Monday, February 6, 2012

"Bad Boy" Guaranties Upended by Recent Court Decisions

Many commercial properties such as retail strips and apartment projects are financed with CMBS, or conduit, loans.   These loans are structured so that the key asset mortgaged to the CMBS lender is owned by a single purpose entity (SPE) so that it's isolated from other liens and indebtedness other than typical trade payables related to the asset's operations.  A key component of these loans is the lender's nonrecourse against the borrower and guarantors for deficiency balances absent an affirmative 'bad act' on the part of the borrower or a guarantor.  These are commonly referred to as "bad boy" guaranties. And the assumption would be that some affirmative 'bad act' is required in order to trigger full recourse against the borrower and guarantors.

A couple of recent decisions in Michigan (one in state court and one in Federal district court) have turned this assumption in its head. One of the 'bad boy' acts is for the borrower to no longer be an SPE. CMBS lenders and rating agencies require SPEs to remain solvent and be able to pay its debts as they come due from its own assets. The courts in Michigan have interpreted this to mean that the insolvency does not have to result from an affirmative act or omission to act by the borrower or guarantor or anyone related to them in order to trigger the 'bad boy' guaranties. This expansive view allowed the lender to pursue the borrower and guarantors for the full deficiency balance on the loans after its foreclosure of the properties despite no bad act or failure to act on their part.

What does this mean?

For borrowers and guarantors on projects located in Michigan, it means:
  • if the mortgaged property is the victim of the bad economy, the resulting insolvency can be sufficient to trigger full recourse against the borrower and guarantors; 
  • a nonrecourse loan subject to 'bad boy' triggers is meaningless, and borrowers and guarantors needs to be aware of their real exposure;
  • when faced with a property that is kicking off sufficient cash flow, a guarantor may want to inject additional equity to prevent a trigger of the guarantor for the full loan amount;
  • when faced with more recourse liability than bargained for, a guarantor may face restatement of its financials as full recourse guaranties are accounted for differently and may itself be thrown into insolvency as a result;
  • there is no incentive for a borrower or guarantor to cooperate with the lender in a foreclosure unless a release will be a part of the bargain, which a lender may or may not be willing to give; and
  • there is no incentive to work diligently to avoid triggering the "bad boy" provisions, as the borrower and guarantor are damned if they do and damned if they don't.

For the rest of us outside of Michigan, we need to be aware of the potential that courts in our jurisdiction will follow the Michigan courts' lead. These court decisions are the first to be decided on this issue. It is anybody's guess what will happen on appeal, but if the decisions stand, they will be included in lenders' briefs to other courts requesting full recourse on the guaranties.

The CMBS real estate loan market isn't doing so well right now and this will not help.
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