Bucking the trend of decisions broadly interpreting non-recourse carve out, or “bad boy,” guaranties, Fried Frank recently secured a significant victory for its client – a defendant in a claim on a non-recourse carve out guaranty – when Judge Deborah A. Batts of the Southern District of New York rejected a lender’s interpretation of a “bad boy” guaranty in an attempt to hold the guarantor liable for post-foreclosure deficiency. Contrary to the lender’s claim, the Court held that mechanics’ and other liens were not unpermitted indebtedness or transfers under the guaranty’s full recourse triggers. See CP III Rincon Towers, Inc. v. Cohen, No. 10-cv-04638 (DAB), slip op. at 18-34 (S.D.N.Y. Apr. 7, 2014) (Dkt. No. 103).

In CP III Rincon Towers, Inc. v. Cohen, a loan-to-own successor lender filed suit against a “bad boy” guarantor after foreclosing on the property. The Cohen litigation arose out of a $143 million real estate development in San Francisco secured by a $110 million non-recourse loan and a “bad boy” guaranty from Richard D. Cohen, the borrowers’ sponsor. After refinancing with Maiden Lane LLC, the former lender, fell through, the loan was purchased by CP III Rincon Towers Inc. (“CP III”) for $83 million. CP III then sued the guarantor, claiming that liens filed by contractors and other creditors with disputed claims triggered three separate full recourse carve out provisions (i) prohibiting any “voluntary Lien encumbering the Property” without written consent of lender; (ii) prohibiting any “Indebtedness” in excess of $250,000 without written consent; and (iii) prohibiting “encumbrances” that were “Transfers” of the collateral.

On March 7, 2014, Judge Batts granted summary judgment for the defendant guarantor in one of the few post-recession decisions that reject the broad reach of earlier decisions and, importantly, took into account both the business justifications for entering into “bad boy” guaranties and the intent of the parties that drafted them to avoid a commercially unreasonable and absurd result. 1 First, the Court rejected Plaintiff’s argument that the “voluntary Lien” provision was triggered by the disputed liens because, although the loan did not define “voluntary Lien,” the liens imposed on the property by third parties were by their very nature “involuntary” in that they arose solely by statute or were otherwise imposed on the property without the consent of the borrower. Second, the Court rejected Plaintiff’s argument that, under the Indebtedness provision, the disputed liens triggered full recourse because the loan did not “expressly require prior written consent before incurring certain indebtedness, liability, or obligations,” including contractor expenses during renovations (which the lender knew of and, in fact, required).

Finally, the Court demonstrated a willingness to look at the parties’ actual intent regarding the Transfer provision – rather than reading the “plain language” of the agreements to a commercially absurd result, as some courts have done. The Court found that the Transfer provision, which prohibited not only transfers but also encumbrances, was ambiguous because the plain application of the provision meant that any Lien would trigger the Transfer provision, rendering the voluntary Lien provision meaningless. Upon examining the extrinsic drafting history, the Court found it clear that the Defendant’s guaranty was not triggered by the liens, comporting with the industry’s understanding of “bad boy” recourse conduct. Indeed, the Court noted that the first draft of the loan and guaranty included as a loss recourse trigger, not a full recourse trigger, the “failure to pay charges for labor or materials or other charges that can create Liens,” which was removed at the behest of Defendant’s counsel. Thus, the Court held that the original parties to the loan documents “agreed that simply having certain Liens, namely the REO, mechanic’s, and judgment liens in question, would not inherently trigger any liabilities under the Guaranty.”

Thus, in keeping with commercial real estate guarantors’ expectations of what it means to sign a “bad boy” guaranty, the Cohen decision has turned the tide against recent decisions that purport to apply “plain language” in a way that causes commercially unreasonable and absurd results. 2 In the face of aggressive lender litigation against guarantors – especially where, as here, the lender itself required an SPE structure of borrowers and then foreclosed upon the SPE’s only asset, wiping out the disputed liens, this decision is a welcome realignment with the realities of the commercial real estate industry and the widespread use of similar agreements to those at issue in the Cohen litigation.

Nonetheless, in spite of this victory for “bad boy” guarantors, commercial real estate developers must remain wary and, as exemplified by the Cohen decision, should: (i) ensure that definitions are clear, welldefined, and accurately cross-referenced; (ii) separately define any key carve outs in the guaranty agreement itself, rather than by incorporation by reference; (iii) be mindful of the intended business operations of the property in drafting guaranties and ensure that such realities vis-à-vis indebtedness, expenses, and potential liabilities are explicit; and (iv) be cognizant of the distinction between indebtedness and the failure to pay invoices “when due” in light of ongoing disputes and the potential for liens being placed on the property. In sum, guarantors recently have faced a costly, uphill battle in the courts – where many decisions have found in favor of lenders, despite the expectation of the industry and intent of the guarantors – and the Cohen decision is a welcome change from what, until now, has been the unfortunate new normal.