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In recent years, increased competition among lenders and lower interest rates has led to greater negotiation power for borrowers and guarantors, and thus more borrower-friendly loan packages. As a result, the acceptance of a carveout guaranty is becoming more common, rather than the traditional full (or even partial) payment-and-performance guaranty that many major banks and life insurance companies previously used in commercial real estate transactions. As one might imagine, the carveout guaranty offers a lender less protection in the event of a default and may require more of a fight to collect on the loan and to enforce the terms of the carveout guaranty. The distinction between the carveout guaranty and the traditional guaranty is becoming even more relevant in the evolving real estate market, making it crucial that attorneys and their clients understand the significance of the carveout guaranty, what protection such a guaranty provides the lender and how the carveout guaranty is enforced and interpreted by courts. With the downturn in the commercial real estate market in the 1990s, several lenders experienced large losses on their nonrecourse loans. Lenders quickly discovered that since the borrowers had no personal liability for the loan, they also had no real incentive to protect the lender’s only recourse, the collateral for the loan. Large deficiencies resulted after the foreclosure and subsequent sale of the property, and the lender had to take the loss because of the limitation on the borrower’s personal liability. As a remedy to all of the losses incurred, many lenders making nonrecourse loans began requiring the principals of the borrower or a financially strong entity related to the borrower to sign a carveout guaranty. This agreement essentially requires the principal to guaranty certain bad acts of the borrower in an effort to motivate the borrower to pay the loan and maintain the viability of the collateral. While most life insurance companies and major banks do not typically make nonrecourse loans, the carveout guaranty is also applicable to those loans since most real estate loans are made primarily to single-asset/single-purpose entities, which typically do not own anything other than the collateral for the loan and therefore would not be able to pay any type of deficiency after a foreclosure. As the use of carveout guaranties increases, the protection that they provide broadens. The modern-day carveout guaranty is divided into two components: “carveout obligations” and “full-recourse obligations.” Carveout obligations are designed to force the borrower to properly maintain the property and preserve its value, but only indemnify the lender for the actual loss or damages incurred by the lender resulting from certain bad acts of the borrower. These actions include fraud; misappropriation of tenant rent and security deposits; failure to pay taxes or insurance; permitting mechanic’s and materialman’s liens to be filed against the property; failure to manage, operate and maintain the property in a commercially reasonable manner; misapplication of insurance and/or condemnation proceeds; and failure to pay claims arising under the environmental indemnity. Full-recourse obligations offer the lender protection against more egregious acts and are commonly referred to as a “springing guaranty.” In the event the borrower commits certain blameworthy actions, the loan becomes full recourse and the guarantor is then obligated to pay the full amount of the loan. Full-recourse obligations include events exclusively within the borrower’s control, such as an unauthorized transfer of the property, an unauthorized creation of a lien against the property or allowing the property to become an asset in a voluntary bankruptcy filed by borrower, guarantor or an affiliate. Whether a carveout obligation or a full-recourse obligation, the carveout guaranty shifts some of the economic risk of the loan back to the borrower and forces the borrower to act appropriately or risk becoming personally liable. By making nonrecourse loans or loans to single-asset/single-purpose entities, the lender assumes the risk that the value of the loan collateral will be insufficient to cover the balance of the borrower’s outstanding debt obligations, and the lender uses the guaranty, whether a carveout guaranty or a full-payment guaranty, to shift some of this risk back to the borrower and guarantor. A traditional payment-and-performance guaranty offers the lender broad protection because the guarantor promises to pay all or a portion of the loan in the event the borrower cannot. Upon the occurrence of a default under the loan, the lender then has several remedies to choose from (all of which are governed by applicable state law), including foreclosure on the property or exclusive collection from the guarantor. A carveout guaranty is a promise on the part of the guarantor to repay the lender for any actual loss incurred or damage sustained as a direct result of the breach by the borrower of the carveout obligations. With this type of guaranty, what the lender can collect from the guarantor is not as clear as the payment guaranty because the lender has to prove that it incurred actual loss or sustained damage as well as the value of such actual loss or damage, which can be difficult to prove, as it is a question of fact. The uncertainty regarding the protection provided by a carveout guaranty is best illustrated by a simple example. In this scenario, assume that a borrower defaults on the loan by failing to make its monthly payments. The lender calls the loan in default and exercises its remedies provided in the loan documents. Unlike the scenario of a full-payment guaranty, the lender cannot simply collect the amount owed from the guarantor unless a full-recourse obligation has occurred. Instead, the lender will exercise its other remedies first. Given the limitations of the carveout guaranty, the lender can be expected to foreclose on the property. Assume that when the property is sold at the foreclosure sale, there is a deficiency and certain amounts are still owed to the lender. The lender now faces the dilemma of how and what it can collect from the guarantor. In the event that one of the full-recourse obligations has occurred, then the guaranty will become a full-payment guaranty, and the lender will be able to collect all amounts still owed. However, it’s likely that none of the full-recourse obligations have occurred, and the lender must try to determine whether the borrower committed any of the acts listed as a carveout obligation pursuant to the terms of the guaranty. In some cases, the guarantor’s obligation may be easier to determine, as the amount is a definitive and tangible number. Examples include losses incurred as a result of any liens filed against the property or the amount of taxes due and payable on the property. The other carveout obligations are more difficult to prove in that the actual loss or damage incurred by the lender is not as obvious. In these instances, the lender would have to prove that it incurred actual loss or damage because the borrower misappropriated tenant rents, failed to properly manage the property, committed fraud or misapplied insurance or condemnation proceeds. These losses are less likely to be definitive amounts, requiring the lender to estimate the damage incurred as a result of these acts. This reliance on estimates provides the borrower more room to argue against liability for the amounts owed to the lender and makes the fight on behalf of the lender more difficult and expensive. Scant case law on enforcement There is little case law with regard to the enforcement and validity of carveout guaranties, but the courts that have looked at the issues have found the carveout obligations to be enforceable. In a recent case, Blue Hills Park LLC v. J.P. Morgan Chase Bank, 477 F. Supp. 366 (D. Mass. 2007), the court enforced a carveout guaranty in a nonrecourse securitized loan wherein the borrower diverted certain funds to itself that it received upon settling a zoning appeal ($2 million), rather than disclosing such settlement to the lender and getting the lender’s consent to take the funds as required by the terms of the loan documents. The diversion of funds without the prior consent of the lender triggered a full-recourse obligation under the terms of the guaranty, and the court ruled that the guarantor was liable for the full amount of the loan, not just the restitution amount of $2 million. The borrower appealed, but the appeal was dismissed and the borrower and guarantors had to pay the full amount of the loan to the lender. The result in this case may have been driven by the facts and may not be followed in all jurisdictions, but it is a good indication that courts are willing to enforce the negotiated provisions of carveout guaranties and protect the lender’s collateral. Although borrowers and lenders are uncertain about how courts will enforce specific provisions, it is clear that all parties need to ensure that the definitions of the carveout obligations and full-recourse obligations are as clear as possible and that all parties understand how and what can be collected when the obligations of carveout guaranties are enforced. While it is true that carveout guaranties offers less protection to lenders, they do provide a very real incentive to borrowers and guarantors to protect the viability of the collateral or risk their own personal liability, which may be a very costly mistake. Staci J. Strong is a real estate and banking associate in the Dallas office of Thompson & Knight. She can be reached at [email protected].

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