We’re in that part of the cycle where many of us are focusing on guaranty agreements, which run the full spectrum from full payment and performance guaranties to “bad boy” indemnification agreements (my recent comment).

One issue being litigated is the bad boy or recourse event tied to a breach of these types of covenants in commercial mortgage documents:

  • failure to maintain adequate capital in the Borrower (to the extent there exists cash flow from operations)
  • failure of Borrower to remain solvent (to the extent there exists cash flow from operations)

These provisions constitute part of the “single purpose” or “special purpose” nature of the Borrower, which lenders require in situations involving a “bankruptcy remote” borrower entity  (as part of the loan structure).  This is very common in permanent loans from lenders such as life insurance companies, GSEs and CMBS lenders.

The use of these provisions as a basis for bad-boy liability is now being recognized (or enforced) by various trial and appellate courts.

One example is this recent Michigan case:

  • Wells Fargo Bank, NA v. Cherryland Mall Ltd. P’ship, et al. (Mich. App. Dec. 27, 2011) (link)

This case might be accepted for review by the Michigan Supreme Court.  So, the ultimate outcome of this case still is “open” – but my personal bet is that the case either will NOT be accepted for review, or the court will review the case but not change the outcome (it will reach the same result).

I’m sure that commentators will take the results of these cases (liability of the guarantor or indemnitor) and spin it into dire predictions of the “end” of the commercial real estate finance world.

It will be an over-reaction.

The fundamental concept behind bad-boy liability for these events or triggers is simple, and even intuitive:

  • run the borrower’s operations and balance sheet like a business; in other words, not as a your personal check book
  • don’t strip cash from operations out of the borrower; in other words, don’t run it into the ground
  • in return, ownership (as bad-boy guarantors) will not have personal liability on the commercial mortgage debt if the local or national economy falls into the ditch (like the one we’re in right now).

If I’m making this too simple, or if you have another perspective, please comment below.