Another Reason to be Cautious about “Bad Boy Non-Recourse

April 25, 2016

Another Reason to be Cautious about “Bad

Boy Non-Recourse Carve-out Guarantees”

IRS Concludes that “Bad Boy Guarantees” May Convert Non-

Recourse Debt into Recourse Obligations

By: Lorne W. McDougall

On February 5, 2016 the IRS released Chief Counsel Advice Memorandum Number 201606027 (the

IRS Memo) concluding that “bad boy guarantees” may cause nonrecourse ﬁnancing to become, for

tax purposes, the sole recourse debt of the guarantor. This can dramatically affect the tax basis and

at-risk investment of the borrowing entity’s partners or members. Non-recourse liability generally

increases the tax basis and at-risk investment of all parties but recourse liability increases only that

of the guarantor.

The IRS Memo has limited precedential value and applies only to the party requesting the advice.

However, it could reﬂect a new approach by the IRS to nonrecourse ﬁnancing.

The IRS Memo concludes that certain events such as voluntary bankruptcy, collusive involuntary

bankruptcy, unapproved junior ﬁnancing and transfers or admitting in writing borrower’s inability to

pay its debts as they become due are not sufﬁciently remote so as to satisfy the meaning of Treas.

Reg.1.752-2(b)(3) which disregards payment obligations that are subject to contingencies that are

unlikely to occur.

Most loan parties believe just the opposite; primarily because the guarantor usually directly or

indirectly controls the borrower and is unlikely to permit conduct that will trigger guarantor’s

personal liability.

The conclusions reached in the IRS Memo seem to assume that a bad boy guaranty is the functional

equivalent of a payment guaranty. But the real purpose of a bad boy guaranty is to discourage

those who control the borrower from allowing it to commit certain “bad acts” that are harmful to

the interests of the lender. Unlike the case with a payment guaranty, unless the prohibited conduct

occurs the guarantor is not liable for payment regardless of what other defaults exist or whether the

loan is ever repaid.

A bad boy guaranty merely provides a non-recourse lender with the leverage to make sure the

mortgaged property, usually its only source of repayment after default, remains in good condition,

stays free of unapproved liens or transfers and ensures that the borrower does not do anything that

will interfere with the recovery of its collateral. Obtaining the right to impose potential recourse

liability on those who can prevent these occurrences gives the lender a signiﬁcant tool to prevent

such harm, but falls far short of assuring repayment.

Careful drafting of a bad boy guaranty can reduce the likelihood of unexpected guarantor liability

if the borrower ends up in liquidation, support good arguments for preserving the application of

Treas. Reg. Section 1.752-2(b)(3) and yet still protect a lender’s legitimate interests.

In addition to the potential tax risk discussed above, recent court cases provide additional reasons

to be concerned about inartfully drafted bad boy guarantees.

In Wells Fargo Bank NA v. Cherryland Mall Limited Partnership, et al., 812 N.W.2d 799 (Mich.Ct.App.,

2011) the court held that a borrower’s insolvency constituted a failure to maintain its status as a

Real Estate Practice

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single purpose entity triggering full recourse liability under the terms of the applicable bad boy

guaranty. Other courts have reached similar holdings. It is very unlikely that the guarantor realized

it was effectively guaranteeing the borrower’s solvency by agreeing to guaranty borrower’s SPE

status. A lender’s deﬁnition of what constitutes an SPE is frequently far broader than what rating

agencies or courts require. No rating agency or court has ever determined that ongoing solvency is

an essential element of SPE status.

Simply inserting the word “intends” before a borrower’s covenant to remain solvent or excluding

that element of lender’s deﬁnition of an SPE in a bad boy guaranty can prevent unexpected

personal liability if the project is unsuccessful.

Another common bad boy recourse trigger is the occurrence of “waste” at the property. In

Travelers Insurance Company v. 633 Third Associates, et al, 14 F. 3rd 114 (2nd Cir. 1994), the court

held that the borrower’s failure to pay real estate taxes constituted waste and triggered recourse

under a bad boy guaranty prohibiting waste. Limiting liability to physical waste not resulting from

borrower’s lack of funds may avoid a surprise such as this.

Recourse liability can also be triggered for (i) a voluntary “Lien”; (ii) an unapproved “Transfer”;

or (iii) incurring additional Indebtedness. If these terms are not properly deﬁned unintended

consequences can result. For instance, adding the words “resulting from the consent or acts of

the Borrower” to the deﬁnition of “Liens” can eliminate liability for a tenant’s mechanics liens or

other statutory liens because such liens are not created with the consent or acknowledgement of

the borrower. Transfers can also be limited to afﬁrmative acts of the borrower and avoid those that

occur by operation of law. Adding an exception for trade debt incurred in the ordinary course of

business can minimize guarantor’s exposure for additional indebtedness.

A lender’s “standard” bad boy non-recourse carve-out language can be a trap for the unwary and

result in often unintended personal liability and/or adverse tax consequences. Careful drafting can

help avoid both results.

Lorne W. McDougall | 617-951-2287 | lorne.mcdougall@lockelord.com

Real Estate Practice

April 25, 2016