Recent court decisions should serve as a warning to borrowers to carefully review the wording of recourse carve-out guarantees in both existing and proposed mortgages, lest they be held fully liable for real estate loans.  

While “non-recourse” loans typically require carve-out guarantees allowing the lender to pursue the guarantor’s assets in instances of “bad-boy” acts — such as waste, funds misapplication, environmental issues and voluntary bankruptcy filings — the precise wording of the guarantees is crucial.

Far-fetched? Think again

The guarantors in a case decided by the Superior Court of New Jersey in 2009 learned just such a lesson. In 4 Princeton Park Corporate Center v. SB Rental I, the carve-out guaranty securing the first mortgage provided that the loan became fully recourse if the property was encumbered by a second mortgage.

The court ruled the borrower was fully liable for the first mortgage as a result of this violation, notwithstanding that the second mortgage at issue had been fully paid over a year before the first mortgage loan defaulted.  

Though the breadth of a carve-out guarantee is a critical and material term of a loan, in good times many borrowers were reluctant to negotiate these terms on the theory that it was “far-fetched” that the loan would go bad. In down times, borrowers do not have the leverage to substantially negotiate these terms.

Borrowers may have hoped that courts would interpret the carve-out language in a way consistent with the premise that the loan was non-recourse, absent the borrower doing something “wrongful.” Some borrowers are now learning that it is difficult to back-pedal from the plain language of a carve-out guarantee, even if the result seems unduly harsh.

Here are examples of recourse carve-out language that are troubling from a borrower’s perspective:

1.  “The borrower must remain solvent and maintain adequate capital to operate its business.”

The whole purpose of a non-recourse loan is to enable the borrower to walk away from the property if it becomes insolvent. Typically this language is “buried” in a general provision, making the guarantor personally liable if any special purpose entity requirements are violated.

2.  “The loan will become fully recourse (a) if the borrower makes a voluntary bankruptcy filing, (b) if an involuntary bankruptcy filing is filed which is not dismissed within 45 days or (c) if the borrower admits in writing that it cannot pay its debts as they become due.”

Although it is customary to have a voluntary bankruptcy filing as a full recourse carve-out event (something that the borrower can generally control), a borrower cannot control an involuntary bankruptcy filing against it.

If the project is insolvent, the borrower cannot avoid admitting that it can’t pay its debts in a deposition, interrogatory, or involuntary bankruptcy petition.

3.  “The borrower shall be personally liable to the extent of unpaid real estate taxes and insurance premiums.”

The loan is not truly non-recourse if there is a perpetual obligation to pay real estate taxes and insurance. There are other examples of “standard” recourse language that could present serious risks to borrowers who did nothing “wrong.”

Common sense prevails

Borrowers already subject to recourse carve-out guarantees should not give up hope that a court might construe the clauses as intended only to penalize for wrongful acts. In the legal case of ING Real Estate Finance v. Park Avenue Hotel Acquisition, the court rebuffed a lender’s argument that a $278,000 late tax payment rendered the $145 million loan fully recourse.

The court said that since the borrower would be potentially liable for the entire loan if “just one day delinquent” on taxes, such result was “impermissible under New York law” and “that such an unlikely outcome could not have been intended by the parties.”

The lesson is that at a minimum, a borrower should attempt to negotiate the precise wording of recourse carve-outs to make them as narrow as possible. This should occur at the application or the commitment stage, when the borrower will have the most leverage. If unsuccessful in limiting the language to truly wrongful acts, then the borrower does not have a true non-recourse loan.  

Borrowers with carve-outs in existing loans should keenly focus on the language and carefully guide their activities to not violate the carve-outs through a technicality.

Robert A. Silverman is a member of the real estate group at the law firm Cozen O’Connor in Philadelphia. He can be reached at rsilverman@cozen.com.