If you are a lender or guarantor of a commercial real estate loan, it's time to think about your guaranty. With commercial real estate values suffering along with the deteriorating economy, more and more lenders will look to guaranties.
As lenders consider enforcing guaranties and guarantors measure their exposure, parties should consider certain factors, including: (1) What is covered under a guaranty; (2) Whether the guaranty is enforceable; and (3) How much the lender can effectively collect on a guaranty.
What Does the Guaranty Cover?
Most term real estate loans are non-recourse to the borrower (and its owners); that is, upon a loan default, the lender's recourse is limited to a borrower's interest in the real estate pledged as collateral for the loan. However, the vast majority of non-recourse loans include some type of guaranty from a borrower's principal, or other party that benefitted from the loan.
Guaranties can take many forms and cover a wide range of exposure. Some guaranties make the guarantor liable for all or a limited portion of the debt upon virtually any default. These types of guaranty were likely required as credit support when the value of the real estate collateral was insufficient for a loan's underwriting, or if there was an especially high level of risk associated with a project.
Carve-Outs Guaranties Expansion
The most common of these guaranties involves "carve-outs," intended to cover a narrow spectrum of events or conditions. These limited guaranties are often thought of as exceptions, or carve-outs, to the non-recourse nature of the loan. Though non-recourse carve-out guaranties are often lumped together as a generic term, they vary quite a bit, and the typical scope has expanded over time.
When first introduced, non-recourse carve-out guaranties were generally intended to cover bad acts by the borrower group. If the borrower engages in bad behavior, a guarantor becomes liable for lender's loss resulting from the bad behavior. The types of bad acts covered typically include matters such as fraud, misappropriation of funds, waste committed by borrower, failure to maintain insurance required by the loan, and other things that most would consider clearly wrong for a borrower to do. The term "bad-boy guaranty" is still sometimes used to describe these guaranties.
Over time, matters covered by non-recourse carve-out guaranties expanded to include economic risks and a wider range of borrower action and inaction. For example, environmental contamination and forms of economic waste, such as failure to pay taxes and properly maintain the property, are now routinely included, even though the borrower may have done nothing wrong, or at least its culpability is less.
Scope of Liability Will Vary
In addition to variation in the matters covered under a guaranty, scope of liability will also differ. Some obligations trigger liability up to the full amount of the loan, some will trigger liability up to the amount of loss suffered by lender as a result of the defaulted obligation.
Each guaranty should be reviewed to determine the scope of matters guaranteed and what liability is imposed. In some cases, the scope of guaranty relates to whether revenue from the mortgage property is applied as required by the guaranty, and if so, both guarantor and lender should be attentive to whether revenue is being applied as required.
Is the Guaranty Enforceable?
For many real estate loans, the non-recourse carve-out guaranty is part of a document package that is largely recycled upon each loan origination. While care was certainly taken in the original drafting and composition of the form, it is possible the guaranty received limited attention in application for many loans. This is likely for two reasons: first, many lenders were focused on generating a high volume of loans at competitive pricing, and second, in a lending environment that assumed increasing property values, the value of the guaranty may have been under-weighted.
Along this theme, one may find that courts have generally ruled favorably to lenders in enforcing guaranties in accordance with their stated terms. In many such cases, borrower conduct may have been viewed as a factor in undermining a particular property's performance. Consider whether this assumption might change, however, in an environment in which lenders might be presumed more culpable for deteriorating economic conditions that have led to a spike in loan defaults.
Therefore, as lenders weigh remedies and guarantors evaluate exposure, it is worth re-examining guaranty enforceability.
Consideration. As a guaranty is a contract, it requires consideration to be enforceable. Usually this is straightforward if the guaranty was provided at the origination of the loan by a party that has an economic interest in the borrower or property. However if this is not the case with the guarantor, the issue of consideration should not be overlooked. If the guaranty was made sometime after origination without fresh consideration, e.g., fresh consideration in connection with a loan modification or extension, lack of consideration could be an issue. Similarly, if the guaranty came after origination, defenses such as duress or undue influence are possible.
Authority. If the guarantor is an entity, the guaranty needed to be properly authorized in order to be enforceable. It is possible that the scope of lender's examination of authority at origination was receipt of a legal opinion and cursory review of an authorizing resolution. It is worth reviewing whether the guaranty was permitted by the guarantor's organizational documents, whether the state of organization contains any statutory hurdles (and whether these were met), and whether all necessary authorizations were obtained.
Procedural Constraints and Amount of Deficiency. Lenders may take for granted they can collect on a guaranty irrespective of enforcement against the borrower or exercise on the collateral. However many statutory and procedural constraints can limit the amount for which a guarantor is liable or complicate the timing of enforcement. Some states have election of remedies laws that limit simultaneous proceedings against both the collateral and guarantor. For instance, statutes may inhibit a lender from enforcing a guaranty until completion of foreclosure.
While a lender may think of a guaranty as a primary obligation, in some jurisdictions it may be, in effect, more of a deficiency obligation. If this is the case or the guaranty is limited to deficiency coverage pursuant to its terms, foreclosure against the mortgage will reduce the remaining debt. In other instances, foreclosure will discharge the entire debt, or a judgment against the guarantor will have the effect of reducing the amount of the debt that is secured. If the mortgage secures property in more than one state, this matrix of complications becomes even more complex.
Creditors Rights. If the property is failing, it is possible the guarantor is in financial trouble as well. Or a guarantor may have transferred assets in anticipation of recourse. As a result, bankruptcy and other creditors rights implications may be a factor. Issues of fraudulent conveyance, adequate consideration, and preference might be examined.
Equal Credit Opportunity. Under the Equal Credit Opportunity Act it is unlawful to discriminate on the basis of marital status, and accordingly if the guaranty of a spouse was required, it may under certain circumstances be unlawful, and if so some courts have held the guaranty to be unenforceable.
Revocation. Guaranty case law permits a guarantor in some circumstances to revoke a continuing guaranty with respect to future obligations. The complexities of the revocation doctrine are beyond the scope of this article, but a guarantor should consider revocation. A lender receiving notice of revocation will of course analyze its applicability to the situation.
Is the Guaranty Collectable?
Aside from bankruptcy and creditors rights issues, more straightforward collectability questions should be asked.
Lenders should re-examine the financial statements previously provided by a guarantor, and should consider whether financial circumstances may have changed, and whether statements accurately reflected a guarantor's net worth to begin with. Lenders should also consider whether assets have been transferred under circumstances that could constitute a fraudulent conveyance.
In addition, many real estate loans are affected by other loans encumbering the same property or collateral related to the property (e.g. mezzanine financing). A lender's rights are often affected by an intercreditor agreement between lenders. For example, it is common for junior lenders to limit their enforcement remedies, and they may be required to hand over recovered money to a senior lender, until the senior loan has been repaid in full.
What to Do Now
For both lenders and guarantors of commercial real estate loans, it's time to think about your guaranty and take measures to ensure your interests are protected.
Steps for lenders to consider include:
- Get current financial statements. Assess collectability. Look for evidence of possible fraudulent transfer.
- Review possible defenses to enforceability.
- Plan your procedural strategy to address complications that may arise in the intersection of enforcing the mortgage and enforcing the guaranty.
- Review and enforce the covenants in the guaranty.
Steps for guarantors to consider include:
- Review all possible defenses to enforceability.
- Consider asset transfers carefully in light of fraudulent conveyance law.
- Consider revoking the guaranty with respect to future obligations.
- Be vigilant in causing the borrower to apply all cash flow in a manner that will not trigger recourse liability under the guaranty.
Reprinted with permission from the June 2009 issue of Real Estate Finance.