If you have a “non-recourse” mortgage loan, chances are you delivered a guaranty related to certain non-recourse “carve-outs”. Now more than ever, it’s imperative that you understand what triggers liability under these “carve-out guarantees”. Understanding the rules of engagement will help you keep the recourse out of your non-recourse loans.
Every guaranty – and situation – is different. Your carve-out guaranty is designed to control your actions during periods of distress – exactly like the distress brought by the COVID-19 pandemic. But what does your carve-out guaranty cover? What triggers liability?
Here are six key issues we are dealing with on a daily basis today:
- Cash is King. Nearly every loan carve-out guaranty makes a guarantor liable for misappropriating cash. For those of you that have large cash reserves at the borrower level, there is a temptation to move those funds out of the SPE borrower’s account. It is not impossible to do this, but it becomes near impossible once an event of default exists. Removing large amounts of cash from the borrower’s bank account is fraught with peril and should be done only after analyzing the guaranty and loan documents. If you are not yet in default, now is the time to analyze this situation.
- Leases and Lease Amendments. Tenant after tenant is asking for lease relief. Clients are calling regarding converting properties into quarantine centers. We were usually able to negotiate “major lease” and “minor lease” provisions that allow for some flexibility. However, if lender approval is needed, and you do not get lender approval, a new lease or lease amendment may trigger the “unpermitted transfers” recourse carve-outs. Most often, this is an actual damage carve-out. However, it may sometimes trigger full recourse (especially in single-tenant deals). The desire to help tenants that are experiencing stress is understandable, but doing so may land you in trouble under the carve-outs. Be careful before amending a lease, executing atypical leases, or changing the use of the property. For example, agreeing to a 90-day abatement of rent is a lease amendment – even if you do it by e-mail.
- Security Deposits. If there is a chance that a property may go back to a lender, you will want to have the security deposits segregated. Most often, carve-out guaranties require the borrower to turn over security deposits to a foreclosing lender. Make sure you have the cash around to make good on this obligation.
- Transfers. Periods of distress cause people to borrow and bring in new partners with fresh cash. Existing investors needing cash often want to be redeemed because of liquidity issues. Transfer restrictions in the loan documents will restrict many things that might make sense under these circumstances. Unpermitted transfers often cause full recourse liability. Be careful. Find out what is permitted and what is not.
- Who to Pay. If you have limited cash after payment of debt service, focusing on those creditors that have lien rights is a good idea. Mechanic’s liens are often a recourse carve-out. If you have contractors that need to be paid, consideration should be given to paying those claimants first because – if they lien the property – you will be paying them anyway under your carve-out guaranty.
- Admissions of Insolvency. As you start communicating with lenders, borrowers need to be very careful about making admissions of insolvency in writing (including e-mails). Insolvency is roughly defined as (i) your assets are worth less than your liabilities, or (ii) inability to pay your debts as they come due. You will be tempted to e-mail your lenders with pleas for forbearance. This is natural. However, it is important to avoid saying things like “the property is underwater” or “we have no money left to pay our bills” or “after this payment, we are out of cash.” All of those may be true, but these kinds of admissions can inadvertently trigger recourse. After the Great Recession, lenders started adding “admissions of insolvency” to the definition of “bankruptcy” in their loan documents. As such, your loan documents may provide that it is a “bankruptcy” if the borrower admits its insolvency. There are actual cases on this issue that came out of the Great Recession. Again, the wording of your loan documents will need to be carefully analyzed. However, you should be careful when communicating with a lender in writing (including e-mails). Saying that you are broke (or almost broke) will not bring the lender to the table any quicker. We can get their attention without triggering recourse.
For more resources and LP's response to COVID-19, visit this webpage.