Banks want as much security as they can when they loan money. Conversely, borrowers want to avoid as much personal liability as possible. It is been that way since the beginning of banking.
One tool that has found favor in recent years is a “springing guaranty” or “bad boy” provision. Such a guaranty is often a compromise between the needs of the lender and borrower.
A springing guaranty is a guaranty that only is effective upon certain conditions. The most common example is a bankruptcy filing by the debtor. As long as the borrower doesn’t seek protections from a bankruptcy court, the lender can’t pursue the guaranty. Other examples include waste or covenants not to withdraw monies unless certain net worth requirements are met. Because the guarantor is in control of the triggering event, it alone can prevent the triggering of the guaranty.
In effect, if the guarantor is a “bad boy” and impairs the lender’s security, then the guaranty takes effect.
With the advent of CMBS loans and Special Purpose Entities (SPE) used to absorb risk for a company, the use of these provisions has grown as has the list of triggering events.
Today there are two types of events that give rise to spring guaranties, “above the line” and “below the line” acts.
An above the line act is an event which causes the lender to suffer costs, losses or expenses. These sums can be collected through recourse against both the borrower and guarantor.
A below the line event is a bit more complex. This is an event that causes the borrower and guarantor to become liable for the full debt whether or not the lender experiences any loss and whether or not the borrower caused the event.
Here are some common above-the-line triggering events:
(a) fraud by borrower in connection with the loan or disposition of the loan proceeds;
(b) the gross negligence or willful misconduct of borrower;
(c) the removal or disposal of any portion of the collateral after an event of default;
(d) borrower’s conversion of rents or security deposits received by borrower after the occurrence and continuance of an event of default;
(e) conversion or misapplication of insurance proceeds;
(f) commissions paid by borrower after the occurrence of an event of default to designated or affiliated parties;
(g) allowing the creation labor liens on the real estate collateral;
(h) allowing the creation of tax liens on the collateral;
(i) any failure by borrower grant access to the property in violation of the loan documents; or
(j) borrower’s breach of warranties and covenants contained in the loan documents.
Examples of below-the line triggers include:
(a) borrower failure to provide financial information as required by the loan documents;
(b) borrower fails to comply with any SPE covenants in the loan documents;
(c) borrower makes any transfer prohibited by the loan documents;
(d) borrower files a voluntary petition under the U.S. Bankruptcy Code or similar state insolvency law or causes creditors to file an involuntary petition against the borrower including an assignment for the benefit of creditors;
(e) borrower consents to or assists in the appointment of a receiver over any portion of the real estate collateral;
(f) borrower fails to repair the property,
(g) borrower fails to maintain insurance;
(h) borrower fails to pay taxes;
(i) borrower permits additional indebtedness not authorized by the loan documents; or
(j) borrower fails to indemnify lender.
Sadly for borrowers, courts usually enforce these bad boy provisions. The exception is with bankruptcy filings.
Because Congress enacted Chapter 11 of the Bankruptcy Code with the stated purpose of allowing struggling businesses to restructure their finances, loan clauses that discourage bankruptcy filings are often void. Unfortunately, the law in this area remains in a state of flux.
Borrowers Must be Extremely Cautious with Springing Guaranties
Lenders have become quite sophisticated when drafting springing guaranties. Some guaranties are so broad that the exception swallows the rule. In other instances, the guarantors are simply caught off guard.
Several years ago, a promoter named Carlton Cabot* raised hundreds of millions of dollars from ordinary “mom and pop” investors. An IRS revenue ruling allowed investors to defer the capital gains from the sale of real estate by pooling their gains with others and investing in larger projects.
*We represented approximately 100 of these investors.
The investors provided the seed money allowing the promoter to obtain CMBS financing for the rest of the purchase price. The loans were billed as “non-recourse.”
The borrowers certainly thought they were safe. At worst, if the entire project became worthless, they would only lose their initial investment. That is still a big deal but they wouldn’t be on the hook for anything.
Or so they thought.
The loans all had a bad boy provision that said if the borrowers took rent money after a default, they became personally liable for the outstanding loan amount.
What no one knew was that Carlton Cabot was a crook. His management company ran the properties. After making a few mortgage payments, Cabot began stealing money. To keep investors from finding out, however, he kept paying them. Even after the loans were declared in default, he kept pocketing the rent money and paying the investors. Only when the sheriff showed for a foreclose sale did the borrowers know anything was wrong.
In many of the projects, the collateral was way overvalued. The lenders sought to collect the deficiency from the borrowers. Even though the loans were nonrecourse, when the borrowers continued to cash their checks after default, they violated the bad boy provisions. Although they may not have known it, they were taking rent money after default was declared.
The lenders said it didn’t matter that they didn’t know about the default. Had they known, of course, they could have cured the default and fired Cabot’s management company. (Carlton Cabot, like most Ponzi schemers, was ultimately caught and sent to prison.)
In 2011, a federal judge in Detroit was confronted by a spring guaranty so broad that it basically said failure to pay the debt triggered a springing guaranty even though the underlying loan was non recourse.
In 51382 Gratiot Avenue Holdings, LLC v. Chesterfield Development Co., the court considered whether a springing guaranty could be void as a matter of public policy. Chesterfield Development borrowed money to purchase a shopping center. 51382 Gratiot Avenue was the lender.
The loan to Chesterfield was made in 2005. After the real estate collapse in 2008, the shopping center lost tenants. In December 2009, Chesterfield defaulted on its loan. The property was foreclosed and sold for less than half the loan amount.
The lender then came after borrowers for the deficiency. The borrowers thought they were safe because they had a nonrecourse loan. Obviously if you are reading this post, you know where the story is heading.
The loan documents said “Borrower or Guarantor is not liable for the full amount of the debt unless certain events ... occur that cause full recourse liability to be triggered. Of the many triggering events was one that said borrower become liable if it “becomes insolvent or fails to pay its debts and liabilities from its assets as the same shall become due.”
In other words, simply defaulting was sufficient to trigger the springing guaranty.
The borrowers’ arguments failed. In ruling in favor of the lender, the court said,
“Regardless of the original, or even essential, purpose of the type of transaction that [Borrowers] wished to enter into with [Lender], they are bound by the terms of the Loan Agreement they actually signed. Before executing the Loan Agreement, Chesterfield was free to negotiate terms favorable to its interests or acquiesce to terms favorable to [Lender]'s interests, but it cannot take the latter course and then void the agreement when that decision produces unfavorable consequences. [Lender] acknowledge that the springing recourse events contained in the Loan Agreement are extremely, even unusually, favorable to Lender… [T]he court must enforce that agreement as a matter of law.”
After the real estate meltdown in 2008, some states (Michigan and Ohio are examples) offered statutory restrictions on bad boy carveouts.
In recent times, a flood of lenders has resulted in more flexibility in the terms of springing guaranties. That gives borrowers a bit more room to negotiate. But it is still borrower beware.
Borrowers today may be able to negotiate notice provisions (those might have saved the Cabot borrowers), cure periods and even liability caps. Although we have not seen any such provisions yet, we can envision borrowers securing requirements that the lender actually suffer a loss before the springing guaranties take effect.
The IRS has now jumped in by issuing a Chief’s Counsel memo that suggests a springing guaranty could cause a nonrecourse loan to become a recourse loan for tax purposes, a concern for lenders.
The lender liability lawyers at Mahany law and Judge Lang & Katers represent borrowers in disputes with lenders. We do not represent banks or loan servicers.
We have extensive experience in litigating springing guaranties and bad boy provisions. We also assist property owners with complex CMBS loan modifications and structuring. Contact attorney Brian Mahany by email [hidden email] or by phone (877) 858-8018 for more details.
Minimum loan value of $5 million required. We regret that we cannot assist folks with smaller loans or on any residential / home mortgage / consumer borrowing matters.