Avoid Triggering Full-Recourse Liability on Your Non-Recourse Carve-Out Guaranty
By: MATTHEW J. SCHNEIDER
July 2010
The recent court decisions discussed in this article demonstrate how easily a borrower of a non-recourse loan can inadvertently trigger full-recourse liability for itself and its principals.
If mortgage financing is non-recourse, the borrower is not personally liable for the debt upon default and the lender’s sole recourse if the loan is not repaid is to foreclose against the mortgaged property or other collateral. In virtually all cases, however, non-recourse loan documents provide that, upon the occurrence of certain specified events (the non-recourse carve outs), the borrower becomes personally liable for losses incurred by the lender or, in some instances, personally liable for the full loan. In addition, lenders often require that a borrower’s principals personally guarantee payment of the lender’s losses under the non-recourse carve outs by signing what is often called a non-recourse carve-out guaranty.
Non-recourse carve-out guaranties typically contain partial-recourse carve outs and full-recourse carve outs. Partial-recourse carve outs vary from guaranty to guaranty but often include a borrower’s: (i) misapplication of insurance proceeds, condemnation awards, or security deposits; (ii) failure to pay real estate taxes or special assessments; (iii) violation of environmental covenants; (iv) waste; and (v) fraudulent representation or failure to disclose a material fact. If a partial-recourse carve out occurs, the guarantor’s liability is limited to the losses and damages suffered by the lender as a result of the event. For example, if a borrower violates a partial-recourse carve out by misapplying casualty insurance proceeds, the guarantor could be liable for the amount of the misapplied proceeds and other foreseeable damages arising from such misappropriation.
In contrast, a guarantor could be liable for the entire amount of the loan if a full-recourse carve out occurs. Typical full-recourse carve outs include a borrower’s sale or transfer of the mortgaged property without the lender’s prior consent, a voluntary bankruptcy involving the borrower, and a borrower’s violation of the separateness covenants or the single-purpose-entity covenants in the loan documents. The separateness covenants are intended to isolate the mortgaged property and the borrower and also to avoid an impact on the borrower as a result of the bankruptcy of a related party. The separateness covenants often include, among other things, covenants that the borrower will not: (i) incur additional indebtedness; (ii) amend its organizational documents; (iii) merge with another entity; (iv) acquire assets other than the mortgaged property; (v) commingle assets with the assets of another; or (vi) engage in business other than the ownership and operation of the mortgaged property.
There are no published court decisions in Minnesota addressing the enforceability of full-recourse carve outs in a non-recourse carve-out guaranty. Recent decisions from other jurisdictions, however, indicate that courts will strictly enforce clear and unambiguous language in guaranties, even when a borrower cures the default that triggered full-recourse liability and when the default does not actually harm the lender.
In a recent New Jersey case, CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC, a lender made a $13.3 million mortgage loan that was secured by a non-recourse carve-out guaranty from the borrower’s principals. The mortgage note and guaranty included non-recourse carve-out provisions that made the loan fully recourse to the borrower and guarantors if the borrower obtained subordinate mortgage financing without the lender’s prior written consent. The borrower subsequently obtained $400,000 in subordinate mortgage financing without the lender’s consent but paid off the subordinate financing within seven months. Approximately 18 months after paying off the subordinate financing, the borrower defaulted on the $13.3 million loan. The lender foreclosed on the mortgaged property and brought an action against the borrower and guarantors for the approximately $5.2 million balance of the loan. The borrower and guarantors did not dispute that the borrower had violated the non-recourse carve-out provision, but they argued, among other things, that it would be unjust and unfair to hold them personally liable for the balance of the loan because the default that triggered full-recourse liability was cured and did not harm the lender. After noting that courts in other states have uniformly held that non-recourse carve-out provisions are valid and enforceable, the court stated that whether the default was cured or actually harmed, the lender was irrelevant and did not diminish the breach. The court concluded as follows: “[h]aving 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, [the borrower and guarantors] may not now escape the consequences of their bargain.”
In another recent case in Ohio, 111 Debt Acquisition LLC v. Six Ventures, Ltd., a borrower defaulted on a $20.9 million mortgage loan and subsequently filed for bankruptcy. The lender asked the court to hold the guarantors of the loan personally liable for the loan based on a provision in their guaranty that made the loan fully recourse if the borrower or any guarantor consented to a bankruptcy by the borrower. The guarantors argued that they should not be liable for the loan because the bankruptcy filing was ultimately dismissed and because one guarantor did not consent to the bankruptcy. But the court determined that both arguments contradicted the plain and unambiguous language of the guaranty; nothing in the guaranty required unanimous consent or approval of the bankruptcy by the guarantors or provided a safe harbor to any guarantor who objected to a bankruptcy filing, and, under the language of the guaranty, it was irrelevant whether the bankruptcy was ultimately dismissed. The court concluded that the guarantors had agreed to be personally liable for all damages that arose from the borrower’s breach of the loan documents by filing bankruptcy.
A Massachusetts case, Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, demonstrates how easily a borrower can trigger full-recourse liability by inadvertently transferring mortgaged property or violating the single-purpose-entity covenants of the loan documents. The borrower’s mortgage, like many commercial mortgages, included an expansive definition of mortgaged property that covered not only the land and improvements but also, among other things, causes of action relating to the mortgaged property, proceeds from those causes of action, and machinery, furniture, furnishings, and equipment located on the mortgaged property. When the borrower, without the lender’s prior written consent, settled a $2 million zoning board appeal and diverted the settlement proceeds to its affiliate, the court held that the borrower had transferred a cause of action relating to the mortgaged property and the proceeds from the cause of action and, therefore, had transferred part of the mortgaged property. The court also held that the borrower had transferred mortgaged property when it sold 1,000 workstations located on the mortgaged property for $100,000, which the court considered a transfer of machinery, furniture, furnishings, and equipment. Finally, the court concluded that the borrower had violated the single-purpose-entity covenants in its loan documents when it comingled the $2 million in settlement proceeds from the zoning board action with the funds of its affiliate. In the end, the court held that the borrower and guarantors were jointly and severally liable for a $10.7 million post-foreclosure deficiency, plus more than $6.5 million in interest and attorneys’ fees.
Other cases also demonstrate how easily a borrower can trigger full-recourse liability for itself and any guarantors. In LaSalle Bank v. Mobile Hotel Properties, LLC, a court concluded that a borrower had triggered full-recourse liability for itself and the loan guarantors when the borrower violated the single-purpose-entity covenants in its mortgage by amending its articles of organization, even though the amendment had no affect on the lender. The court concluded that “the mortgage means what it says.” In Heller Financial, Inc. v. Lee, a borrower and its principals were held liable for the entire amount of the loan when tax liens and mechanics’ liens were filed against the borrower’s property in violation of the non-recourse carve-out provisions of the loan documents.
Takeaway
Courts have strictly interpreted and enforced non-recourse carve-out provisions in guaranties and have not been sympathetic to guarantors’ arguments that enforcement would be unjust or unfair or that violation of the non-recourse carve outs was eventually cured and did not harm the lender. If you have signed a non-recourse carve-out guaranty, carefully review the non-recourse carve-out provisions in the loan documents and take appropriate steps to ensure that the borrower does not violate the provisions.