Carve-outs: Bad-boy Guarantees Have Borrowers Getting Spanked

So-called bad-boy guarantees have recently created headaches for borrowers when CMBS loans go bad, industry experts told Mortgage Observer. A number of recent cases across the nation have interpreted the guarantees, which prohibit certain borrower activity, like “indebtedness,” and “insolvency,” to mean that the principals of a borrowing entity are personally liable for losses in the event of default—a shocking development for CMBS borrowers and lenders alike.

It began with a 2011 case, Wells Fargo vs. Cherryland Mall, which rose to the highest court in Michigan. A provision that the borrower would “not become insolvent” was found to constitute a personal guarantee by the principal of the development company, which had defaulted on a CMBS loan, said Sam Lee of Duval & Stachenfeld. “It created a ripple effect,” in the industry, he said, because that “innocuous phrase,” one type of bad-boy clause, was boilerplate in many CMBS loan documents at the time. (The ruling by the Michigan court was actually later overturned by the state legislature, in an unprecedented move).

The Michigan ruling “meant, in effect, that a non-recourse loan—a loan that is asset-based, where you’re only looking at the property—all of the sudden became a recourse loan,” said Jonathan Mechanic, head of real estate at Fried, Frank, Harris, Shriver & Jacobson LLP. Cherryland was followed by a similar case in Georgia, in 2012, where the court followed the Cherryland court’s precedent (and Wells Fargo was also the plaintiff ), and later by CP III Rincon Towers vs. Richard Cohen, filed this year in New York’s Southern District.

Many in the industry agree that the Cherryland case was not in line with industry expectations, or with the intentions of borrowers when they signed. In fact, the court did not look at intention in Cherryland, said Janice Mac Avoy, a partner in Fried, Frank’s real estate group.

Even lenders do not universally want the guarantees interpreted this way, a source told MO, because they could discourage borrowers from from taking out CMBS loans in the future. (Bad-boy guarantees have largely been removed from loan documents now, that attorney said, though legacy CMBS could continue to spur suits for the next couple of years).

In the Rincon case, a fund named Carmel Partners bought the debt after Bear Stearns went belly up, said Ms. Mac Avoy, who represented borrower Mr. Cohen. Carmel argued that clauses prohibiting “unpermitted” indebtedness and transfers triggered full recourse when the borrower was slapped with a mechanic’s lien. Carmel sought to take control of the property, a San Francisco condominium conversion, by way of a non-judicial foreclosure. But the fact that in draft documents with the original lender the borrower deleted a clause that would have triggered loss recourse in the event of a mechanic’s lien supported Mr. Cohen’s argument this instance should not trigger full recourse, and the court found in favor of Mr. Cohen.

Carmel is appealing, however, and, if successful, the outcome would alarm many CMBS borrowers, sources said. It would also potentially open the door for a bevy of litigation, since so many CMBS loans would fall under the same New York jurisdiction.

The industry is keeping a watchful eye on the case. The appeal should be decided early next year, Ms. Mac Avoy said.

“Some people are outraged that [bad boy clauses] are getting enforced,” said Chris Delson, a partner in the real estate group at Morrison & Foerster LLP.

And the Georgia and Cherryland rulings run contrary to industry understanding of CMBS loans and their risks, Ms. Mac Avoy asserted. “The issuer is saying ‘we are not making individual credit decisions,’” when originating a CMBS loan, she said. Rather, they are lending based on property fundamentals.

Still, many believe the courts in New York will take the side of CMBS borrowers. Such a ruling would be in line with the sentiment of past, similar cases brought and decided here, sources said.

“We had a case at 610 Lexington Avenue about a year and a half ago where a lender tried to take the position that it was recourse,” said Mr. Mechanic. “The court sided with us and said, ‘no, that doesn’t make sense.’”

Private Equity: When Lenders Question Funds on Their Guarantees

Concerns over the net worth and liquidity of private equity funds are increasingly causing disputes and delays in commercial real estate transactions, Schulte, Roth & Zabel’s Jeffrey Lenobel told Mortgage Observer.

“I represent a lot of private equity and disputes and extensive negotiations happen on virtually every deal where a guarantee from a private equity fund is involved,” said Mr. Lenobel, head of the of the New York-based law firm’s real estate group.

With private equity investors now playing such a pivotal role in commercial real estate deals, those investors are now asked to sign guarantees ranging from non-recourse carve-out guarantees to environmental indemnity agreements to completion guarantees in construction deals. A leading cause of friction is unmanaged expectations, wherein lenders expect a consistent and concrete proof of income and liquidity, according to Mr. Lenobel.

“The first and threshold issue is that just because a private equity firm has a series of funds doesn’t mean that fund II can guarantee the obligations of fund I,” he said. “These funds, for the purposes of guarantees, are separate entities and I don’t think the investors in one fund would have any interest in guaranteeing the real estate held by investors in a different fund,” he added.

The concerns are multilayered. During the investment period of a given fund, there is little if any liquidity, Mr. Lenobel said. Instead, the value of that fund comes from uncalled capital commitments made by various investors and is, essentially, theoretical.

“At the point, if a lender says, ‘O.K. private equity fund, you need to guarantee the obligations, what’s your net worth?’, you are going to look at the fund’s financial statement during this investment period and see that it virtually has no assets and virtually no equity,” he explained. In those situations, disputes often arise between lenders and private equity investors over whether uncalled capital commitments count as assets.

After the investment period, when all of the capital has been called and a private equity fund owns several assets, a different issue arises. Since the average lifespan of a private equity fund is relatively short compared to most real estate companies, REITs and pension funds—in many cases between seven and 10 years after the investment period—the sale of a private equity fund’s assets may raise new concerns about its net worth. As a fund sells off its assets, the liquidity and net worth tests often imposed by lenders can yield unsatisfying results, making it more difficult for that fund to prove its solvency.

“Everybody has to look at the timing of the tests imposed by lenders on private equity funds,” the real estate attorney said. “This will avoid unexpected problems.”

In order to comply with customary net worth and liquidity covenants, private equity funds can mitigate guarantee concerns by holding onto a percentage of their assets to establish reserves and also by establishing third party lines of credit, among other measures, he said.

In most cases, lenders just need to manage their expectations, he added.

“Lenders are starting to understand how funds work and that is paramount to these issues, since private equity funds are among thebiggest players in the real estate industry today,” Mr. Lenobel told MO.