Real estate finance transactions typically involve non-recourse mortgage loans to single asset special purpose entities (“SPE’s”). In these situations, upon non-payment of the loan, the lender’s recourse is limited to the mortgage property, and to the rents, deposits accounts and other assets affixed to or derived from the operation of the property. The owners of the SPE/borrower are not personally liable for the non-recourse loan, unless the lender required the execution of a non-recourse carve-out guaranty. Non-recourse carve-out guaranties are commonly referred to as “bad boy” guaranties, because the owners who sign them undertake to have repayment obligations in the event of certain specified acts or violations of the loan documents.
In New Jersey, as in many other states, courts strictly construe bad boy guaranties to impose liability for the entire loan balance irrespective of the nature of the damages to the lender arising from the breach at issue. In this regard, the case of Princeton Park Corporate Center v. SB Rental I, 410 N.J. Super 114 (App. Div. 2009) is illustrative. There, the mortgage loan documents executed in 2001 prohibited secondary financing without approval by the mortgage lender. A subordinate loan was obtained in 2004 without the knowledge or approval of the lender, and it was paid off in just seven months. Nonetheless, when the first mortgage loan went into default in 2006, the lender foreclosed, and immediately thereafter sued the signers of the bad boy guaranty for the full deficiency of $5 million. The lender won at both the trial court and on appeal at the Appellate Division. The appeals court held that even though the lender was not actually damaged by the second lien loan that had been paid off before the default, the absence of direct damages was not relevant. In this regard, the court said “[h]aving freely and knowingly negotiated for the benefit of avoiding recourse liability generally, and agreeing to the burden of full recourse liability in certain specific circumstances, defendants may not now escape the benefit of their bargain.” See also, Wells Fargo Bank v. Cherryland Mall, 812 N.W. 2d 799 (Mich.Ct.App. 2011), where trial and appellate courts of Michigan found the non-recourse carve-out guarantors liable for the full deficiency, because the SPE/borrower became insolvent and therefore in violation of the loan covenant requiring that the SPE remain able at all times to pay its debts and liabilities from its assets as the same became due.
The lesson here is that parties signing bad boy guaranties need to be very clear about the extent of the exposure they will undertake. If the intent is to limit the lender’s recovery to the extent of damages actually realized, the documents need to be very specific in that regard. In New Jersey and elsewhere, the courts will strictly construe unambiguous text making for a potentially unexpected and unsettling result for the non-recourse carve-out guarantor.