"Bad Boy" Guarantys

A. BACKGROUND

The term “bad boy” guaranty is used in certain circumstances to describe a guaranty to be provided – usually by an individual, not an entity – in connection with, most often, real estate financing.

The original intent of “bad boy” guarantys was to influence the post-closing behavior of a principal of the borrower, in order to discourage bad conduct that would harm the lender’s position and collateral. Traditionally, the triggers for recourse to the borrower and/or guarantor liability were events such as:

• fraud
• misapplication of casualty or condemnation proceeds
• “waste” of assets
• environmental liabilities

Since the occurrence of these “bad” events was infrequent and largely within the guarantor’s control, guarantors frequently agreed to the terms of the guaranty without controversy.

However, with the advent of new non-recourse financing structures designed to avoid the delay and difficulty of bankruptcy (and other litigation) – often related to the “commercial mortgage backed securities” (CMBS) market – which required the use of single asset or “special purpose entities” (SPE) and “bankruptcy remote entities” (BRE), the list of “triggers” for recourse and/or guarantor liability has grown.

B. STRUCTURE

SCENARIO 1

Typical “Limited” Guaranty Structure
(lender desires protection of “bad boy” provisions, even in a recourse loan)

1. Promissory Note from borrower to lender, contains either (a) full recourse terms or (b) non-recourse terms with exceptions for recourse events.

2. Guaranty from the “carve-out” guarantor to the lender is limited to specific triggering events or to specific types of obligations or liabilities to address the conduct and involvement of the guarantor.


SCENARIO 2

Typical Non-Recourse Guaranty Structure
(typical for CMBS loans with an SPE)

1. Promissory Note from borrower to lender, contains non-recourse terms with exceptions: events which will cause the obligation to become recourse.

2. Guaranty from the “carve-out” guarantor to the lender, which is unconditional and unlimited, but guarantees, in some way, the recourse liability under the note.


C. TRIGGERS

The triggering events which may give rise to recourse and/or guarantor liability are often divided into two (2) groups:

Type 1. “Above-the-line” acts or recourse events which cause the lender to suffer costs, losses or expenses, the amount of which may be collected through recourse to the borrower and/or guarantor; and

Type 2. “Below-the-line” acts or recourse events which cause the borrower and/or guarantor to become liable for the full debt (or full deficiency after foreclosure), often referred to as “springing recourse”, whether or not the lender experiences any loss and whether or not the borrower causes the event.

Examples of Type 1 triggers are:

(a) fraud or intentional misrepresentation by borrower or any of certain related parties in connection with the loan;

(b) the gross negligence or willful misconduct of borrower;

(c) the removal or disposal of any portion of the collateral after an event of default;

(d) borrower’s misapplication, misappropriation or conversion of rents received by borrower after the occurrence and continuance of an event of default;

(e) borrower’s misapplication, misappropriation or conversion of tenant security deposits or rents collected in advance;

(f) the misapplication, misappropriation or conversion of insurance proceeds or condemnation awards;

(g) Personal Property (as defined in the security agreement) taken from the real estate collateral by or on behalf of borrower or any of certain related parties and not replaced with Personal Property of the same utility and of the same or greater value;

(h) any act of arson by borrower or any of certain related parties;

(i) any fees or commissions paid by borrower after the occurrence of an event of default to any certain related parties in violation of the terms of the loan documents;

(j) failure to pay charges for labor or materials or other charges that can create liens on any portion of the real estate collateral;

(k) any security deposits, advance deposits or any other deposits collected with respect to the real estate collateral not being delivered to lender upon a foreclosure of the real estate collateral or action in lieu thereof, except to the extent any such security deposits were applied in accordance with the terms and conditions of any of the leases;

(l) any failure by borrower to permit on-site inspections of the real estate collateral as...