Written By: Eric D. Dean
Often a lender finds a proposed loan transaction attractive but the principals of the single purpose entity (“SPE”) borrower are unwilling to sign an unconditional absolute guaranty. The lender has a variety of forms of guaranty to select from, each giving the lender varying degrees of protection and in some instances focused around specific risks or concerns. This Article will also explore the lender’s available remedies under different forms of guaranty agreements.
1. THE ABSOLUTE AND UNCONDITIONAL GUARANTY
The guaranty will normally take one of two forms: (a) an unconditional and absolute guaranty of all of the borrower’s obligations under the loan documents and additional covenants in the guaranty or (b) what may be referred to as a “limited”, “bad boy” or “carve out” guaranty that limits the guarantors’ obligations. Often, a breach by one guarantor (such as a bankruptcy filing) will be deemed a breach by all other guarantors and the borrower. The death or incapacity of a significant interest holder in the borrower or a guarantor may depend on the terms of the loan documents and also be a breach and allow the lender to declare a default.
Put simply, where the guaranty is unconditional and absolute, breaches by co-guarantors or the borrower can, depending on the loan terms, result in the loan being accelerated, a default rate of interest being imposed and other remedies being exercised by the lender. Even if the lender does not elect to exercise the full extent of its available remedies, it still may demand concessions from both the borrower and guarantors such as payment of a fee, changes in loan terms or additional collateral.
California has adopted a series of statutory guarantor protections that appear to limit the lender’s exercise of remedies against guarantors until after the lender exercises its claims against the borrower and the collateral. However, these protections can be waived and are waived as a general rule. Further, California has adopted the “independence principle” under which in the event of a breach by the borrower, the lender may pursue remedies against the borrower, loan collateral and guarantors all at once or in whatever order the lender determines. This can place guarantors in immediate financial jeopardy.
Not all states provide the lender the same flexibility as California. For example in Nevada, the lender may not pursue claims under the guaranty until after all collateral is fully liquidated. Unlike California, this puts the lender at a distinct disadvantage.
2. THE CARVE OUT, “BAD BOY” OR LIMITED GUARANTY
A guaranty is defined and limited by its contractual terms. The obligations under a limited, bad boy or carve out guaranty will depend on the express terms of the guaranty which will in turn focus on the lender’s primary areas of perceived risk. For example, the lender may focus on the value of the collateral and limit the amount of the guaranty or even have the guaranty agreement terminate if there have been no defaults for a set period of time. The lender may also tie the life of the guaranty to completion of stated improvements by a certain date.
The events that will trigger a default can vary drastically in a bad boy guaranty. Some of these events include:
a) False Financial Information and Documents. The Lender will typically include a provision in the guaranty that any misrepresentations by a borrower or any guarantor will allow the lender at its sole option to declare a default and accelerate the loan balance. The Guarantors will want to limit this to only misrepresentations by the guarantor, not the borrower or other guarantors, and only to material misstatements, and provide a notice and cure period.
b) Environmental and Toxic Waste Conditions. The lender will typically want the right to declare a default and accelerate the loan balance for any environmental conditions discovered on the property. The guarantors will want a provision requiring notice and a reasonable cure period and to exclude items commonly used on this type of property in this geographic area.
c) Rents and Security Deposits. The lender typically includes a provision for the immediate turnover on demand of all rents and security deposits by existing tenants. The SPE and guarantors want to limit this by including a notice and cure period before such a demand can be made.
d) Waste or Damage to the Property. Waste and property damage are typically included in a Guaranty as giving rise to a right to accelerate. The SPE borrower and guarantors typically propose that a default can only be called for waste or damage to the collateral caused or contributed to by the SPS borrower or its agents. The fallback position for the proposed guarantor is to require notice and an opportunity to cure before a default or acceleration are declared.
e) Taxes, Impositions and Insurance. The requirement that taxes and impositions be current is commonly included in a Carve Out Guaranty. The SPE borrower and guarantors typically request a notice and cure period and a provision that if a payment arrangement is in effect with a governmental agency as to taxes or there is a good faith dispute as to taxes, no default will be declared so long as the SPE borrower is current on payments under the tax plan
f) Impairment of SPE Borrower or Guarantors. A change in management or ownership of the SPE entity or ownership of the collateral is typically considered to be a default. Whether the guaranty is absolute or limited in nature, the borrower and guarantors should insist that a change in ownership or management of the SPE entity as the result of death or incapacity is not an event of default as long as the substitute manager or ownership meets certain qualifications. There also should be negotiations as to the effect of a lawsuit or bankruptcy of one guarantor on the lender declaring a default as to the borrower or other guarantors.
g) Transferring or Encumbering Ownership Of All or Any Part of the Collateral or a Lien Against the Collateral. This is typically considered a default in a Carve Out Guaranty. The SPE borrower should include notice and cure provisions if possible and a right to substitute a guarantor’s obligation and interest in the borrower entity to a qualified substitute.
h) Failure to Maintain The Collateral. Lenders typically require a provision that a failure to maintain the collateral in a reasonable provision is a default. Proposed Guarantors want to limit these requirements as much as possible.
3. TORT LIABILITY
Normally, lenders focus around contract claims when there has been a breach of a guaranty agreement. However, there may in certain instances also be tort claims or liability based on the guarantor having engaged in or authorized “bad acts”. This could include such things as waste, fraud, selling off or granting rights in parking or free access and diversion of income, deposits or assets of the SPE borrower in breach of the requirements of the loan documents. The significance of tort damages versus contract damages is twofold. First, in a tort claim, 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 a Guarantor, the judgment may be found to be nondischargeable despite the guarantor filing a bankruptcy.
4. CONCLUSION
Guarantees are often viewed as both standard in terms and formalistic in nature. Understanding that the Lender has significant opportunities to vary the terms of guarantees, may give the lender the opportunity to focus in on key concerns in formulating the guaranty requirements while creating a more marketable and attractive product for potential borrowers. This can be accomplished while the lender continues to maintain the desired level of protection resulting from the guaranty provisions. In essence, the guaranty agreement can in the right circumstances provide the lender with a competitive edge over other banks mandating absolute and unconditional guarantees while still having the level of protection desired by the lender in the guaranty agreement.