In this article, the authors describe bad boy guaranties, which provide for personal liability against borrowers and principals of borrowers upon the occurrence of certain enumerated bad acts committed by the borrower or its principals.
A typical mortgage loan requires the borrower and/or its principals to execute a “bad boy guaranty” (a/k/a recourse carve out guaranty), which provides for personal liability against the borrower and principals of borrower upon the occurrence of certain enumerated bad acts committed by the borrower or its principals. Where the transaction involves mezzanine debt, it is essential that the mortgage lender and the borrower and/or guarantors take certain steps to ensure that the bad acts of a foreclosing mezzanine lender do not trigger this personal liability. If triggered by enumerated bad acts, bad boy guarantees require the borrower and/or guarantor to be personally liable for damages to the lender, or alternatively, converts an otherwise non-recourse loan into a full recourse loan as against the borrower or guarantor. In either result, lenders will have the right to seek significant personal liability against the borrower and/or guarantors, so it is essential that borrowers and/or guarantors have complete control over the potential triggering acts.
Legal Challenges to Bad Boy Guaranties
In the last 15 years, there have only been six legal challenges to the enforceability of bad boy guaranties. This lack of challenges indicates that these guaranties have largely accomplished their goal of forcing borrower and guarantors to stay away from the typical bad boy acts enumerated in these guaranties, such as waste, fraud, misappropriation, bankruptcy, violation of SPE covenants, or incurring subordinate debt without lender's consent. Furthermore, all of these recent challenges have resulted in the enforcement by the courts of the bad boy guaranties in question. By way of example, recently, in the Extended Stay of America Chapter 11 bankruptcy proceeding,1 guarantor David Lichtenstein was held jointly and severally liable with his company, Lightstone Capital, for a $100 million guarantee following the company's bankruptcy filing. The court enforced the clause and the investors of the senior lender subsequently indemnified him.
Improper Acts of Third Parties
Nonetheless, these guaranties can have the unintended consequence of penalizing guarantors for improper acts of third parties outside of their control. After a mezzanine takeover of a guarantor's equity interests in the borrower, the new equity owner can create personal liability for the borrower and/or guarantor without any repercussions for itself. Since the guarantor has in most cases lost its managerial and ownership interest in the borrower following a foreclosure, the guaranty has lost its purpose as a mechanism to constrain borrower's activity.
By way of example, the mezzanine lender, with its controlling equity interest, can, without the input of the guarantor either: 1)put the borrower into bankruptcy thereby triggering the guaranty against the guarantor and impeding the primary lender's foreclosure or 2) use bankruptcy as a threat in its negotiations with the mortgage lender. Neither the mortgage lender nor guarantor benefit from this scenario. Accordingly, it is essential that the mortgage lender and borrower protect themselves from the unintended consequences of these bad boy guaranties where mezzanine debt is to be in place.
Mortgage lenders should be aware that a bad boy guaranty ceases to be effective as a mechanism of behavioral control when the party directing a borrower's actions will feel no repercussions from the violation of the covenant. Thus, mortgage lenders should require a poison pill of sorts to prevent the mezzanine lender from triggering these clauses. Lender's initial agreement with borrower (or any inter-creditor agreement with the mezzanine lender) should stipulate that any mezzanine lender (or other entity approved by mortgage lender) must sign an agreement that stipulates upon potential foreclosure of equity interests, that such mezzanine lender must accept and assume the same guaranty provisions as the original guarantor. If borrower breaches this requirement by obtaining secondary financing without this provision, the bad boy clause could be immediately triggered. In this way, any mezzanine lender would be forced to assume the guaranty if they control borrower's equity interest which would benefit both the mortgage lender and the guarantor.
Borrowers, however, may severely balk at this requirement as it could greatly limit their ability to obtain mezzanine financing. Borrower/guarantors simply want their guaranty obligations to terminate when they lose managerial power. Lenders may be skittish about such an immediate termination, because foreclosing mezzanine lenders would still retain the power to put the company into bankruptcy and/or violate the provisions of the bad boy guaranty without repercussions. So, rather than seeking a termination of the guaranty, as an alternative middle ground, guarantors should require the mezzanine lender and/or a credit entity affiliated with the mezzanine lender to indemnify borrower if the bad boy guaranty is triggered by the acts of mezzanine lender. This transfers the liability under the guaranty to the mezzanine lender, and creates an inducement for the mezzanine lender to not trigger the guaranty. The strategy you seek depends on your position. If lenders do not protect themselves, they have entrusted the borrower to shift the guaranty to the mezzanine lender. Regardless of lender strategies, the borrower/ guarantor should require an indemnification from the mezzanine lender. All of the above referenced strategies have the effect of transferring the liability under the guaranty to the mezzanine lender upon foreclosure by the mezzanine lender on the equity interests of the borrower. Thus, these practices should not significantly change the cost of mortgage lending because both parties benefit. However, the foregoing strategies may well result in an increase in pricing for the mezzanine financing.
Ultimately, mortgage lenders will continue to ask for bad boy guaranties triggered by bankruptcy and other bad acts. As mezzanine lending becomes more available, mortgage lenders and borrowers have an opportunity to assert new practices which seek to limit a mezzanine lender's leverage in a foreclosure situation.