carveout guarantee is a guarantee of certain acts or omissions of the borrower in connection with a secured real estate loan where the guarantor is not liable, or is only partially liable, for repayment of the principal and interest on the loan.

Traditionally, nonrecourse loans were thought of as not including any recourse against guarantors. However, as more loans were made to single-asset borrowers, lenders realized that if recourse was limited to the borrower’s real estate assets, events other than normal market conditions, such as so-called “bad acts” by the borrower, could seriously erode the value of the collateral. Thus originated the idea of the nonrecourse carveout guarantee.

Originally, nonrecourse carveout guarantees were limited to addressing so-called “bad acts,” such as fraud, theft or filing of a voluntary bankruptcy by the borrower. But over the years, the scope and types of borrower actions or omissions resulting in recourse against guarantors have expanded.

This article provides an overview of the types of nonrecourse carveouts typically included in recourse guarantees and how lenders and guarantors are dealing with the issues they present.

Structure and Customary Provisions

The matters covered by a typical nonrecourse carveout guarantee fall into two basic categories — those that cause the entire principal balance of the loan to become fully recourse to the guarantor’s so-called “springing recourse” events, and those for which the guarantor is liable only for the lender’s actual damages — so-called “below-the-line” matters.

Springing recourse events normally include:

Filing of a voluntary bankruptcy or similar proceeding by the borrower
Filing of an involuntary bankruptcy against the borrower by any of its owners, the guarantor or anyone affiliated with the borrower — a so-called “collusive” bankruptcy
Violation of a due on sale or further encumbrance clause in a mortgage
Fraud, theft or intentional misrepresentation
Violation of the single-asset entity or single-purpose entity provisions of the loan documents
Actions by the borrower or guarantor to delay or impede the lender’s enforcement of remedies under the loan documents

The “below-the-line” matters for which lenders seek liability include:

Misapplication of rents and revenues from the property
Misapplication of insurance or condemnation proceeds
Failure to pay off mechanics liens
Failure to pay real estate taxes or insurance premiums when due
Failure to pay operating expenses for the property
Failure to turn over security deposits to the lender
Waste
Misrepresentations or false representations or warranties

Negotiations of Nonrecourse Carveouts — Guarantor’s Perspective

The guarantor naturally wants to limit as much as possible both the springing recourse carveouts and the below-the-line matters. As a philosophical matter, the guarantor starts from the premise that the guarantee should cover only so-called “bad acts” — where the borrower has intentionally acted in a manner intended to frustrate the lender’s legitimate interests in enforcing the loan documents and regaining control of its collateral in good financial and physical condition.

Only those acts or omissions that can be characterized as “bad” should trigger any recourse, let alone full recourse. The guarantor will object to converting what it felt was a nonrecourse loan into a recourse loan through the carveouts. Counsel for the guarantor often will seek to modify the springing recourse events in the following ways:

Remove violation of the due on sale or prohibited transfer provisions as full recourse carveout events and move them “below the line” to events giving rise to damages. Especially in complex ownership structures where the violation of a prohibited transfer provision could be triggered by minor transfers of indirect ownership interests, guarantors are concerned that violations that do not result in harm to the lender, or may not be known by the guarantor, could result in full recourse.
Move fraud and theft below the line. Guarantors argue that fraud or theft may result from the acts of lower level employees of the borrower and may not cause significant harm to the lender.
Move challenges to enforcement of the loan documents below the line, or provide that they only result in recourse if a court finds they were made in bad faith.
Move minor violations of single-purpose entity provisions below the line. In cases decided in the last two years, courts have imposed liability upon guarantors for full repayment of nonrecourse loans where the borrowers were found to have violated a fairly standard single-purpose covenant requiring them to have sufficient capital to operate their businesses. The courts held that failure to pay the loans when due meant the borrowers did not have sufficient operating capital, resulting in the violation of the covenant and causing the loans to become fully recourse to the guarantors. While state legislatures have passed legislation to reverse the effect of some of these decisions in future loans, guarantors are justly wary of the implications of this line of cases.

The lender’s response might be as follows:

Agree to move the violation of a due on sale or prohibited transfer provision below the line, except for the actual conveyance of the title to, or placing a mortgage on, the property.
Keep as springing recourse events violations of the special purpose entity provisions that result in a substantive consolidation of the borrower’s assets with those of another entity in a bankruptcy proceeding, but move other violations below the line.

Since fraud is certainly a “bad act,” lenders normally resist moving it below the line — both for philosophical reasons and because proving fraud and damages for fraud can be difficult. Nevertheless, there are instances where lenders agree to do so.
Agree to move resisting enforcement of the loan documents below the line, as long as the borrower demonstrates in court that it had a good-faith basis for doing so and is the prevailing party.

Counsel for guarantors often seek the following changes in the “below-the-line” events giving rise to damages:

Where recourse arises if the borrower doesn’t pay mechanics liens, taxes, insurance premiums and operating expenses, limit recourse to situations where the property generates enough revenues to pay the items but they are not paid. The guarantor argues that making these items recourse in effect converts the guarantee to a guarantee of carry and operating deficits. Guarantors argue that the failure to generate sufficient revenue to pay such items generally results from market conditions, not bad acts.
Limit enforcement costs to actions in which the lender is the prevailing party, or at least where the borrower does not have a good-faith defense.
Limit breaches of representations and warranties to intentional misrepresentation instead of negligent misrepresentation.
Limit waste to intentional waste.

Lenders might respond as follows:

Lenders normally will agree to limit damages for failure to pay operating expenses to the extent available cash flow is not applied to these costs. However, failure to pay lienable items that prime the mortgage, such as mechanic’s liens and taxes, are more problematic.
Lenders usually will not condition damages for resisting efforts to enforce the loan documents upon prevailing in court, but sometimes will agree to permit a carveout if the borrower demonstrates a good-faith defense.
Damages for misrepresentations are often limited to those made intentionally or negligently intentional misrepresentation.
Waste is often restricted to intentional waste.

The examples discussed above are representative of typical guarantees, but each lender usually has its own list of nonrecourse carveouts and different tolerances for changes to them. The area is one of intense negotiations between guarantors and lenders and continues to evolve.

To learn more, contact Michael S. Kurtzon, member of Dykema’s Real Estate practice group at 312-627-5674 or . This article was originally published in Law360, a subsidiary of Portfolio Media Inc., and is reprinted withpermission.