Negotiating Non-Recourse Clauses
By: ERIC S. ANDERSON
Winter 1996
A recent article in The National Law Journal stated "Real estate financing in the 1990s has been characterized by a steady erosion of the principle that loans secured by real estate should be non-recourse...." (Leinhardt, W. and Berg, M., December 25, 1995-January 1, 1996) The article discusses the interpretation of the term "waste" as used in typical non-recourse clause "carve-out" provisions. According to recent interpretations, the non-payment of taxes against the mortgaged property constitutes waste. The trend in the 90s, as discussed by Leinhardt and Berg, is not for lenders to refuse to grant "non-recourse" loans; it is for the courts and the drafters of "non-recourse" clauses to expand the "carve-outs" for which borrowers remain responsible under a non-recourse loan -- "carve-out" liabilities.
However, the battle is fought more in the drafting room than in the courtroom. Most institutional lenders expressly include the non-payment of taxes in their list of "carve-out" liabilities. Other typical "carve-outs" under non-recourse loans include liability for:
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Damages suffered by the lender on account of waste, fraud, or willful misrepresentation by the borrower;
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Any retention of rental income or other income of the property after and event of default has occurred and the retention of security deposits that are not paid to tenants when due or transferred to the lender or purchaser at foreclosure sale;
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The replacement cost of any personal property or fixtures which are removed or disposed of by the borrower and not replaced;
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The misapplication of insurance proceeds or condemnation awards;
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Any loss resulting from the failure to maintain adequate insurance;
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Damages resulting from the presence of hazardous substances on or near the property;
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Compliance with the Americans with Disabilities Act (ADA): and
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Costs of enforcement.
Some lenders will attempt to define "trigger events" which result in the borrower's full recourse liability on the loan in certain instances, such as violations of due-on-sale clauses or clauses prohibiting junior liens.
Retention of income is a reasonable carve-out only if the borrower pockets the money or diverts it to another purpose after a default. The borrower should not, however, be liable to the lender if it uses rental income to pay operating expenses, maintain the property, or make necessary capital improvements. Unless the borrower is able to make such expenditures, he or she may incur liability under the "waste" carve-out provision.
Non-payment of taxes is a reasonable carve-out only to the extent that (i) there is adequate available income to pay the taxes and (ii) the taxes accrue prior to loss of possession (and rental income) by the borrower. Once the lender, or another party through rights granted to the lender, has a receiver appointed or obtains the right to receive rental income through foreclosure or the exercise of other remedies, the borrower should not have recourse liability for non-payment of taxes.
Loss resulting from the failure to carry "adequate" insurance is not a reasonable carve-out. If the borrower satisfies the insurance requirements of the mortgage, the inadequacy of that coverage should not give rise to recourse liability. Further, if the carve-out is tied to the insurance requirements of the mortgage, the borrower should make sure that those requirements set forth an objective, definite test and not a subjective, indefinite test for the amount of required insurance coverage.
Some commentators argue that recourse responsibility for all environmental liabilities is not reasonable, and that the borrower should be responsible only for its non-compliance with environmental laws. Although such arguments have merit, nearly every institutional lender will require recourse responsibility for all liabilities resulting from the presence or release of hazardous substances on or near the property, regardless of the borrower's fault.
A carve-out for costs of collection should be limited to collection costs under the carve-out provisions, and should not include the cost of foreclosing the mortgage or exercising other remedies under the primary loan documents. a deed in lieu of foreclosure cannot always effectively be given, and a lender may often be forced to go through the foreclosure process regardless of the cooperation of the borrower. Only when the borrower does not pay its other carve-out obligations should liability for costs of enforcement arise.
Recourse liability for ADA compliance is problematic. First, the requirements of the ADA are very subjective, and many responsible property owners comply with the ADA on a "squeaky-wheel" basis. If some complains, a barrier will be removed. Certainly, every responsible property owner will perform basic, well-recognized barrier removal, but the line between compliance and non-compliance is not always clear. In most projects, compliance with the ADA in tenant spaces is the responsibility of the tenants. Further, the requirements of the ADA depend to a large extent on the use made of the property; that use may change without the fault of the borrower by reason of actions of tenants or the lender.
"Trigger event" carve-outs, which provide that the borrower becomes fully liable for the entire loan amount upon the occurrence of certain events, are not the norm in the current marketplace and should be strenuously resisted. If a trigger event must be accepted, it should be determined to be fully within the control of the borrower. Many violations of due-on-sale clauses and clauses prohibiting junior liens are not voluntary, but result from the actions of third parties or other involuntary events such as foreclosure of junior liens or bankruptcies.
As always in the real estate business, standard clauses are not standard, and non-recourse clause carve-outs should be carefully reviewed and negotiated. Since the non-recourse clause carve-outs are frequently set forth in the commitment letters issued by institutional lenders, borrowers should seek competent counsel to review and negotiate the commitment letter for a non-recourse loan.