Bad-Boy Guaranties: What You Do Not Know Could Cost You Personally (Sponsored by Selzer Gurvitch Rabin Wertheimer & Polott, P.C.)
The Fine Print That Turns a Business Deal Into a Personal Risk
Guaranties are often used in real estate and corporate finance transactions as credit enhancement for all types of financings. Before signing any loan documents, take a hard look at the guaranty. These agreements can expose you to far more personal risk than you might expect—even if the loan is tied to a business.
Depending on how the guaranty is drafted, you could be on the hook for the full loan amount or other damages, even if a payment default does not occur. Do not assume your personal assets are protected.
First, let’s discuss the difference between the two general types of guaranties: absolute and conditional.
ABSOLUTE GUARANTIES
Absolute guaranties are generally considered guaranties of payment and do not require any action to be enforced; in other words, the lender can pursue the guarantor under an absolute guaranty without having to initiate a judicial proceeding against the borrower after a default under the applicable loan documents.
CONDITIONAL GUARANTIES
Conditional guaranties only become enforceable upon the happening of a certain event, after which the lender can pursue its remedies against the guarantor. Conditional guaranties can take many forms, depending on the trigger, for example: non-recourse carveout guaranties (certain acts must precede the lender’s enforcement of such guaranty); completion guaranties (the borrower must have failed to complete the required construction or improvements); debt service guaranties (borrower has failed to pay debt service as required under the applicable loan documents); collection guaranties (lender must exhaust all remedies against the borrower prior to seeking recovery against the guarantor); and springing guaranties (which are triggered upon the occurrence, or non-occurrence, of a certain event).
We will focus on non-recourse carveout guaranties since they are the most typical in real estate transactions.
NON-RECOURSE CARVEOUT GUARANTIES
Most real estate financings are made on a non-recourse basis, meaning the borrower does not have personal liability for the repayment of the loan in the event of a default under the loan documents. Non-recourse loans, however, usually contain exceptions or “carveouts” creating recourse (i.e., personal liability) for specific behavior, commonly known as “bad boy” acts. The non-recourse exceptions covered in the non-recourse carveout guaranty will typically mirror the non-recourse exceptions covered in the loan documents and for which the borrower will be personally liable; thus, the guarantor will be personally liable for those same bad boy acts.
Lenders will often employ non-recourse exceptions as a behavior control tool, to allocate risk with respect to certain events. For example, a lender may add a non-recourse exception because the property is legal non-conforming with respect to zoning compliance and the borrower must rebuild within a certain time period to retain the non-conforming status.
NON-RECOURSE EXCEPTIONS
The non-recourse exceptions were originally tailored to cover a narrow range of behavior, such as bankruptcy, fraud, waste, or misapplication of funds (rents, casualty proceeds, or condemnation awards, etc.). These days, the non-recourse exceptions have expanded to address other types of events, including:
• Gross negligence or willful misconduct
• Misrepresentations (intentional or unintentional) by borrower in connection with the origination of the loan or ongoing financial reporting
• Failure to pay insurance premiums or taxes on a timely basis
• Failure to deliver financials per the terms of the loan documents
• Unauthorized transfers
• Mechanics liens filed against the property
• Termination of certain leases without lender’s consent
• Failure to maintain single-asset or single purpose entity status/covenants
• Failure to complete certain repairs or capital improvements (outside of what a completion guaranty would cover in a typical construction loan)
• Performance under any environmental covenants or environmental indemnity agreements
• Collection of fees and costs under the loan documents
ABOVE THE LINE / BELOW THE LINE
Another consideration regarding non-recourse exceptions is that some exceptions will be placed “above the line” and some “below the line.” “Above the line” exceptions are triggered only to the extent of any actual loss suffered by the lender as a result of the occurrence of the particular event, whereas “below the line” exceptions will trigger full recourse for the entire amount of the debt. Lenders and borrowers will often negotiate moving exceptions from being below the line, to being above the line.
For example, a violation of one of the single asset/single purpose covenants (loan documents typically contain several covenants in this category) may trigger full recourse liability, which the borrower and guarantors will want to avoid. One technique many use is to divide the single asset/single purpose covenants and place some of the covenants as above the line exceptions, with the remainder of the covenants remaining below the line. Another technique is to keep most of the single asset/single purpose covenants above the line, but below the line covenants will include single asset/single purpose covenants. This will result in the substantive consolidation of the assets and liabilities of the borrower with the assets and liabilities of a debtor pursuant to Title 11 of the United States Bankruptcy Code, 11 U.S.C. Section 101 et seq.
IDENTIFYING WHO WILL BE PERSONALLY LIABLE
If the borrower is a single asset/single purpose entity whose sole asset is the real estate which secures the loan, then the lender will not gain much by having the borrower be personally liable for a violation of the non-recourse exceptions since the borrower does not have assets beyond those already encumbered by the loan. Therefore, most lenders will look to the ultimate principals of the borrower, or those who control the borrower (directly or indirectly), who also have the requisite net worth and liquidity to fulfill the guaranty obligations. This is based on the idea that those who control the behavior of the borrower are also best suited to keep the borrower in line and prevent the borrower from triggering recourse under the non-recourse exceptions.
Guaranties are incredibly complex documents that can have sweeping and detrimental effects on your financial future. A poorly understood or overly broad guaranty can result in personal liability and put your assets at risk. Before you enter into any type of guaranty or indemnity, consult an attorney to confirm you are sufficiently protected.
If you have questions about guaranties in real estate and corporate financing transactions, please contact Alonso J. Cisneros, Esq. at acisneros@sgrwlaw.com.
DISCLAIMER
This article is for informational purposes only and is not intended to provide legal advice. Reading this article does not create an attorney-client relationship between you and Selzer Gurvitch Rabin Wertheimer & Polott, P.C. or the author. Legal outcomes may vary based on specific facts and jurisdictions. The information presented is current as of the date of publication and may not reflect recent legal developments. If you have questions about your particular situation, please contact a qualified attorney.
Alonso Cisneros, an attorney with Selzer Gurvitch Rabin Wertheimer & Polott, P.C., represents owners and developers in the acquisition, development, and disposition of commercial real property. He also represents institutional lenders in a variety of real estate finance transactions secured by all asset classes, including workouts of non-performing loans.
Selzer Gurvitch Rabin Wertheimer & Polott, P.C. is a leading real estate, trusts and estates, business transactions, tax, land use and zoning, family law, and litigation law firm in Bethesda, Maryland. Since 1982, the firm has delivered innovative solutions to meet the needs of investors, owners, developers, and businesses throughout the Washington, D.C. metropolitan area.
(Sponsored content includes material submitted independently of the Mortgage Bankers Association and MBA NewsLink and does not connote an MBA endorsement of a specific company, product or service. For more information about sponsored content opportunities, contact Bill Farmakis at bill@jlfarmakis.com or 203/834-8832.)
