From around 1999 through 2007 I negotiated over one hundred loans for borrowers which were said to be non-recourse but with exception for "the usual bad-boy and environmental exceptions." All of them started with a loan commitment which mentioned "usual and customary carve-out provisions." And I can recall numerous conference calls where borrowers would ask what this meant. The lenders would always reply "It's just standard legal stuff that has to be in there. We can't delete it 'cause rating agencies won't let us. Just don't do anything "bad" and there won't be any problem." Standard "bad acts" are: (i) fraud, intentional misrepresentation by the borrower; (ii) waste occurring to the mortgaged property (i.e. allowing it to "go to pot"); (iii) gross negligence or criminal acts of the borrower; (iv) misappropriation of rents received by the borrower post loan default; and (v) any sale, transfer of interests in the borrower or giving a junior mortgage on the mortgaged property, without the prior written consent of the lender. Sometimes these bad acts would allow a lender to sue to the extent of their losses or damages resulting from the borrower's bad act and sometimes bad acts were used as predecates for "springing recourse" clauses whereby non-recourse loans were to become fully recourse. And these non-recourse carve-out provisions were usually integrated into loan guaranties so that recourse liability would follow upon the occurance of any one of those bad acts - and certain other acts, such as the borrower filing for bankruptcy or a breach of the single purpose entity provisions (including use of the wrong letterhead) or a prohibited transfer of a limited partnership interest or ownership within a general partner or guarantor entity.

These loans were clearly intended by the parties to be non-recourse and the expressed purpose of the non-recourse exceptions were solely to create the threat of a huge resulting penalty for a borrower even considering committing a bad act. But until recently these clauses hadn't been tested too often in court. Historically, courts wouldn't enforce "penalty provisions" as they unfairly and unjustly enrich a party way beyond their actual damages and often result in a party being practically forced to adhere to a contract even when the otherwise economically efficient action would be to breach it. Specifically in the context of liquidated damages provisions, courts generally have not enforced them absent a showing that they approximate actual damages as opposed to being an "in terrorem" clause, i.e. a contract clause whose primary purpose is to make a party terrified of taking certain acts or failing to act due to the potential penalty which might follow. In spite of this historical jurisprudence, a number of court rulings since 2007 have strictly enforced non-recourse carve-out clauses, and even "springing recourse" provisions. While so far they have all been from courts east of the continental divide, California guarantors should take note of the trend and consider it a wake up call to review these loan provisions and be hyper-vigilant about avoiding even technical breaches.

Two recent cases which have struck fear into the heart of borrowers: 111 Debt Acquisition LLC v. Six Ventures, Ltd., 2009 WL 414181 (U.S. District Court, S.D. Ohio) (Feb. 2009). In November 2006, Six Ventures, Ltd. refinanced six apartment projects with a $20,900,000 mortgage loan. The mortgage loan was non-recourse; however, a guaranty executed by three guarantors provided for full-recourse liability for the entire loan balance upon the occurance of any "springing recourse event," one of which was if the borrower ever filed for bankruptcy. In September 2008, after having defaulted in its mortgage payments, Six Ventures, Ltd. filed for bankruptcy. One month later the bankruptcy court granted the lender relief from the automatic stay so it could proceed with foreclosure. The borrower's bankruptcy filing, though, prompted the mortgagee to sue the guarantors for the full balance of the $20,900,000 loan, because the bankruptcy filing was a "springing recourse event" under the guaranty. The judge granted the lender's motion for partial summary judgment, holding the guarantors liable for the full balance of the $20,900,000 loan. In his opinion, the judge analyzed whether the guaranty provision violated public policy by discouraging debtors from filing for bankruptcy protection (he found that it did not, based on the logic that the bankruptcy prohibition is a clause in the guaranty, as opposed to the loan agreement or note, so it doesn't actually prevent the borrower from filing bankruptcy!). However, the judge's opinion contains no discussion of whether the springing recourse provisions, which in this instance would cause the guarantors' liability to increase from zero to an amount approaching $20,900,000, might have prescribed an unenforceable "penalty" since the effect of the borrower's prohibited action appears to have resulted in nothing more than an approximately one-month delay in the mortgagee's foreclosure process. So basically the borrower's action in filing bankruptcy didn't damage the lender by more than (i) one months' interest and late fees and (ii) one month of market price decline, if any, due to the delay caused by the borrower having filed bankruptcy.  

CSFB 2001-CP4 Princeton Park Corporate Center, LLC vs. SB Rental I, LLC, 410 N.J. Super. 114; 980 A.2d 1 (NJ Super.App.Div. 2009). A judge upheld a lender's suit on a full springing recourse guaranty of a $13,300,000 non-recourse senior mortgage loan triggered by the borrower voluntarily placing a junior mortgage on the property; even though (i) the junior mortgage was repaid 18 months prior to the eventual default on the senior mortgage and (ii) the mortgagee had not suffered, and in fact had no risk of suffering, any actual damages from the junior mortgage lien (since the foreclosure of a superior lien wipes out a subordinate lien anyway). The judge pointed out that the "defendants received and retained $13.3 million in loan proceeds" [didn't they buy the loan collateral with it?] and that the imposition of $13,300,000 liability on the guarantors for the borrower's subordinate financing was "actual damages" because: "In fact, the damages which the plaintiff seeks are equal to the outstanding loan balance and nothing more." The judge did not attempt to distinguish between damages caused by the borrower's failure to pay the loan (which was not a springing recourse event) and damages caused by the borrower's subordinate financing (likely none).