REAL ESTATE law
January 2010
"Bad
Boy" Provisions in Commercial Real Estate Transactions
Many long-term commercial loan transactions –
particularly those entered into in the last five or ten years – are essentially
non-recourse except for certain carve-outs or “bad boy” provisions – describing
events which, if they occur, can create partial (or even total) personal
liability under the loan.
Those of us who have been handling commercial real
estate financing transactions for a long time can almost mentally track the
evolution of these carve-outs – which started out as “if the place burns down
and you steal the insurance money and go to Mexico” and evolved into a long
laundry list of things that you can do to trigger personal liability for what,
on its face, is a non-recourse loan.
My guess is that there are a lot of cases in the
judicial system – not yet decided or reported – testing whether these provisions
are enforceable. I happened to see a recent case out of New Jersey – CSFB
2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC, 980 A.2d
1 (N.J. App.Div. 2009) – in which the appellate court held that a bad
boy/carve-out provision was enforceable.
The case involved a $13 million non-recourse loan that
contained carve-outs for, among other things, entering into subordinate
financing secured by the subject property without the lender’s consent. During
the term of the loan, the borrower obtained $400,000 in subordinate financing
secured by a second lien on the property without the first mortgage holder’s
consent. In less than a year, the borrower paid off this secondary financing but
ultimately defaulted on the primary loan. After completing a foreclosure on the
property, the lender brought suit against the borrower and the borrower’s
principals (who had executed guaranties) for the deficiency. The defendants
argued that the carve-out was unenforceable since, among other things, the
lender had suffered no harm, as the secondary lien had already been satisfied.
In the trial court, the lender was granted summary
judgment against the borrower and the borrower’s principals, who then appealed.
The appellate court affirmed the grant of summary judgment, finding that the
carve-outs were unambiguous and part of a commercial transaction negotiated by
sophisticated parties. Furthermore, the fact that the default was later cured
did not alter the fact that the bad boy provisions had already been triggered,
potentially affecting the property and adversely affecting the lender’s security
therein.
The court’s decision seemed to turn on the level of
sophistication of the parties and the fact that the default was a voluntary act.
Also, the damage, or potential damage, to the lender’s interest was clear. On
the other hand, the more recent laundry list of bad boy provisions often
includes such acts as seeking bankruptcy protection or contesting the
appointment of a receiver during a foreclosure – actions that are arguably
statutory rights (federal or state) and may be looked at differently than a
simple contract violation.
I am almost certain that cases challenging the validity
of those types of provisions will be litigated, and I am curious to see what the
result will be.
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