Non-Recourse Carve-Outs: Borrower and Guarantor Considerations
The Federal Reserve Bank of New York's market intelligence revealed particular concerns about the commercial real estate sector, where "respondents highlighted concerns over higher interest rates, valuations, and shifts in end-user demand."
The report cited both the dramatic reduction in demand for office space arising from the shift toward telework in many industries and professions and the difficulty in refinancing debt due to the past year's interest rate increases as factors that could lead to instability in the commercial real estate industry. In addition, the report highlighted concerns about exposure in the commercial real estate market trigging further banking sector issues.
Approximately $4.5 trillion in commercial real estate debt is currently outstanding in the US (with an additional $467 billion in construction loans also outstanding), according to the report. Estimates vary on the amount of those loans that are scheduled to mature in 2023 and 2024, but an amount between $930 billion and $1.4 trillion seems likely, with loans secured by hospitality assets accounting for approximately $150 billion of that amount. Inevitably, demand for loans to refinance currently outstanding debt will increase even in the face of higher rates and tighter lending standards. Increasing interest rates and tightening lending standards will continue to make it difficult for borrowers to refinance their existing loans, with the consequence of many existing loans going into special servicing and default.
In the past several years, the US hospitality industry has been buoyed by growth in average daily rates (ADR}, which was up by 17% between the first quarters of 2019 and 2023 and has outpaced general U.S. inflation. This has led to first quarter revenue per available room (RevPAR) being up 13% during the same period despite overall occupancy being down 2.1 % that period. However, with the rate of increase in RevPAR already showing signs of slowing and increasing interest rates putting pressure on overall capitalization rates, the industry remains vulnerable to the same refinancing and sale valuation risks that are impacting other categories of real estate assets. Indeed, the hospitality industry will find itself in competition with other classes of real estate in finding available credit to refinance or to come to favorable arrangements with their lenders.
With these clouds on the horizon - and, many would argue, clouds that have been hovering over commercial real estate for some time - borrowers and their guarantors would be well served to familiarize themselves with the recourse triggers in their loan documents and accompanying guaranties that may turn a presumed non-recourse loan into one where the borrower and guarantor may find their assets at far greater risk than they may have assumed. Even though lenders are unlikely to agree to modify recourse triggers after loan origination, borrowers and guarantors should benefit from a better understanding of their vulnerabilities and may be able to limit their liability when considering strategies for addressing potential loan defaults and when negotiating with lenders and servicers.
Overview of Carve-Outs from Non-Recourse Liability
Long a staple of commercial mortgage-backed securities (CMBS} debt, non-recourse loans have become pervasive in the commercial real estate industry. In a typical non-recourse loan structure, the lender agrees to look only to the assets of the borrower for repayment of a loan unless certain actions are taken or situations arise - "carve-outs" from the non-recourse nature of the loan. These carve-outs are frequently mirrored or incorporated by reference in the loan guaranty delivered by the borrower's principal and normally fall into two principal categories: so-called "bad boy acts" and actions related to insolvency.
Generally speaking, the carve-outs for bad boy acts are intended to incentivize the borrower to preserve the lender's collateral. These acts may include the misapplication of funds, permitting waste to collateral, wrongful acts that lead to seizure of the collateral, the failure to pay taxes or insurance premiums, allowing mechanics· or materialmen's liens to attach to the collateral, obtaining financing that is not permitted by the loan documents. or transferring or disposing of the collateral in a manner that is not permitted under the loan documents. The bad boy acts usually also include acts of fraud, misrepresentations by the borrower in its interactions with the lender, or the borrower's hindering of the lender in its exercise of its remedies under the loan documents.
The carve-outs are also intended to incentivize the borrower to avoid availing itself of the protections afforded to debtors in bankruptcy and other insolvency proceedings or taking actions that might cause the borrower entity and its assets to be consolidated with other related entities in an insolvency proceeding. In many loan documents, the borrower's filing of a voluntary bankruptcy petition, colluding with third parties to cause a bankruptcy petition to be filed with respect to the borrower, or making an assignment for the benefit of its creditors will trigger recourse liability to the borrower and guarantor.
Lenders usually require borrowers to be "single-purpose entities" and impose rather stringent obligations on their borrowers in order to prevent the single-purpose entity from being consolidated with any other entity in an insolvency context. These obligations are the so-called "separateness covenants." The borrower's failure to adhere to the "separateness covenants" specified in the loan documents may also trigger recourse liability.
The guarantor in a non-recourse loan structure is usually a party that controls the borrower and is a credit-worthy entity standing behind the borrower. By having that controlling party guaranty the recourse liabilities of the borrower, the lender incentivizes the guarantor to exercise its control to avoid having the borrower, or other affiliates of the borrower and guarantor, engage in any of the bad boy acts, insolvency actions, or other actions. The potential guarantor liability for the carve-out recourse provides a powerful incentive for adherence by the borrower to the various lender-imposed obligations.
Types of Recourse Liability
Borrowers and guarantors should pay close attention to the type of recourse liability that is triggered by reason of the violation of a nonrecourse carve-out. Most loan documents contain two distinct categories of liability for a borrower and guarantor: (i) an indemnity for losses or damages suffered by the lender as a result of a breach of the applicable covenant; and (ii) full liability for the amount of the loan (usually, including accrued interest, default interest, late payment fees, protective advances, and expenses of the lender).
The latter form of liability is a more draconian remedy that is commonly triggered by the occurrence of the insolvency actions mentioned above. However, full liability may be triggered by breaches of other carve-out covenants, such as unpermitted transfers of the collateral, a change in control of the borrower, the incurring of additional debt obligations, or a breach of separateness covenants. Borrowers and guarantors should carefully review the non-recourse carve-outs in their loan documents and be aware of which covenants can trigger full repayment liability under the loan.
Hidden Issues in the Wording of Carve-Outs
The term "bad boy acts" can be deceiving as, depending on the exact language of the carve-out, recourse liability can be triggered without the borrower or guarantor taking any malicious action.
For example, many loans will impose recourse liability where the borrower fails to make payments of taxes or insurance premiums with respect to the collateral. It could be expected that this would mean that the borrower is merely required to use available revenues to make these payments; however, if the language in the loan documents does not expressly limit the recourse carve-out to available revenue produced by the collateral, then the borrower and the guarantor may be required to pay these expenses from their own funds to avoid recourse liability.
Another provision that frequently appears among non-recourse carve-outs imposes recourse liability if the borrower allows "waste" to the collateral. Waste is the legal concept of allowing damage or decay to occur to property by neglecting to take reasonable steps to repair or maintain the property. If this obligation is not similarly qualified to be satisfied by revenues generated by the collateral, then the borrower may again be required to pay for the physical upkeep and repair of the collateral from its own funds to avoid recourse liability.
Even where the obligation under a carve-out is limited to the revenues of the collateral, borrowers and guarantors should be cognizant that such a limitation may still open the door to extensive borrower and guarantor recourse liability. For instance, where a carve-out is qualified such that it does not require a guarantor to expend its own funds to pay for insurance premiums, taxes, or other similar items, a lender may argue that there is no affirmative requirement that the guarantor expend funds to cover such items, but that recourse liability will be triggered where the guarantor elects not to do so. Where a carve-out limits the obligation of the borrower to pay for such items to revenues produced by the collateral, if the language of the carve-out is not sufficiently precise, a lender may successfully argue that this obligation extends to all revenues generated by the collateral, even if such revenues have previously and appropriately been distributed to the borrower. The result may be that the borrower and its guarantor will be required to disgorge previously received revenues if they wish to avoid more dire recourse liability.
Borrowers and guarantors should also be wary of provisions that impose recourse liability following the placement of impermissible encumbrances upon the collateral. Such a limitation is usually not limited to the formal placement of a lien against the collateral. An unpaid vendor could trigger recourse under such a provision by simply recording a mechanic's lien against the real property collateral, thereby forcing the borrower and guarantor to pay the vendor from their own funds if revenues from the project are not available or sufficient to make full payment, or even triggering full recourse for the entire debt obligation.
Single Purpose Entity Covenants
Single purpose entity (or separateness) covenants are designed to ensure, among other things, that the assets of the borrower do not become consolidated with those of another entity in a bankruptcy proceeding and that the liabilities of other entities cannot adversely impinge upon the lender's exercise of its remedies against the collateral for the loan. Courts generally construe these covenants - and other provisions of loan documents - very strictly. Therefore, breaches of the single purpose entity covenants can cause the borrower and its guarantor to become liable for the full loan amount, even in situations where the breach seemingly causes no harm to the lender or seems contrary to the non-recourse nature of the loan.
This result occurred in the much-discussed Michigan proceedings of Wells Fargo Bank, N.A., v. Cherryland Mall Limited Partnership, et al, (295 Mich. App. 99 (Mich. Ct. App. 2011); 493 Mich. 859 (Mich. Sup. Ct. 2012); 300 Mich. App. 361 (Mich. Ct. App. 2013)) frequently referred to as "Cherryland." The Michigan Court of Appeals reviewed a single purpose entity covenant contained in loan documents for a non-recourse loan that required the borrower to "remain solvent." The court held that the borrower's becoming insolvent was a violation of this covenant and that, notwithstanding the notion that the loan was "non-recourse," the borrower was therefore liable to the lender for the full amount of the loan. Unpersuaded by other provisions of the loan documents that stated that the loan was intended to be non-recourse except for certain carve-outs, the court agreed that this relief was "extreme," but noted that the "borrowers were apparently not able to negotiate for less strict language and this Court declines to write it into the contract."
Shortly after the Court of Appeals' decision, the Michigan legislature passed the Nonrecourse Mortgage Loan Act, (MCL 445. 1591) which prohibited the use of any "post closing solvency covenant" from being used as a basis for a claim against a borrower or guarantor of a "nonrecourse loan." The Michigan Supreme Court then remanded Cherryland back to the Court of Appeals for reconsideration in light of the provisions of the Act. Despite the Act having been passed after the execution of the loan documents at issue and events triggering a default under those documents, the Court of Appeals found for the borrower and limited the reading of the carve-out at issue as provided in the Act.
Some have viewed the reversal of the Court of Appeal's initial Cherryland decision as evidence that courts would avoid a strict interpretation of a carve-out to preserve the non-recourse nature of the loan. From the record, however, it appears that the opposite is the case. In its original opinion, the Court of Appeals cited opinions from courts across the country for the proposition that courts should strictly interpret non-recourse carve-outs even where such an interpretation would lead to a non-recourse loan becoming a recourse loan.
The final decision in Cherryland was a direct result of the Michigan legislature's statutory intervention in mandating how certain nonrecourse carve-outs must be interpreted. In the absence of such statutory direction, (Ohio has adopted similar legislation. See Ohio Revised Code §§1319.07 through 1319.09) or where such direction exists and the carve-out does not relate to the solvency of the borrower, there is ample evidence that courts will strictly interpret the carve-out rather than try to balance the effect of the carve-out with the purported non-recourse loan intent. Therefore, borrowers and guarantors should scrutinize with care the exact wording of their non-recourse carve-outs, generally, and of their single purpose entity covenants, in particular.
As with the covenant at issue in Cherryland, many single purpose entity covenants will require the borrower to remain solvent or to maintain adequate capital for its business. Without the sort of statutory protections that are available in Michigan and a few other states, these covenants can be read to trigger recourse liability unless the carve-outs contain specific limiting language, such as requiring solvency or adequate capital only to the extent of currently available revenues from the collateral.
Single purpose entity covenants also frequently impose administrative requirements, such as maintaining separate books, records, and bank accounts, utilizing stationary with the borrower's letterhead, issuing invoices and checks in the borrower's own name, allocating expenses for any overhead that is shared with an affiliate of borrower, or segregating the borrower's assets and funds from those of any other entity. In light of the administrative burdens imposed by these sorts of requirements and the fear of a single failure to comply with them triggering full liability under the loan, some borrowers are able to negotiate limitations on the remedies available to the lender for such breaches.
Examples of these limitations may include the loan only becoming fully recourse where the breach actually results in the borrower being consolidated with another entity in a bankruptcy proceeding; or providing that the borrower is only liable for losses or damages actually suffered by the lender that result from the breach.
Hindering the Lender's Exercise of Its Remedies
Another common carve-out imposes recourse liability for the delay, hinderance, or interference of the lender's exercise of its rights and remedies under the loan documents by the borrower, guarantor, or any of their affiliates. Sometimes this carve-out can be qualified as applying only to legal proceedings filed against the lender or actions taken in bad faith or it may exclude answers filed by the borrower parties in a proceeding by the lender. If not so qualified, however, a borrower and guarantor should be cautious about any actions that may be taken in response to a lender's exercise of remedies granted in the loan documents, whether that exercise involves a legal proceeding or not.
To be forewarned is to be forearmed. Many borrowers and guarantors lack the leverage to negotiate some of the more desirable qualifications into the non-recourse carve-outs of their loan documents before signing them. Even so, a careful review of those carveouts when considering a potential loan default may help a borrower and guarantor to protect their assets and to gain a better outcome when negotiating with lenders and their servicers concerning the non-performing loan.
Importantly, being aware of the precise language regarding borrower and guarantor liability in loan documents can be critical in developing a strategy with respect to a troubled loan. By being fully cognizant of the potential recourse pitfalls, borrowers and guarantors can develop strategies that will avoid inadvertently triggering liability of which they may not have been aware, but which, if not anticipated, can at the most difficult moment assert itself and derail efforts to resolve issues arising from a troubled loan.
Special thanks to Gerard Leval for his assistance with this article.