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“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

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“Bad Boy” Guaranties–Enforceable or Not?

Oct. 18, 2017

Barry Lee| Partner, Manatt, Phelps & Phillips, LLP

Jubin Meraj | Partner, Manatt, Phelps & Phillips, LLP

“Bad Boy” Guaranties–Enforceable or Not?

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

 Topic Overview

– The History and Purposes of “Bad Boy” Guaranties

– Common Provisions in Bad Boy Guaranties

– Seminal Cases

– Drafting More Enforceable Provisions

– Q&A

The History and Purposes of “Bad Boy” Guaranties

 Definitional Matters

– “Non-recourse Loan” - a secured loan for which the lender has agreed it

will seek to be repaid from only the mortgaged property

– “Bad Boy” Guaranty - a guaranty that holds the guarantor personally liable

for either lender’s losses, or the entire amount of the loan, if certain “bad

boy” events occur

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

The History and Purposes of “Bad Boy” Guaranties

 Uses of “Bad Boy” Guaranties Pre-CMBS and Post-CMBS

– Prior to CMBS, “bad boy” events–to the extent they were used–generally

were egregious acts (like fraud and gross negligence) within the control of

the guarantor

– CMBS loans added failure to pay taxes and insurance, allowing liens to be

placed on the property, failure to provide financial statements, and similar

triggers

– Bankruptcy was added to the list in the real estate recession of the 1990s;

it was used as a strategy to delay the lender’s exercise of nonjudicial

foreclosure remedies

– Rating agencies such as S&P and Moody’s required each borrower to be

an SPE with numerous separateness covenants

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

The History and Purposes of “Bad Boy” Guaranties

 Today “Bad Boy” Guaranty = misnomer

 “Bad Boy” carve-outs in other contexts: joint ventures (change in

management control provisions) and development management

agreements (for construction companies with few assets)

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Common Provisions in Bad Boy Guaranties

 “Actual Loss” versus “Full Recourse” Triggers

– “Actual Loss”/ “Above the Line”–guarantor has liability for the actual losses

incurred by a lender resulting from the triggering event

– “Full Recourse” / “Below the Line”–guarantor becomes liable for the entire

amount of the debt (i.e., any deficiency)

– What determines which trigger goes above or below the line?

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Common Provisions in Bad Boy Guaranties

 List of Typical “Actual Loss” Triggers

– Fraud by borrower or its affiliates

– Misappropriation of funds by borrower or its affiliates

– Gross negligence or willful misconduct

– Waste

– Failure to pay contractors or suppliers, which may result in liens

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Common Provisions in Bad Boy Guaranties

 List of Typical “Full Recourse” Triggers

– Bankruptcy events (voluntary bankruptcy, collusive involuntary bankruptcy)

– Prohibited transfers/encumbrances of the property

– Insolvency

– Borrower admits in writing it is unable to pay its debts as they become due

– Violation of the SPE/separateness covenants, such as engaging in

business other than operation of the property, merger with any other

person, failure to maintain separate accounts books and records, failure to

maintain separate legal formalities, and failure to pay its own liabilities from

its own accounts

 Intended to avoid substantive consolidation in bankruptcy

 Why would a secured lender who made a non-recourse loan be worried about

substantive consolidation? The lender does not lose the security interest as a

result

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 General Trends

 The Insolvency Cases – Gratiot and Cherryland Mall

 Settlement Agreement as Prohibited Transfer – Blue Hills Office

Park

 Failure to Pay Real Estate Taxes – Park Avenue Hotel

Acquisition

 “Waste” cases

 Contesting Enforcement Actions – Bank of America v. Freed

 IRS General Legal Advice Memorandum re Bad Boy Guaranties

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 General Trends in the Cases

– Lenders prevail against guarantors and borrowers

– Courts generally enforce the express provisions of the guaranties, even if

there is parol evidence suggesting that the parties’ intent was not

consistent with the express provisions

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 51382 Gratiot Ave. Holdings, LLC v. Chesterfield Development

Co., LLC, 835 F. Supp. 2d 384 (E.D. Mich. 2011)

– In April 2005, Chesterfield Development Co. borrowed $17MM in a

commercial loan from Morgan Stanley, who later sold the loan to Gratiot

– In November 2009 Borrower ceased making mortgage payments because

the project was failing

– The lender put the borrower in default, accelerated the debt and foreclosed

on the property, which was sold for only $7.6MM, leaving a $9MM

deficiency

– The court held that the express language of the guaranty controls

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 51382 Gratiot Ave. Holdings, LLC v. Chesterfield Development Co.,

LLC, 835 F. Supp. 2d 384 (E.D. Mich. 2011)

– Defenses to Enforceability

 “Extremely absurd,” “ridiculous” and “draconian” result

 Mutual mistake

 Public policy

– “[t]he court does not sit to propagate or enforce best business practices; instead, it

is the court's duty to give effect to discrete agreements executed by individual

parties… the court will hold those parties to their bargain.”

– Related case – UBS Commercial Mortgage Trust 2007-FL1, Commercial Mortgage

Pass-through Certificates, Series 2007-FL1, and Normandy Reston Office, LLC v.

Garrison Special Opportunities Fund L.P. (N.Y. Sup., March 8, 2011)

▪ “No doubt that there are many real estate developers who now regret having

exposed themselves to the loss of fortune by investing in an overheated real

estate market … However, the Court is not a bank, insurance or pension fund

regulatory authority with the administrative power required to address these

circumstances. The Court is an arbiter of commercial disputes, charged with

upholding freely entered into contractual arrangements in accordance with

common law precedents and the rules of legislative interpretation.”

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 51382 Gratiot Ave. Holdings, LLC v. Chesterfield Development

Co., LLC, 835 F. Supp. 2d 384 (E.D. Mich. 2011)

– Other possible defenses

 Unenforceable penalty

 Invalid liquidated damages

 Unconscionability

 Fraud in the inducement

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 Wells Fargo Bank, NA v. Cherryland Mall (Mich. Ct. App. 2011)

– As a result of this case, the Michigan Legislature passed the Nonrecourse

Mortgage Loan Act of 2012 (NMLA)

 “A post closing solvency covenant shall not be used, directly or indirectly, as a

nonrecourse carveout or as the basis for any claim or action against a borrower or

any guarantor or other surety on a nonrecourse loan.”

 “… applies to the enforcement and interpretation of all nonrecourse loan documents

in existence on, or entered into on or after, the effective date of this act.”

 The Michigan Supreme Court, in 2012, remanded the Cherryland case for

reconsideration in light of the NMLA and the judgment against the guarantor was

overturned

– “We recognize that our interpretation seems incongruent with the perceived

nature of a nonrecourse debt and are cognizant of the amici curiae's

arguments and calculations that, if accurate, indicate economic disaster for the

business community in Michigan if this Court upholds the trial court's

interpretation. Nevertheless, the documents at issue appear to be fairly

standardized nationwide, and defendants elected to take that risk—as did

many other businesses in Michigan and nationwide. It is not the job of this

Court to save litigants from their bad bargains or their failure to read and

understand the terms of a contract.”

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, 477 F.

Supp. 2d 366 (D. Mass. 2007)

– “… wise counsel would have explained all the risks involved in so

transferring the settlement funds, counseled against it, and pushed for

disclosure to the Lender.”

– The court expressed “regret over the time, money, and resources that

necessarily have been expended to correct this faulty settlement structure.”

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 ING Real Estate Finance (USA), LLC v. Park Avenue Hotel

Acquisition, LLC, 907 N.Y.S.2d 437 (N.Y. Sup., Feb. 24, 2010)

– Borrower wins

– “The question before the Court is whether, by the terms of the contract, the

nineteen-day tardiness in paying less than $300,000 in property taxes

triggers a full recourse obligation by the Guarantors of up to $90 million.”

– “… plaintiffs would have … defendants potentially liable for the entire debt

of up to $145 million if the Borrower is just one day delinquent in paying a

dollar in property taxes … Such an unlikely outcome could not have been

intended by the parties, sophisticated commercial borrowers and lenders

aided by competent counsel at the time of the drafting, and is

impermissible under New York law …”

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 The “Waste” Cases

– Failure to pay insurance premiums can constitute waste when mortgage

requires same. Alden Park, LLC v. Anglo Irish Bank Corp., 2009 WL

499157 (ED Mich.)

– Failure to pay real estate taxes is “waste.” Travelers Inc. Co. v. 633 Third

Associates, 14 F.3d 114 (2

Cir. 1994)

– Failure to renew an important parking lease (that provided necessary

parking for a commercial building) is not waste because it does not impair

the collateral or make it subject to a superior lien. Boucher Investments,

L.P. v. Annapolis West Ltd. Partnership, 784 A.2d 39 (Md. Ct. Spec. App.

2002)

– Borrower’s changing the “flag” of the hotel from a Holiday Inn to a Clarion

Hotel, which reduced appraised value of property, is not waste. U.S. Bank,

N.A., as Trustee, and Orix Capital Markets, L.L.C. v. American Realty

Trust, Inc., 275 S.W.3d 647 (Tex. App. 2009, pet. denied)

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 Bank of America, N.A. v. Freed, 983 N.E.2d 509 (Ill. App. 2

2012)

– Guaranty provided for full recourse if borrower contested an enforcement

action. Borrower filed an interlocutory appeal objecting to the to

appointment of a receiver and the court ruled that the appeal triggered

recourse liability

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 IRS General Legal Advice Memorandum AM2016-001 Released

April 15, 2016

– In response to Chief Counsel Advice 201606027 issued Feb. 5, 2016

– “Typical” non-recourse carve-outs, as listed in the memorandum, will not

cause an otherwise non-recourse liability to be treated as recourse for the

purposes of determining the allocation of partnership liabilities for tax

purposes

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Seminal Cases

 Conclusions From Cases

– Express language will generally be enforced in many jurisdictions

– Legal right ≠ economic sense

– The role of the transactional lawyer is key

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Drafting More Enforceable Provisions

 Solvency and Separateness Covenants

– Borrower shall at all times is solvent as of the date hereof and intends to

remain solvent to the extent there are sufficient Project Revenues, provided

that nothing herein shall obligate any person, including any Affiliate of the

Borrower, to contribute any funds to Borrower for the purposes of complying

with this subsection.

– Borrower breaches any representations, warranties, or covenants regarding its

status as a “special purpose entity” under the Loan Documents, provided,

however, that any such breach shall not result in recourse liability to the

borrower or the guarantor unless such breach is cited as a factor in a judicial

action resulting in the application of the doctrine of substantive consolidation of

the assets and liabilities of Borrower with those of any other person pursuant to

Bankruptcy Code and related case law.

– Borrower or Guarantor admits, in writing or in any legal proceeding, its

insolvency or inability to pay its debts as they become due.

– Borrower or Guarantor admits, in writing or in any legal proceeding, its

insolvency or inability to pay its debts as they become due.

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Drafting More Enforceable Provisions

 Gross Negligence and Willful Misconduct

– The gross negligence or willful misconduct of Borrower; provided, however,

borrower’s failure to perform its obligations under the loan documents shall

not constitute gross negligence or willful misconduct if such failure resulted

solely from the fact that performing such obligations required the Borrower

to make expenditures and Project revenues were insufficient to fund such

expenditures.

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Drafting More Enforceable Provisions

 Failure to Pay Taxes and Assessments

– Borrower’s failure to pay any of the taxes, assessments or similar charges

specified in the Security Instrument, provided that Borrower shall not have

any liability under this subsection during any time that there was insufficient

revenue from the Project to prevent such failure to pay.

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Drafting More Enforceable Provisions

 Waste

– Material physical waste of the Property resulting from the acts or omissions

of Borrower or Principal other than physical waste resulting from insufficient

revenues from the Project.

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Questions?

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Barry W. Lee is a partner in the San Francisco office, co-chair

of the Trial Practice Group, and co-chair of the Financial

Services Litigation and Enforcement Group. He focuses on

commercial litigation and has extensive jury and bench trial

experience encompassing a variety of areas, including real

estate, banking/lender liability, antitrust/unfair competition,

consumer class actions, environmental, construction,

probate, securities, products liability, and insurance

coverage.

In addition to his trial work, Barry has been a contributing

author to an antitrust treatise and has authored numerous

articles and appeared as a speaker for the Practicing Law

Institute on various topics, including trial practice, discovery,

directors’ and officers’ liability, professional liability

insurance for lawyers and accountants, and antitrust.

Education

 University of California, Hastings College of the

Law, J.D.

 Duke University, B.A.

Barry W. Lee

Partner, Financial Services

Litigation and Enforcement

San Francisco: 415.291.7450

bwlee@manatt.com

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Thank you!

About

Jubin Meraj is a partner in the real estate practice group in

the firm’s Los Angeles office. Jubin’s practice focuses on a

wide variety of real estate transactions, including

acquisitions and dispositions, joint ventures, tenancy-in-

common agreements, development management

agreements, construction contracts, architectural

agreements, management agreements, ground leasing, retail

leasing, financing, easements, restrictive covenants and

settlement agreements.

As investor’s counsel, Jubin works closely with clients to

identify and mitigate key risks in a venture. Jubin structures

transactions with attention to each stage of the investment

lifecycle, from partnership formation, to major decisions

relating to land acquisition, obtaining entitlements and

financing, all the way through exit strategies. When

representing developers and sponsors, Jubin is focused on

finding efficient, practical and creative solutions to the

myriad obstacles that often arise in maneuvering through the

various phases of a project.

Education

 Yale Law School, J.D.

 Brown University, B.A.

Jubin Meraj

Partner, Real Estate

Los Angeles: 310.312.4125

jmeraj@manatt.com

“Bad Boy” Guaranties – Enforceable or Not? | Manatt, Phelps & Phillips, LLP

Thank you!

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