Most owners of real estate look forward to the day when they are able to refinance their personally guaranteed construction and acquisition loan with a non-recourse loan. A non-recourse loan is a loan that is secured by a pledge of collateral (in this case, real estate), but for which the owner is theoretically not personally liable. If the borrower defaults under such a loan, the lender’s recovery is limited to foreclosing on the real estate. In most of these non-recourse loans, however, the controlling owner is obligated to personally enter into a carve-out guaranty, under which the owner guarantees certain acts or omissions related to the loan. These guarantees were originally known as “bad boy guarantees” since the actions that triggered recourse liability were limited to the wrongful acts of the borrower. Over time, and especially since the recent financial crisis, many lenders have expanded the personal liability under these guarantees and, if the guarantor is not careful, these loans can easily become full personally guaranteed loans.
There are normally two types of carve-outs covered by these carve-out guarantees. The first carve-outs are those that result in the guarantor being liable only for the loss sustained by the lender. These carve-outs normally include: (i) certain wrongful acts, such as fraud, willful misconduct and misappropriation of funds; (ii) certain protections for the priority of the lender’s lien on the real estate and the physical condition of the property, such as paying real estate taxes, maintaining insurance and preventing mechanic’s liens; and (iii) indemnification for the environmental condition of the property. With regard to the foregoing items related to the lender’s lien and the physical condition of the property, it is important for the guarantor to limit the liability to the extent there is sufficient cash-flow from the property to pay for the applicable costs. Also, with regard to the potential environmental liability, it is important to have a full environmental investigation of the property performed and to include environmental protections in all of the leases at the property.
The second carve-outs are those that result in the guarantor being fully liable for the entire loan amount and losing all of the non-recourse protections. Originally, these carve-outs were limited to voluntary bankruptcy and transferring the property; however, lenders have been expanding on these carve-outs. In negotiating these guarantees, a guarantor should be careful that the involuntary bankruptcy of the borrower is not included as a carve-out. Also, a guarantor should be careful that the carve-out for the transfer of the property does not include transfers of non-controlling partnership interests, leases of space at the property and granting easements benefitting the property. Although a lender might desire consent rights over these transfers, such transfers should not cause the loan to become fully recourse. In expanding the bankruptcy protections, lenders sometimes include provisions regarding the operation of the borrower entity to maintain its “single purpose entity” status and, therefore, a guarantor must be careful so that using the wrong stationary or bank account does not trigger the loan to become a full recourse loan.
Since the security for a non-recourse loan is intended to be limited to the foreclosure of the real estate, borrowers and guarantors should negotiate the carve-out guaranty with an argument that the guaranty be limited to liability for intentionally preventing the lender to regain control of the collateral. Without carefully reviewing and negotiating the non-recourse carve-out guaranty, a real estate owner may be under the false impression that they have no personal liability under a defaulting loan.