Authors
Timothy John Carter
Director, Boston
tcarter@goulstonstorrs.com+1 617 574 3561
Douglas B. Rosner
Director, Boston
drosner@goulstonstorrs.com+1 617 574 6517
Jonathan C. Hayden
Associate, Boston
jhayden@goulstonstorrs.com+1 617 574 0528Source
WSJ
Related Expertise
Savvy commercial real estate (CRE) borrowers and lenders seeking to minimize downside exposure pay close attention to the triggers for nonrecourse carveout (NRC) guaranty liability. Many CRE loans are structured as “nonrecourse,” meaning that after a default, the lender may only look to the collateral property itself for repayment of the loan, with no personal liability of the borrower entity and no credit support or payment guaranties from a borrower’s owners. This lack of personal liability raises moral hazard issues, with little downside to a distressed CRE borrower filing for bankruptcy to prevent a foreclosure or otherwise hinder its lender’s exercise of remedies. To limit these types of risks—and incentivize borrower parties to cooperate with their lender’s exercise of remedies after a default—CRE lenders often look to NRC guaranties, under which a credit-worthy principal or parent entity may become partially or fully liable for a borrower’s obligations upon the occurrence of specified trigger events. In other words, a list of recourse liability triggers is “carved out” from the otherwise nonrecourse nature of the loan. NRC liability triggers are highly negotiated and raise a host of potential issues for both lenders and guarantors looking to protect themselves from financial distress.
Expansion of NRC Liability Triggers Over Time
Initially, lenders used NRC guaranties to dissuade a borrower and its principals from taking actions that would be detrimental to the lender. A guarantor would be required to cover a lender’s actual losses arising from the occurrence of any of a relatively straightforward list of specific bad acts, known as “above-the-line” liability triggers. This guaranty was commonly known as a “bad boy guaranty” or, more generically, a “springing recourse guaranty.”
Over time, the list of NRC liability triggers expanded to include additional “below-the-line” triggers, such as a borrower’s voluntary bankruptcy filing, that would result in liability of the guarantor for the entire outstanding balance of the loan. More recently, NRC liability further expanded to include liability for property-level economic risks, including failure to pay taxes, insurance or vendors, waste, insolvency, SPE covenant breaches and transfers.
The expansive list of NRC liability triggers, including those highlighted below, creates a web of traps for unwary borrowers and guarantors, leading to increased risk of guarantor exposure.
Admissions of Insolvency
Under many loan documents, the borrower’s written admission of insolvency may trigger NRC liability. This language raises the possibility that preparation and dissemination of a distressed borrower’s financial statements, or a casual email notifying the lender that the borrower will not be able to make a timely loan payment, may be viewed as an insolvency admission and trigger recourse to a guarantor.
Some courts read these provisions more narrowly to require an express, unconditional admission of insolvency or inability to pay debts. At least two courts in New York have held that financial statements are not admissions because they require the reader to interpret the data and infer insolvency. Other courts have concluded that written communications describing a borrower’s financial difficulties coupled with the likelihood of being unable to make a future payment or a request for a modification of loan terms did not constitute admissions and instead were viewed as conditional statements of a future event.
To avoid these concerns—and the resulting hesitancy by a distressed borrower to be transparent in its discussions with its lender—some parties negotiate up front to exclude from the insolvency admission carveout communications to the lender and investors, delivery of financial statements and admissions required by a court or applicable law. It is equally prudent for distressed borrowers to carefully review their loan documents before communicating with other parties about solvency issues to determine whether such communications may trigger recourse to a guarantor.
Limits on Permitted Debt
Many loan documents include limitations on the debt the borrower may incur. Noncompliance may trigger NRC guarantor liability in some cases. Borrowers are generally permitted to incur ordinary course trade payables, but only if they are paid in a timely manner and do not exceed a specified cap. While this provision is intended to prevent a borrower from deliberately creating a class of unsecured creditors that can be used to accept a Chapter 11 bankruptcy plan over the opposition of the lender (a so-called “cram-down plan”), this carveout can also be triggered unintentionally if the property is not generating sufficient cash flow to pay ordinary course-operating expenses timely or if the lender is sweeping the borrower’s cash and not releasing it to pay operating expenses.
To address this issue, parties to a loan may negotiate an exception to this liability trigger if the available cash flow from the property is not sufficient to pay trade payables (sometimes referred to as a “cash flow qualifier”). And here again, certain courts have established reasonable limits, with some denying lenders’ attempts to trigger full recourse in response to the aging of an insignificant amount of trade payables when viewed in proportion to the overall loan amount.
Waste or Neglect
Another common NRC liability trigger is the occurrence of waste at a property based on a failure to maintain the property or repair damage. Some states, including New York, also recognize the failure to pay property taxes as “economic waste,” since it diminishes the value of a lender’s security interest in the collateral property. Consequently, borrower’s counsel may try to add qualifiers such as “intentional” and “physical” waste when negotiating this liability trigger. Even with these limits though, there is a risk of guarantor liability if the property is not generating sufficient cash flow to cover repair and maintenance costs. Thus, in some loan negotiations the parties add cash flow qualifiers to excuse unintentional lapses in maintenance and repair to the extent there is no cash available to complete the work.
What’s Next?
The current CRE cycle continues to test the interpretation and enforceability of the growing list of bad boy carveouts in nonrecourse mortgage loans. Understanding their purposes and limits should help parties formulate workout strategies and limit exposure on underperforming loans.
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