By Kim Alexander, A.Y. Strauss
Guarantors typically will not balk when required by lenders to be parties to “bad boy” guaranties as, at first glance, it seems fair to be on the hook for losses incurred by lenders in the event that certain “bad acts” are committed.
Photo by khrawlings/ Flickr
However, the actual terms of “bad boy” guaranties may go beyond including the typical bad-boy carve-outs such as gross negligence, fraud, willful misconduct, intentional material misrepresentations, physical material waste and misapplication of proceeds.
As such, guaranties should be carefully scrutinized and negotiated to not only limit liability to “bad acts”, but to also ensure that the carve-outs do not subject guarantors to liability triggered by acts outside of their control.
Below are some carve-outs that guarantors should attempt to limit as the terms of guaranties are negotiated:
FAILURE TO PAY TAXES AND INSURANCE PREMIUMS
If carve-outs for failure to pay taxes and insurance premiums are not limited, then guarantors may risk exposure for liability even if the nonpayment is due to the property’s inability to produce sufficient cash flow. This may be outside the control of property owners and is not necessarily a “bad act”.
Thus, losses triggered by the failure to make payments should be limited to when there then exists sufficient cash flow from the operation of the subject property to make such payments. In addition, liability should also be limited in the event that tax and/or insurance escrows have been established as lenders should be required to use the escrowed funds toward the required payments.
And, equally as important, liability should end after the earlier of the date upon which the lenders (or their successors and/or assigns) foreclose or take title to the property through other measures or the date a deed in lieu of foreclosure is tendered. Otherwise, these types of carve-outs may expose guarantors to greater liability than anticipated.
FAILURE TO PAY FOR MATERIALS, LABOR AND OTHER CHARGES
Similar to the failure to pay taxes and insurance, the failure to pay for other charges should also be limited to cash flow and liability should terminate after the earlier of foreclosure or tender of a deed in lieu of foreclosure.
Otherwise, guarantors may continue to be on the hook for losses even when the borrower no longer owns the subject property and even if those losses result from a situation outside of the borrower’s control.
BREACH OF REA, CONDOMINIUM DECLARATION OR OTHER KEY DOCUMENTS
Often lenders will include a carve-out for losses in the event that borrowers breach, terminate or modify key documents such as reciprocal easement agreements that are essential to the operation of the property.
In the event that guarantors will agree to this type of carve-out which may not necessarily be the result of “bad acts” or fall within their control, at a minimum, these carve-outs should not be triggered until applicable notice is given and cure periods have passed and such carve-out should be limited to when the carve-out event has a material adverse effect on the property. In addition, liability should also not be triggered if the carve-out event occurs after foreclosure or tender of a deed in lieu of foreclosure.
WASTE
A carve-out for waste should be limited to “material” waste to the Property and, to the extent possible, should be limited to “intentional” acts by a borrower or its principals. Otherwise, the waste carve-out may not necessarily result from an overt “bad act”. In addition, this carve-out should not be triggered if outdated or worn property is replaced.
MISREPRESENTATION
Similar to the limitations for the waste carve-out, the typical carve-out for misrepresentation should also be limited to “material’ misrepresentation by a borrower or its principals in connection with the subject loan and, to the extent possible, should be limited to “intentional” acts.
NEGLIGENCE
Negligence is too low of a threshold to trigger liability as it may not be viewed by guarantors as the result of intentional bad acts. Rather, this type of carve-out should be limited to losses triggered by gross negligence or willful misconduct.
To further complicate matters, rather than limit liability to losses as described above, often lenders require guarantors to be liable for the whole loan upon the occurrence of other events, some of which are discussed below.
BREACH OF SPE PROVISIONS
To the extent that a breach of certain SPE provision triggers full recourse liability, such liability should only be triggered to the extent such breach results in the substantive consolidation of the liabilities and assets of a borrower with another person and such breach is cited by the court as a factor in such decision.
In addition, any consolidation joined in by or petitioned for by lenders should be excepted out of such carve-out such that said consolidation does not trigger liability. Borrowers may also want to limit this carve-out so that only specific SPE provisions trigger liability and may want to consider removing this as a full recourse carve-out all together or moving it to the carve-out for losses section of the guaranty.
PROHIBITED TRANSFERS
To the extent that a transfer triggers full recourse liability, there should be exceptions for certain permitted transfers, including transfers to family members, transfers for estate planning purposes and transfers of a certain percentage interest in the property owner. The permitted transfer provision should be negotiated at length to ensure that borrowers have some flexibility to transfer interests without risking full recourse liability.
In addition, death and incompetency of members, partners, guarantors and control parties should not trigger full recourse liability as those events are outside of anyone’s control. If there is more than one guarantor, the remaining guarantor shall remain acceptable to lenders and there needs to be some mechanism for providing a substitute guarantor reasonable acceptable to the lender upon the death of the remaining guarantor or upon the death of the sole guarantor (if there is only one guarantor).
BANKRUPTCY
To the extent that certain bankruptcy events trigger full recourse liability, the carve-out should be limited to voluntary bankruptcy. Borrowers should avoid situations in which other parties (including lenders) force borrowers into bankruptcy and, as a result, trigger full recourse liability.
LIENS
A materialman’s, mechanic’s or other involuntary lien should not trigger full recourse liability as borrowers may have a good faith dispute with a laborer who files a lien against the property. If the removal of this carve-out is not acceptable to lenders, then borrowers may consider including the carve-out but excluding liens to the extent borrowers bond or arrange for the payment of same within a reasonable amount of time following notice of such lien.
Notice is key because often times borrowers will not have notice of the lien and full liability should not be triggered if borrowers are unaware of the liens.
