Recourse against individual owners or sponsors (andor their operating companies) is a significant leverage point for any lender in a distressed commercial real estate loan.
Both CMBS loans and portfolio loans (typically life company) technically are “non-recourse” in that the lender agrees to look to the collateral for the ultimate recovery of the loan. However, the loan documents “carve out” or reserve liability in the event certain events occur, or if certain loan document provisions are not followed. These liability events or provisions are called “bad boy carveouts.”
Generally, courts are tending to enforce bad boy provisions very literally, exactly as written – and have not accepted arguments (or readings of the provisions, statutes or other case law) to allow bad boy guarantors (or indemnitors) to avoid liability.
The "deal" is the deal; and it could be a big deal.
Generally, there are two types or categories of bad boy liability:
- Actual Loss. Upon the occurrence of the event, or breach of the loan document provision, the guarantor (or indemnitor) is liable for the actual loss or damages incurred by the lender.
- Full Liability. For this category, liability for the entire loan comes into play (regardless of the actual loss or damage incurred by the lender). In other words, the non-recourse loan becomes full recourse.
Below is a list of typical bad boy provisions (or recourse events) that often were overlooked at the time of closing the loan, but can be very influential during a workout, and a source of recovery for a lender following foreclosure.
Stripping the “no liability” feature from a loan can be a meaningful tool to a lender or servicer.
- Allowing a lien that is prior in rank to the lien of the loan. Example: tax liens; M&M liens (in states where they prime or have priority); etc.
- Waste committed by Borrower or that occurs on the property. Some states have very broad definitions of “waste” – such that failure to maintain the property could qualify as waste
- Separate and distinct paper work. Examples: tax returns; financial statements; stationary; invoices; checks – this list can go on for over a page
- Failure to maintain adequate capital. Example: distributions of net income were made and then the entity needs capital in order to improve the property, finish out space for a new tenant, etc.
- Solvency requirement (provision stating the borrower will not become insolvent and will not fail to pay is debt and liabilities as they become due). Example: if rent does not cover operating costs and debt service, then . . . the borrower is insolvent.
- Bankruptcy (voluntary or involuntary, where Borrower fails to obtain dismissal). Example: Ownership is forced to infuse capital into Borrower even though cash flow is not sufficient to pay operating costs and debt service
- Lock box & cash management. Failure to create or maintain the lock box and cash management of rent
- Transfer of interests. Broad definitions of the “mortgaged property” can trigger a recourse event when a "transfer" of an interest in the collateral is a bad boy event . Examples: granting a new easement, consenting to the widening of a street, settlement of a zoning dispute or of a boundary line or fence disagreement.
I’ve closed numerous new loans for life companies and CMBS lenders during the last 6 months. It is interesting that these provisions were not given much attention during those closings – probably because the borrower was just thankful (or amazed) for the privilege of closing a new loan.
If you have other bad boy events that you view as important, please comment below.