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Approaches to Carve-Out Guarantees

Non-recourse commercial real estate loans and carve-out guarantees have changed considerably over the years. Non-recourse loans developed as a way for a real estate developer to promote a project, without personal liability, in a manner that tax benefits and deductions could be passed on to passive investors. In early non-recourse loans, carve-outs were limited to the basics: fraud, misrepresentation, misappropriation of insurance or condemnation proceeds. If the project failed, the principals could walk away without personal liability, unless they had committed “bad acts.”

More recently, carve-outs have become more extensive, in response to lender’s concerns on delays in their ability to realize on collateral, or losses relating to “bad acts.” Carve-outs are generally broken down into two categories: those bad acts for which the guarantor will incur full personal liability for the entire indebtedness, and those bad acts for which the guarantor will have liability only to the extent of damage incurred by the lender.

Bad acts which generally cause full liability for the debt include voluntary bankruptcy filings, violation of single purpose entity covenants, transfer of the property in violation of due-on-sale provisions, placing subsequent financing on the property, as all of these acts can substantially delay a lender’s ability to realize on its collateral and reduce its losses. These acts are within the owner’s control, and from a lender’s point of view, having a carve-out guaranty calling for full personal liability will motivate the principal not to cause delay or interfere with the lender’s ability to realize on its collateral quickly.

Bad acts which create limited liability on the debt to the extent of losses caused by the lender generally include fraud or misrepresentation, gross negligence or willful conduct, failure to maintain insurance, misappropriation of insurance or condemnation proceeds, failure to pay taxes or liens, commission of waste and lender’s costs of bringing an action to realize on the collateral. From a borrower or guarantor’s point of view, it is important to carefully negotiate language so that liability is limited to actual losses incurred by the lender. Provisions to negotiate in favor of the carve-out guarantor include notice and cure periods, limiting liability for failure to pay taxes or other expenses only to the extent that there is sufficient cash flow and it is not applied to property expenses, eliminating carve-outs based purely on insolvency, which is not controllable by the guarantor, and terminating liability at the point in time that the property is tendered back to the lender.

Carve-outs are unique to each transaction and can be targeted to particular situations. The lesson to be learned is that carve-outs are not “standard” by any means and that care should be taken to negotiate for the benefit of your client, whether it is the lender concerned about managing risk, or the guarantor concerned about eliminating unintended liability.