Real estate lawyers everywhere can vividly remember the real estate boom that many analysts say peaked in early 2006 and how little attention they thought borrowers and even lenders gave to personal guarantees. In the race to participate in that incredible growth in real estate, both sides of the deal equation were often less than concerned about losses. Well, the real estate bust certainly proved the dangers of that short term thinking. Many developers and investors are still sitting on the sidelines, stifled by obligations under personal guarantees. But are borrowers really being more cautious now?

Many borrowers willingly executed so-called “bad-boy” carve outs in non-recourse guarantees, which created springing liability in the event of a default. Borrowers expected to simply walk away from the loan, and the liability, in the event the mortgage was foreclosed upon, unless certain bad acts were performed by the principals of the borrower. Typically, a guaranty liability would arise from the borrower’s or the principal’s performance of bad acts, such as a voluntary bankruptcy filing, entry into additional indebtedness and making prohibited transfers. For developers, this was deceptively safe – if there was no default, there was no liability. Often these bad-boy guarantees were required in conjunction with “non-recourse” loans and special purpose entity (SPE) borrowers. After the bust, enforcement of these bad-boy provisions manifested itself in state court litigation, and, less commonly, Chapter 11 filings.

As the market appears to be truly moving into boom times again, both borrowers and lenders are struggling with the use of “bad boy” guarantees. For lenders, the almost non-negotiable starting point in this market is high loan to value ratios, plus unconditional personal guarantees from “deep-pocket” principals. That leaves borrowers with a Hobson’s choice – seize opportunity but risk their personal fortunes.

Pulling lessons from the last bust, there are a number of things borrowers and guarantors should consider:

First, negotiate the terms of the non-recourse carve outs in the term sheet. It’s critical to know what the guarantor is getting into early in the loan process. Too often, before the last bust, the terms of the bad-boy guarantees were developed after the loan commitment letter was drafted, the non-refundable loan application fee was paid and the parties were deep into the drafting of loan documents. Set expectations early.

Second, clearly spell out what events trigger a springing liability in the event of a default. For example, guarantors should avoid bad-boy guarantees that spring from the actions of third parties, such as fraud by another principal. Other limits can include hard caps on liability, and restrictions to the time period during which the guarantor is at risk (e.g., the construction of improvements), or exclusions of guarantees for involuntary bankruptcy proceedings or voluntary filings initiated without the guarantor’s approval.

Third, if the bad boy guaranty is “non-negotiable,” then it is critical to limit the guarantor’s exposure and expenses. Guarantors should push for dollar caps, or liability tied to actual losses from a particular default.

Fourth, guarantors must be prepared to “walk away” and shop for a better deal. As the lending environment continues to improve and becomes more robust, borrowers should shop for competing financing to improve leverage on guaranty negotiations.

Advising borrowers and guarantors to carefully consider their springing liability is critical in these times where “irrational exuberance” may make them forgetful of the painful lessons of the past.