Trends in Commercial Real Estate Loan Guarantees
In general terms, a guarantee is a legally enforceable promise made by one party (the guarantor) to answer for the payment of debt or performance of the obligations of another party (the principal obligor or borrower) if the principal obligor fails to make payments or perform its obligations. A guarantee may be required if a lender determines that the credit strength of the principal obligor needs to be enhanced and that the guarantor can provide meaningful support.
Recently, we have seen high profile cases involving the enforcement of commercial real estate guarantees against individual guarantors. As described in a Wall Street Journal article dated September 29, 2010 (Robbie Whelan, Real Estate Stings a Backer), Harry Macklowe, a New York developer, has been forced to liquidate or turn over to creditors much of his real estate empire in efforts to resolve the indebtedness he incurred through a personal guarantee. Similarly, Bruce Elieff, chief executive of SunCal Cos., a closely held development and residential building company, may be liable for up to $230 million in personal guarantees he signed in connection with loans made by Lehman Brothers Holdings to SunCal Cos. on twenty large residential property developments. The plight of both men should alarm anyone who ever signed a personal guarantee backing commercial real estate loans.
With the increasing default rate on loans secured by commercial real estate, both CMBS loans and loans held on the balance sheets of various lending institutions, guarantors who signed a personal guarantee for this type of loan should be reviewing those loan documents and closely examining the terms in the related guarantees.
In this article, I will look at some of the different types of guarantees individuals may be asked to sign in connection with commercial real estate loans. I will examine recent cases dealing with the enforcement of commercial loan guarantees. I will focus on language to look for in those guarantees and suggest some areas for negotiation. Finally, I will look at trends in future lending requirements for guarantees.
II. Types of Guarantees
Whether commercial real estate loans are originated through a conduit lending program or by a bank, most of these loans are secured by a guarantee of some sort. The guarantors for these loans are typically, but not always, individuals who provide some value other than having an interest in the property or an equity interest in the borrower.
. The most basic guarantee is a payment guarantee in which the guarantor provides a full recourse guarantee to pay the entire amount owed by the principal obligor. The guarantor typically waives notice, presentment, demand for payment and any requirement that the lender proceed against the principal obligor or the collateral before making a claim against the guarantor. If there are multiple guarantors, they will be jointly and severally liable. In addition, this type of guarantee will likely include language that allows the lender to make changes to the loan and its documentation without notice to the guarantor. As we will see in the cases below, courts generally find such waivers to be enforceable. Recourse Loan Documents.pdf
Limited Guarantees. Another common guarantee is a limited guarantee. The scope of this type of guarantee may be limited in many ways. Most frequently, a limit is placed on the amount for which the guarantor is liable. For example, the guarantor can be liable for a specific amount set forth in the guarantee or reference can be made to a specific loan amount for which the guarantor is liable. The limitation can also be expressed as a cap or as a percentage of the principal amount of indebtedness of the borrower for which the guarantor is providing a guarantee. The guarantee may be limited to certain specific agreements signed by the borrower. Whatever the method used, there is some limitation on the liability of the guarantor in this type of guarantee.
. As conduit loans became more popular in commercial real estate lending over the last fifteen years, one of the strongest selling points for this type of loan has been that it is a non-recourse loan. This means the lender agrees to take action against the property to recover for losses suffered on the loan rather than taking action against the borrower or guarantor, with a few exceptions. The guarantor will typically sign a non-recourse guarantee outlining the circumstances under which this non-recourse loan becomes a limited or full recourse loan. The list of triggers for guarantor’s liability, sometimes called “bad boy carve-outs”, increased as this type of lending became more popular. Whether the events triggered full or partial recourse evolved over time as well. Non-Recourse Loan Documents.pdf
A guarantor’s liability is outlined in the exceptions, or carve-outs, in a non-recourse guarantee. The carve-outs generally fall into two categories-limited recourse or full recourse. The types of activities which may trigger limited recourse to a guarantor, meaning the guarantor is only liable for losses suffered by the lender attributable to a specific event or activity, may include misapplication of casualty or condemnation proceeds or security deposits, failure to pay taxes or assessments, commission of waste to the property; failure to provide environmental indemnification, failure to maintain insurance or allowing liens to be placed against the property.
The triggers which make a guarantee full recourse are more serious violations, such as a voluntary or involuntary bankruptcy filing, fraud or intentional misrepresentation in connection with the property or the loan, or violation of the separateness covenants set forth in the single purpose entity (SPE) requirements established to keep the borrowing entity separate from any other business entity or debt.
More exotic types of guarantees, such as various types of construction loan guarantees, LTV maintenance guarantees or remargin guarantees are beyond the scope of this article.
III. Enforcement of Non-recourse Guarantees
Courts tend to strictly enforce the obligations under these non-recourse guarantees against guarantors. Most of the decisions focus on the specific terms in the applicable guarantee and the borrower’s sophistication in the marketplace, as well as borrower’s representation by knowledgeable counsel, as the basis for enforcing the guarantees.
The most recent significant case in this area is the March 8, 2011 New York Supreme Court, New York County, decision granting summary judgment for the plaintiff in UBS vs Garrison.pdf
). The court held that the non-recourse guarantee, in that case called a “bad boy guaranty”, was an instrument for the payment of money only and not an unenforceable penalty or a violation of public policy relating to bankruptcy. In that case, the lender’s claim under the guarantee was triggered by a bankruptcy filing by the borrowers during a forbearance period after the loan was in default. This case seems to trump the ING case mentioned below.
The court in 111 Debt Acquisition LLC v. Six Ventures, LTD, 2009 U.S. Dist. LEXIS 11851 (S.D. OH 2009), reached a similar decision based on another borrower’s bankruptcy filing. In that case, the borrower filed for bankruptcy, a violation of one of the carve-out provisions contained in the loan guarantees. The guarantors argued that since the bankruptcy petition was eventually dismissed, the guarantor’s liability under the carve-out provision had not been triggered. The Court found it was irrelevant that the bankruptcy petition was dismissed. The debtor’s act of filing for bankruptcy triggered the carve-out provision and made the guarantors fully liable for the debt. Other courts have also found recourse provisions prohibiting the filing of a bankruptcy petition enforceable. See First Nationwide Bank v. Brookhaven Realty Assocs., 223 A.D.2d 618 (N.Y. App. Div. 1996); FDIC v. Prince George Corp., 58 F.3d 1041 (4th Cir. 1995).
In CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC 980 A.2d 1 (N.J. Super. 2009), the court strictly construed a carve-out provision requiring the borrower to obtain lender approval of any subordinate financing. The borrower secured subordinate financing without bank approval but paid the subordinate loan off eighteen months prior to defaulting on the primary loan. The guarantors and the borrower argued that their liability under the carve-out provision should not be enforced because the default was cured and the lender was not harmed. The court held it did not matter that the lender had suffered no damages as a result of the borrower’s violation of the carve-out provision. ”Having freely and knowingly negotiated for the benefit of avoiding recourse liability generally, and agreeing to the burden of full recourse liability in certain specified circumstances, defendants may not now escape the consequences of their bargain.”
In Blue Hills Office Park, LLC v. JP Morgan, 477 F. Supp. 2d 366 (D. Mass. 2007), the borrower settled a zoning dispute with an adjoining property owner and received a cash payment without obtaining bank approval. The borrower subsequently transferred those funds to a different entity. The court found the zoning rights to be a part of the mortgaged property pledged to the bank based upon the definition of mortgaged property in the loan agreement. Therefore, the settlement of the zoning issue, without prior bank approval, and transfer of those funds resulted in a violation of the carve-out provision relating to misuse of funds relating to the mortgaged property and pledged to the bank. As the Court stated: “[W]here sophisticated parties choose to embody their agreement in a carefully crafted document, they are entitled to and should be held to the language they chose.”
Even an amendment of the borrower’s articles of organization can trigger full recourse liability because this may be viewed a violation of the SPE covenants. In LaSalle v. Mobile, 367 F. Supp. 2d 1022 (E.D. La. 2004), the borrower amended its original articles of organization to change its name to modify its stated purpose from “solely … the acquisition, ownership, operation and management of a hotel…and such activities as are necessary, incidental or appropriate in connection therewith” to the broader language of “any lawful activity for which limited liability companies may be formed under the Act.” The mortgage clearly stated that the loan would become full recourse if the borrower failed to maintain its status as a single purpose entity. The borrower and the guarantor argued that the amendment of the articles did not harm the bank because the borrower never engaged any activity other than the management of the hotel. The court found these arguments irrelevant and held the recourse provision had been triggered based solely on these changes to the articles of organization.
The one case that goes against this trend is ING Real Estate Finance (USA) LLC v. Park Avenue Hotel Acquisition LLC, 2010 Westlaw 653972 (02/24/10) (Unpublished). In that case, the court narrowly construed the full recourse language in the guarantee in favor of the guarantors. The court focused on an inconsistency between language found in the cure provisions of the loan agreement and language found in the carve-out provisions. The non-recourse carve-out language included incurring any additional debt or permitting a lien to obtain priority over the secured lien as a carve-out provision. The default language in the loan agreement similarly prohibited additional debt and liens obtaining priority, but that section of the loan agreement also provided the borrower with for a thirty (3) day period to cure this type of default. After defaulting on the mortgage, the borrowers then failed to make a tax payment. The lenders argued this triggered full recourse liability under the carve-out provisions. However, the borrowers paid the taxes, with accrued interest, in less than the thirty (30) day cure period. The court held it was necessary to reconcile the cure period provided in the default clause with the lack of a cure period in the “bad boy” carve-out provisions. The court also noted that New York would not attempt to collect on a tax lien for at least a year, so the lender’s lien position was never in jeopardy, ultimately ruling that the guarantee was not triggered. As mentioned above, however, the recent decision in Garrison appears to have put lenders back in their position of strength in regard to the enforcement of commercial real estate loan guarantees against guarantors.
These cases show how even a temporary violation of a carve-out provision can result in the entire debt becoming a full recourse obligation for a guarantor. Guarantors need to know and abide by all the carve-out provisions in the loan documents. They also need to know if the principal obligors are similarly abiding by all terms of the loan documents.
IV. Language in Guarantees
Because of the potential liability facing a guarantor, any reviewer of an existing guarantee or negotiator of a future guarantee should be sensitive to certain key words and phrases found in guarantees.
Clearly identify the collateral pledged in any guarantee. If the loan is being made by a local bank, the guarantee form provided by that bank may specify that the guarantor grants the bank a security interest in all of the guarantor’s property that is in the bank’s control or custody. This creates a problem if the guarantor has several different accounts or deposits at the bank because the bank can and will draw on those accounts or deposits should the guarantor’s liability under the guarantee be triggered. If there is no specific reference limiting the security for the guarantee, be sure that the guarantor knows the full extent of guarantor’s property the lender can attach should it seek to enforce the guarantee.
A guarantor needs to be aware of all the events of default, or triggers, in any guarantee. These could include obvious ones such as payment default, bankruptcy, or failure to perform required obligations; but less obvious and more subjective ones might also be included, such as the death or dissolution of the guarantor or the lender’s determination that a material adverse change has occurred in the financial condition of the guarantor or borrower.
Note all the waivers specified in guarantee. These may include guarantor’s waiver of any limitation of liability or recourse arising under any law; waiver of certain defenses, such as lack of consideration; waiver of a homestead exemption or any other exemption under applicable law; waiver of the argument based on unenforceability of the borrower’s obligations; waiver of bankruptcy ruling; or waiver of jury trial. It is important to know if any of these waivers are unenforceable under the state laws governing the guarantee.
Venue and Governing Law.
The guarantor needs to know where litigation on the guarantee will take place and what laws will govern interpretation of the documents. It is important to determine the convenience of such a location for the guarantor prior to guarantor’s having to appear in that court.
A guarantor needs to determine the length of the term of any guarantee. A guarantee may be specifically tied to one loan as the term of that loan may be extended or renewed. If a guarantee is construction-related, the term may be for a specific period of time beyond payment in full of the related indebtedness, such as one or two years. Be sensitive to any attempts to extend the term of a guarantee, such as language including the institution and pursuit of any action on the guarantee as part of the term of the guarantee. Some guarantees are continual and on-going; for example, a guarantee may cover all future indebtedness of the borrower or a continuing guarantee may remain in force as long as any of the borrower’s liabilities are outstanding. Be sure the guarantor knows how long this liability will be in place.
A guarantor must know what kind of financial information he is to provide to the lender and how frequently he is obligated to provide this information. These requirements can range from the guarantor providing certain financial statements upon the lender’s request to the guarantor’s having to provide quarterly financials and audited annual reports. Note if failure to provide any required financial information triggers a default under the guarantee or carries financial penalties.
There are some areas of negotiation in guarantees.
● Try to limit the waiver language to items that are legally enforceable under the applicable law.
● Limit the liability of the estate after the death of a guarantor.
● Avoid having the spouse of the guarantor sign a guarantee.
● Ask for a specific revocation as to future transactions.
● Limit the collateral affected by the guarantee.
● Limit the representations and warranties for which the guarantor is responsible.
● Make the time frame for which the guarantor is responsible as narrow as possible.
● If there are multiple guarantors, try to cap liability to a specific amount for each guarantor.
● Try to cap the overall liability.
● Be aware of applicable legal constraints on suretyship, waiver language, notice requirements and dispute resolution provisions.
The key focus of any review, or negotiation, of a guarantee is the language in that document. Read every word carefully. Any guarantor must be fully aware of all his responsibilities and liabilities.
V. Looking ahead to new lending programs
We are seeing the return of capital to the commercial real estate market through a variety of lending sources. As borrowers and guarantors enter the marketplace, it is helpful to have some idea of what may be considered standard or minimal requirements for guarantees in these new programs. We have two sources of information that provide some insight into what may be ahead for guarantors in the commercial real estate markets.
Conduit Lending Programs. Conduit lending is gradually returning to the marketplace. The volume of conduit loans is higher this year than last. More conduit lenders are opening shop. At that same time, securitized lending industry groups are working to develop standardized representations and warranties, underwriting, and other documentation to be utilized in connection with conduit loans in order to comply with proposed rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed representations and warranties are of interest to potential guarantors because guarantor is defined and because a baseline for limited and full recourse obligations is outlined in the proposed section setting forth Recourse Obligations.
In these proposed representations and warranties, a guarantor is defined as a natural person or persons, or an entity distinct from the borrower (but may be affiliated with the borrower), that has assets, other than equity in the related mortgaged property, that are not de minimus. In other words, the guarantor must have an independent source of net worth. This is a change from the past practice of sometimes allowing SPEs with no net worth to sign guarantees.
In the draft representation to be given by issues relating to the recourse obligations for loans to be securitized, a loan will become full recourse: (i) if the borrower should file, consent to, or acquiesce in bankruptcy or (ii) if the borrower or guarantor colludes with other creditors to cause an involuntary bankruptcy filing with respect to the borrower or (iii) if the borrower allows or engages in unpermitted transfers of the property or equity interests. The limited recourse provisions include: (i) misappropriation of rents, security deposits, insurance proceeds or condemnation awards; (ii) borrower’s fraud or willful misrepresentation; (iii) willful misconduct by borrower or guarantor; (iv) breaches of the environmental covenants or (v) commission of material physical waste at the property. These proposed recourse provisions give us some idea of the minimum recourse provisions that are likely to be required in conduit lending programs.
Fannie Mae Loans.
Fannie Mae has issued new loan documents to be used beginning in April 2011. These documents can be found on the efanniemae.com
website. Fannie Mae has promulgated a new payment guarantee and a guarantee of non-recourse payment obligations, as well related loan agreements which set forth the terms of the obligations under those guarantees. In non-recourse loan agreement, the triggers for limited recourse liability are: (i) failure to pay rents and security deposits to lender after an event of default; (ii) failure to maintain insurance; (iii) failure to apply insurance or casualty proceeds as required under loan documents; (iv) failure to provide books and records as required; (v) failure to apply rents as required; or (vi) waste or abandonment of the property. Full recourse is triggered by (i) failure to abide by SPE requirements; (ii) an unauthorized transfer; (iii) bankruptcy or consented-to involuntary bankruptcy or (iv) fraud or material misrepresentation by any party in connection with the loan. Again, these recourse provisions give us an idea of the obligations of a guarantor of any loan made through a Fannie Mae lending program.
Both Fannie Mae guarantees have been updated to address several issues, including the effect of a claim made pursuant to a guarantee on community property. The guarantee is now cross-defaulted with the loan documents in the sense that a default under the guarantee is a default under the loan documents. Waiver language includes notices, presentment, demand for payment and a requirement that lender proceed against the borrower and collateral prior to proceeding against the guarantor. Changes can be made to the loan and the loan documents without notice to the guarantor. The lender can pull a credit report on the guarantor once a year or get a credit score at any time for the guarantor. In addition, Schedule 1 to each of these guarantees contains all the state-specific language to be incorporated into a specific guarantee. This schedule provides a quick reference to the applicable statutes impacting guarantees in the various states.
Becoming familiar with these new Fannie Mae documents and keeping up with the representations and warranties as finally adopted in conduit lending programs will better prepare a guarantor for more realistic negotiations of guarantees in connection with future loans.
All guarantors must know the potential liabilities they are assuming by signing a guarantee. Guarantors also need to be cognizant of the impact borrower’s actions have on them as individuals, as they may have the most to lose.