Lenders operating under Illinois law scored a victory when an Illinois appellate court held that the carve-out provision in the guaranty was valid and enforceable.  Bank of America vs. Freed, Nos. 1-11-0749, 1-11-2112, 1-11-3372, 2012 WL 6725894 (Ill. App. 1 Dist. Dec. 28, 2012).  Carve-out provisions operate to incentivize borrowers and guarantors to forego certain enumerated actions in exchange for limited liability under a guaranty.   In the event that the borrower and/or guarantor choose to engage in the proscribed conduct, expanded or full recourse is allowed. 

In this case of first impression, real estate developer (“Borrower”) entered into a construction loan with a maximum principal amount of $205,000,000 with Bank.  The loan was secured by a mortgage encumbering the commercial property and a guaranty of payment executed by Borrower’s president and parent company.  Guarantors’ liability, however, was limited to $50,325,000, or 25% of Borrowers’ maximum principal debt, provided that Borrower did not challenge Bank’s exercise of its remedies.  Specifically, the carve-out provision required full repayment if Borrower “contest[ed], delay[ed] or otherwise hinder[ed] any action taken by the Agent or Lenders in connection with the appointment of a receiver for the Premises or the foreclosure of the liens, mortgages or other security interested created by any of the Loan Documents.” 

Borrower defaulted on the loan.  Bank brought suit to foreclose on the property and collect the limited principal amount under the guaranty.  The trial court granted Bank’s motion for the appointment of a receiver.  Borrower appealed the appointment.  One month later, Bank amended its petition seeking to collect the full amount owed under the loan, including interest, costs and attorneys’ fees, because Borrower had contested the foreclosure and appointment.   The trial court entered judgment against Guarantors in the amount of $206,700,222.39.  Guarantors appealed the judgment for the full repayment arguing, among other issues, that the carve-out provision (1) was vague, ambiguous, overly broad and an unenforceable penalty provision; (2) was designed solely to secure defendant’s performance; and (3) precluded Borrower from exercising its due process rights to defend against the foreclosure action .

The court was not persuaded by Guarantors’ arguments and upheld the carve-out provision.  The court disposed of Guarantors’ argument that the provision was vague and ambiguous in short order.  Borrower’s appeal clearly constituted a contest of the Bank’s actions, the precise conduct proscribed in the carve-out.   Next, the court found that the provision did not constitute an unenforceable penalty designed solely to discourage Borrower from challenging the Bank’s actions.  The carve-out provision provided for only actual damages, the amount owed under the loan, and operated to define the terms and conditions of the Guarantors’ liability.  Finally, the court found that the carve-out provision did not prohibit Borrower from asserting its due process rights and defending against the foreclosure.  To the contrary, Borrower was free to act as it so chose.  Its actions, however, carried consequences—full recourse liability under the guaranty.

Under Bank of America, borrowers and guarantors are accountable for their actions when they engage in mutually agreed upon proscribed conduct.  Lenders should be encouraged that these provisions will be enforced in Illinois.