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The Business of Signing Bad Boy Carve-Outs

January 19, 2020

Almost all commercial loans for multifamily properties are non-recourse yet they require a “warm body” to sign carve-out provisions making the loan recourse subject only to “bad boy” acts. Bad acts are typically related to fraud, gross negligence, misappropriation of funds, and any transfer, pledge, encumbrance of the mortgaged property without the prior written consent of the lender. These intentional actions are fairly easy to avoid if you are simply a well-intentioned operator. However, some lenders will try to push for very aggressive bad boy carve-out guarantees which include a laundry list of actions which would trigger the loan to become recourse.

“This is why borrowers must be careful to ensure that the terms of their non-recourse loan are reasonable and that recourse would not be triggered by poor market conditions or small oversights. In particular, we recommend that a non-recourse loan agreement have the following provisions in regards to bad boy carve-outs:

Limited and full recourse triggers can appear daunting to be sure but they are primarily used as a negotiating tactic by lenders as a way to give them a strong lever to ensure borrower compliance. From my research I have learned that most lenders have no interest in actually utilizing the recourse remedy but they will as a tool of last resort. Their primary objective is to get the loan performing as agreed. “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.” (Walker). With over 10,000 loans made per year, the statistical likelihood of bad boy carve-outs being triggered is extremely low. Additionally, there has been recent case law which has narrowed the scope of what courts will uphold as being reasonable carve-out guarantees. For example, Michigan enacted the Nonrecourse Mortgage Loan Act of 2012 which “provides that a post-closing solvency covenant cannot be used as the basis for a claim under a nonrecourse loan” (Pollack). This essentially means that the loan cannot become recourse if the SPE becomes insolvent or the property cannot pay its debt.

After getting comfortable with the risks associated with signing on non-recourse debt, the next step is to find out if you qualify. Lenders aren’t interested in having just anyone be the guarantor of their loans. Typically, to qualify for a loan, the guarantor(s) must have a net worth equal to the loan balance (sometimes more) and liquidity (cash, cash equivalents, stocks, bonds) equal to 10% of the loan balance or 9 months of debt service. This is no easy task! We pursue $10MM to $20MM loans, which require potentially more than $20MM in net worth and $2MM in liquidity! For me, satisfying the lender loan guarantor requirements has been the single most frustrating aspect of this business. Cosigners aren’t cheap and can be especially predatory when you’re just starting out in this business (we have learned the hard way). For the size of loans we pursue, giving up 10% to 20% of all of the general partnership economics to a loan cosigner is considered market. We have a smaller balance sheet so we are interested in finding opportunities to help operators who need a loan guarantor for smaller loans. We like the idea of finding good partners that are doing quality deals which we can invest in, raise equity for, and sign on the loan.