Bad Boy Guaranties: Know What to Do When the Lender Comes for You
| Jurisdiction | Colorado,United States |
| Citation | Vol. 42 No. 9 Pg. 29 |
| Pages | 29 |
| Publication year | 2013 |
By Michael Guyerson, David M. Little.
Articles Business Law
Business Law articles are sponsored by the CBA Business Law Section to apprise members of current substantive law. Articles focus on business law topics for the Colorado practitioner, including antitrust, bankruptcy, business entities, commercial law, corporate counsel, financial institutions, franchising, and securities law.
Coordinating Editors
Trygve E. Kjellsen of Lathrop & Gage LLP, Denver—(720) 931-3145, tkjellsen@lathropgage.com; David P. Steigerwald of Sparks Willson Borges Brandt & Johnson, P.C., Colorado Springs—(719) 475-0097, dpsteig@sparkswillson.com; Curt Todd, Denver—(303) 955-1184, ctodd@templelaw.comcastbiz.net (Bankruptcy Law)
About the Authors
Michael J. Guyerson is a member and David M. Little is an associate with the Denver law firm of Onsager, Staelin & Guyerson, LLC. The firm emphasizes commercial bankruptcy, insolvency, commercial litigation, and business matters. They can be reached at (303) 512-1123 or through the firm 's website at www.osglaw.com.
Courts nationally have upheld "bad boy " guaranty terms imposing full-recourse liability on nonrecourse loans for events that turn out not to be so "bad" after all Colorado and Tenth Circuit precedent is likely to follow this trend, but defenses to recourse liability exist, and a legislative solution is being tested.
Lenders and private equity investors have found that to be competitive in today's global economy, it sometimes is best to limit a borrower's exposure to the value of the collateral—a classic nonrecourse loan. Unconditional and full guaranties of sophisticated real estate and commercial development loans are rare these days, although they certainly can be found. Guarantors are understandably reluctant to sign full and unconditional guaranties; private equity developers, REIT funds, or foreign developers may be restricted from doing so in their organizational or operational agreements. Many commercial borrowers prudently wish to limit their own exposure to the value of the collateral—or perhaps a fixed dollar amount—with no recourse liability for any deficiency. A "bad boy" clause or guaranty agreement is one mechanism that attempts to meet these sometimes conflicting concerns, but frequently fails to do so, leaving unexpected full liability for the borrower and the guarantor.
Definition
Nonrecourse loans are common, but most come with a twist. In its basic form, a bad boy guaranty is part of a commercial nonrecourse loan transaction where the liability of the borrower and the third-party guarantor are transformed from nonrecourse liability for any deficiencies typically to full recourse liability in the event of certain triggering actions or "bad boy" events.
Historically, the triggering events that made the borrower and the guarantors fully liable for all losses were serious events of defalcation, such as theft or conversion of collateral, unauthorized sale of assets, waste, or fraud. However, far less egregious behavior now frequently triggers the recourse liability, including the filing of a voluntary or involuntary bankruptcy proceeding by, for example, a borrower or guarantor or both, zoning law changes, judgments, adverse awards, or falling below a minimum debt-to-equity ratio.[1] In Colorado, using property in a way that may be legal under state law but not federal law—for example, a marijuana growing operation—also might trigger such full recourse liability. Sometimes, the guaranty will be limited in amount, perhaps to actual damages caused, but that often is not the case.
Impact on Commercial Lending
The Bank of America, N.A. v. Lightstone Holdings, LLC[2] opinion provides an example of a bankruptcy filing triggering recourse liability. In 2009, Extended Stay Hotels, then one of the country’s largest owners of hotels, filed a bankruptcy petition. In 2007, an investor group had acquired Extended Stay Hotels for a reported $8 billion in a highly leveraged purchase. The borrowers’ mortgage and mezzanine loans were nonrecourse, except that certain bad boy acts—among them a voluntary or involuntary bankruptcy filing by or against the borrowers—would trigger recourse liability to the borrowers. The guarantors personally guaranteed the borrowers’ recourse liability up to $100 million, with the so-called bad boy act prohibitions in place. One could have scarcely forecasted in 2007 when the acquisition was made and the loan agreement and guaranties signed—in what was a robust business and personal travel climate with a growing economy—that just two years later, bankruptcy would be filed.
In 2008, the overall economic crisis caused Extended Stay Hotels to encounter financial difficulties. The borrowers tried to return their properties to the senior lenders, but junior lenders prevented this attempt and ultimately Extended Stay Hotels filed a Chapter 11 petition as part of a plan with the senior lenders. The bankruptcy filing triggered the guarantors’ recourse liability on mezzanine loans, and these lenders sued the guarantors in the New York Supreme Court of New York County in June 2009. In July 2009, the guarantors removed the state court action to the bankruptcy court where the Extended Stay bankruptcy case was pending, but the bankruptcy court remanded the case to state court. The junior lenders then moved for summary judgment in the state court litigation.[3]
Guarantors’ Defenses in Lightstone Holdings
In challenging the "springing nature" of the bad boy guaranties, the guarantors in Lightstone Holdings advanced several arguments against enforcement. Chiefly among their defenses, the guarantors argued that the springing nature of the guaranty provisions that resulted in recourse liability against the borrowers and the guarantors in the event of a voluntary bankruptcy filing were void as a matter of public policy.[4]
The New York Supreme Court rejected this argument, holding that: (1) the guaranty agreements contained an enforceable waiver of defenses clause such that the guarantors effectively waived asserting the guaranty was void as against public policy; and (2) there was no public policy reason to justify the borrowers or the guarantors walking away from their contractual obligations.[5] The Court further observed that the waiver of defense clause also prevented any argument that the guaranties were invalid as an unenforceable penalty not commensurate with damages resulting from the bad act at issue.[6] In explanation, the court pointed out that the borrower and guarantor were sophisticated distressed real estate investors, the guaranty itself was a common feature in commercial mortgage loans, and such guaranties almost uniformly contain language that makes them unconditional and that waives the right to assert defenses.[7] Another court similarly upheld such features as valid financing arrangements .[8]
Unintended Consequences
Another illustrative case is Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, in which a borrower settled a zoning dispute with a neighboring property but pocketed the $2 million cash settlement instead of depositing the settlement into the borrower’s account.[9] The borrower eventually stopped making payments on its mortgage loan and the lender foreclosed. The lender was not happy to find out that the principals pocketed the $2 million rather than making it available to the borrower to pay the mortgage loan and invoked bad boy provisions in the loan agreement.
The court found that, under the language of the loan documents, the $2 million settlement for the zoning dispute was part of the collateral for the...
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