On February 5, 2016 the IRS released Chief Counsel Advice Memorandum Number 201606027 (the IRS Memo) concluding that “bad boy guarantees” may cause nonrecourse financing to become, for tax purposes, the sole recourse debt of the guarantor. This can dramatically affect the tax basis and at-risk investment of the borrowing entity’s partners or members. Non-recourse liability generally increases the tax basis and at-risk investment of all parties but recourse liability increases only that of the guarantor.

The IRS Memo has limited precedential value and applies only to the party requesting the advice. However, it could reflect a new approach by the IRS to nonrecourse financing.

The IRS Memo concludes that certain events such as voluntary bankruptcy, collusive involuntary bankruptcy, unapproved junior financing and transfers or admitting in writing borrower’s inability to pay its debts as they become due are not sufficiently remote so as to satisfy the meaning of Treas. Reg.1.752-2(b)(3) which disregards payment obligations that are subject to contingencies that are unlikely to occur.

Most loan parties believe just the opposite; primarily because the guarantor usually directly or indirectly controls the borrower and is unlikely to permit conduct that will trigger guarantor’s personal liability.

The conclusions reached in the IRS Memo seem to assume that a bad boy guaranty is the functional equivalent of a payment guaranty. But the real purpose of a bad boy guaranty is to discourage those who control the borrower from allowing it to commit certain “bad acts” that are harmful to the interests of the lender. Unlike the case with a payment guaranty, unless the prohibited conduct occurs the guarantor is not liable for payment regardless of what other defaults exist or whether the loan is ever repaid.

A bad boy guaranty merely provides a non-recourse lender with the leverage to make sure the mortgaged property, usually its only source of repayment after default, remains in good condition, stays free of unapproved liens or transfers and ensures that the borrower does not do anything that will interfere with the recovery of its collateral. Obtaining the right to impose potential recourse liability on those who can prevent these occurrences gives the lender a significant tool to prevent such harm, but falls far short of assuring repayment.

Careful drafting of a bad boy guaranty can reduce the likelihood of unexpected guarantor liability if the borrower ends up in liquidation, support good arguments for preserving  the application of Treas. Reg. Section 1.752-2(b)(3) and yet still protect a lender’s legitimate interests.

In addition to the potential tax risk discussed above, recent court cases provide additional reasons to be concerned about inartfully drafted bad boy guarantees.   

In Wells Fargo Bank NA v. Cherryland Mall Limited Partnership, et al., 812 N.W.2d 799 (Mich.Ct.App., 2011) the court held that a borrower’s insolvency constituted a failure to maintain its status as a single purpose entity triggering full recourse liability under the terms of the applicable bad boy guaranty. Other courts have reached similar holdings. It is very unlikely that the guarantor realized it was effectively guaranteeing the borrower’s solvency by agreeing to guaranty borrower’s SPE status. A lender’s definition of what constitutes an SPE is frequently far broader than what rating agencies or courts require. No rating agency or court has ever determined that ongoing solvency is an essential element of SPE status.    

Simply inserting the word “intends” before a borrower’s covenant to remain solvent or excluding that element of lender’s definition of an SPE in a bad boy guaranty can prevent unexpected personal liability if the project is unsuccessful.

Another common bad boy recourse trigger is the occurrence of “waste” at the property. In Travelers Insurance Company v. 633 Third Associates, et al, 14 F. 3rd 114 (2nd Cir. 1994), the court held that the borrower’s failure to pay real estate taxes constituted waste and triggered recourse under a bad boy guaranty prohibiting waste. Limiting liability to physical waste not resulting from borrower’s lack of funds may avoid a surprise such as this.

Recourse liability can also be triggered for (i) a voluntary “Lien”; (ii) an unapproved “Transfer”; or (iii) incurring additional Indebtedness. If these terms are not properly defined unintended consequences can result. For instance, adding the words “resulting from the consent or acts of the Borrower” to the definition of “Liens” can eliminate liability for a tenant’s mechanics liens or other statutory liens because such liens are not created with the consent or acknowledgement of the borrower. Transfers can also be limited to affirmative acts of the borrower and avoid those that occur by operation of law. Adding an exception for trade debt incurred in the ordinary course of business can minimize guarantor’s exposure for additional indebtedness.

A lender’s “standard” bad boy non-recourse carve-out language can be a trap for the unwary and result in often unintended personal liability and/or adverse tax consequences. Careful drafting can help avoid both results.