Written By: Eric D. Dean
In most instances, the borrower on a commercial real estate loan will be a single purpose entity (the “SPE”) which is in title to the real property offered as the primary security for the loan. In many instances some or all of the principals of the SPE borrower are required to execute an unsecured guaranty of the loan as a condition of the loan closing. The SPE offers the lender bankruptcy protection while offering the principals of the venture protection from a house of cards if they own multiple assets held in different entities and one asset fails.
The guaranty will normally take one of two forms (a) an unconditional and absolute guaranty or a limited or “carve out” guaranty in the case of a non-recourse loan. The unconditional absolute guaranty puts the guarantors at risk for all forms of default by the SPE borrower regardless of the cause and in many instances regardless of the materiality of the default. Therefore, the guarantor may be liable under the guaranty for defaults by the SPE borrower resulting from general economic conditions out of the control of the SPE borrower such as a failure to maintain a required debt coverage ratio or other economic indicia required by the loan documents or an inability to pay loan payments timely, contribute required amounts to reserves or pay real property taxes timely.
Put simply, if any of the loan terms are not met, depending on the terms of the guaranty, the lender without prior notice or demand may have the right to file a legal action against the guarantor for the full amount of the loan obligation. Since the guaranty is an unsecured obligation, the lender can pursue immediate collection remedies in the court action such as a prejudgment attachment of the non-exempt business and personal assets of the guarantor up to the full amount of the loan obligation. If and when the real property security is foreclosed on, the lender is required to give credit against the guarantor’s obligation for the successful bid at the non-judicial foreclosure sale. However, the successful bid at the foreclosure sale may be significantly less than the market value of the property or the loan amount leaving the Guarantor and the Guarantor’s assets exposed to substantial liability in a lawsuit where the Guarantor may have no defenses to the lender’s claim. This may result in a judgment being entered in favor of the lender and against the Guarantor early in the court case if the lender files what is called a summary judgment motion asking the court to decide the case without a trial.
The limited or carve out guaranty also exposes the Guarantor to substantial risk and liability if the lender declares a default. However, the lender is limited by the terms of the guaranty as to which defaults by the SPE borrower the Guarantor is responsible for. The Guarantor is personally at risk only for the specific defaults designated in the guaranty.
The limited or carve out guaranty can take many forms. In some instances, the guarantor is only exposed to liability for bad acts of the SPE borrower. This typically includes such things as not maintaining the real property security or waste, toxic or environmental contamination on the property, diversion of income or assets of the SPE borrower and fraud. The limited guaranty can also include as defaults such things as failure to pay real property taxes and insurance timely, a transfer or conveyance of the real property security without lender approval, failure to complete construction of agreed improvements in a timely manner, failure to maintain the SPE entity in good standing, failure to keep the real property collateral free of other liens or encumbrances not approved by the lender and failure to have an independent director (in the case of a corporate SPE) or manager (in the case of a limited liability company) appointed whose vote is required on issues such as the filing of bankruptcy, liquidation or dissolution.
In addition to negotiating the defaults that the Guarantor is ultimately responsible for when negotiating the guaranty, the Guarantor can further attempt to limit the guaranty by having the lender agree to a maximum amount the Guarantor will be responsible for in the event of a covered default or a release of the guaranty if certain conditions are met such as completion of construction, a certain debt service ratio being met by the SPE borrower for a stated period of time or an appraisal of the real property security establishing a stabilized value of the collateral at or above an agreed amount.
In addition to the contract damages referenced above, in certain instances the Guarantor may be exposed to tort damages for “bad acts”. This would include such things as waste, fraud and diversion of income or assets of the SPE borrower that the lender has a security interest in. The significance of tort damages is twofold. First, in addition to its actual damage claims the lender may seek a punitive damage award over and above the lender’s actual damages to punish the Guarantor for the bad acts. Secondly, if an intentional tort judgment is entered against the Guarantor in civil court this judgment may not be dischargeable in bankruptcy court.
Too often borrower and its counsel ignore the guaranty when negotiating the loan documents and assume that the terms of the draft guaranty presented by the lender and its counsel are standard and non-negotiable. In fact, the guaranty is an essential part of the loan documentation and its terms should be negotiated wherever possible. In fact, efforts to limit the guaranty should start at the time the loan commitment is being negotiated in conjunction with the negotiation of the other loan terms. Once the loan closes, the managers and guarantors need to understand the nature of the defaults the guarantors are personally responsible for and avoid these defaults wherever possible. Diversion of property income or other loan collateral is particularly risky and opens the Guarantor up to significant potential exposure as well as the ire of the lender. It behooves the SPE borrower and Guarantor throughout the term of the Guaranty to maintain as good a relationship and as much credibility with the lender as possible. If a problem arises or is foreseen in the future, rather than attempt to hide this problem from the lender (which may in and of itself be a default under the loan documents) it may be beneficial for the Guarantor to approach the lender at the early stages of the problem and attempt a work out rather than risk the wrath of the lender when it later discovers the problem through other means.