A Potential Pitfall in Non-Recourse Loans
Non-recourse borrowers may, through no fault of their own, find themselves on the hook for more than they had bargained for
Like many states, Arizona allows real estate secured lenders to sue commercial borrowers personally for a
"deficiency judgment" if a loan goes into default and the foreclosure sale does
not bring enough to pay the balance due on the note. Competition among lenders
(among other factors) has given rise to the increasingly common practice of
offering "non-recourse" loans to borrowers whose projects and track records can
justify the risk that, in the event of a default, the real property collateral
may not cover the entire indebtedness.
However, as demonstrated
by a recent case from a federal court in Illinois, non-recourse loans are not
without their possible pitfalls to borrowers. So-called "bad-boy provisions"
(i.e., carve-outs) of non-recourse loans invariably require borrowers to remain
personally liable for certain "bad acts," such as environmental contamination,
misappropriation of funds, fraudulent misrepresentation, waste, and other types
of serious defalcations.
In the Illinois case, Heller Financial Inc. v. Lee, the lender had made a $9.9 million "mezzanine"
loan to a limited partnership, its corporate general partner, and their
respective principals, secured only by the principals' equity interests in each
entity borrower. Together with a $34.2 million first trust deed loan from
another lender, the mezzanine loan was used to finance the purchase of a hotel.
Although the mezzanine loan was non-recourse, a carve-out made each borrower
personally liable for breaches of a covenant prohibiting further liens against
the hotel property.
Unknown to any of the
borrowers, a third-party management company permitted various tax and mechanics'
liens - totaling $820,000 - to be filed against the property. The mezzanine
lender gave notice of default to each borrower, accelerated the $9.9 million
note, eventually conducted a foreclosure sale of the equity interests, and later
caused the hotel to be sold as well. The proceeds of sale were insufficient to
pay off the mezzanine note, and the lender sued two of the individual borrowers
for the "deficiency."
In their defense, the
borrowers argued that:
they could have cured
the default and reinstated the note by simply paying the $820,000 in liens;
circumstances, the lender's actual damages were only $820,000; and
clause essentially provided for a type of liquidated damages greatly
exceeding actual damages and amounting to a "penalty", rendering the clause
The court rejected this
argument presumably because the borrowers in fact had not cured and reinstated.
Confining itself to a reading of the loan documents, the court analyzed the
contract as requiring the borrowers to repay a loan that unquestionably had
benefited them, and ruled that the non-recourse carve-out did no more than
permit the lender to recover what had now become its actual damages - here, the
balance due on the note after application of the sale proceeds.
In our experience,
carve-outs have become broader and more expansive over the past five years or
so. When the practice of creating bad-boy carve-outs to otherwise non-recourse
loans began, the carve-outs were limited to pretty serious acts - for example,
pocketing fire insurance proceeds and fleeing to Brazil - but they are no longer
limited to such extreme cases.
It would appear that the
concept of true non-recourse liability is simply not as palatable to the lending
industry as it perhaps once was. In that light, and especially in view of the
holding in the Heller case, it is very important to focus on the
carve-outs from non-recourse liability in each set of loan documents. If
possible, the borrower should negotiate against any type of "springing"
liability for the full amount due on an accelerated note, where (as in Heller)
a default may trigger actual damages that are less than the accelerated balance
of the note.
The safest way to
accomplish this result would be through a provision requiring the lender to give
the borrower sufficient opportunity - before commencing foreclosure proceedings
- to cure any default that could give rise to a right of acceleration and
personal liability under the bad-boy provisions.
If that protection cannot
be negotiated, Arizona borrowers can still rely on the statutory right to
reinstate a defaulted loan by curing the default during the 90-day period before
a trustee's sale (assuming the lender elects the trustee's sale route).
In either event,
borrowers will do well to keep in mind that "non-recourse" does not always mean
"non-recourse," and that even non-recourse borrowers may, through no fault of
their own, find themselves on the hook for much more than they thought they had