Traditionally, loans were made on either a recourse or non-recourse basis. As to a borrower, a non-recourse loan meant that the lender would only look to its collateral in the event of a default and that the borrower did not have liability beyond the value of the collateral for repayment of the loan.
With respect to the principals of the borrower, non-recourse meant that no personal guaranties were required by a lender and even further that the lender could not go beyond the borrower to hold the principals or officers of the borrower liable for the lender’s losses on a loan, and therefore that only the borrower was responsible for repayment of the loan. In these non-recourse situations, lenders are often confronted with the fact that the lack of personal liability allowed and possibly incentivized distressed borrowers or unscrupulous principals to divert and misuse collateral and revenues almost with impunity. While the out-right theft of collateral by a principal of a borrower might provide a lender with the basis for a claim against a non-recourse borrower or a non-guarantor principal, the ability of a lender to succeed in court in this situation requires clear evidence of significant illegality (e.g., conversion of assets) by the parties involved.
The solution that lenders devised to address the perils of having no guaranties or personal recourse in these types of loan structures was the creation of so-called “non-recourse”, “limited recourse”, or “recourse carve-out” guaranties which are also often colloquially referred to as “bad boy” or “bad girl” guaranties or “springing guaranties” (collectively, “NRG”). For simplicity’s sake this article will focus on NRGs but the principles apply to all such provisions whether in loan documents or guaranties.
While initially used only in conduit lending deals, NRGs are now common in both commercial real estate and corporate lending relationships. They are intended to keep borrowers and their principals honest. If a borrower commits certain bad acts, such as diversion/misappropriation of funds (i.e., “lies, cheats or steals”), then the obligors on an NRG (who typically would be key principals of the borrower) will be liable to the lender for the losses suffered by the lender as a result of such bad acts. An NRG is a contingent guaranty, meaning that the party who signs an NRG will only have liability if such party or the borrower commits the acts described in the NRG.
NRGs are used in the absence of an unlimited guaranty to protect the lender against wrongdoing by a borrower. Where the lender is obtaining an unlimited guaranty an NRG provision would be superfluous as the guarantor is already fully liable on the guarantied loan obligations. NRGs function both as an avenue for recovery and also as a “Sword of Damocles” to deter the principals of a borrower from causing the borrower to engage in fraudulent or quasi-fraudulent or other harmful activity at the expense of the secured lender. NRGs are often a compromise solution between a lender’s desire for as much support for a loan as possible and the desire by the principals of a borrower not to be subject to recourse against them and personal liability for the loan.
NRGs can impose liability on a contingent guarantor either
- (i) limited to the extent of the actual damages caused to the lender by the prohibited conduct (i.e., an indemnity in favor of the lender), or
- (ii) with full recourse for the entire amount of the loan upon the occurrence of certain prohibited conduct.
Examples of the type of conduct that would trigger the indemnification provisions under an NRG typically include any or all of the following:
- (a) fraud or other criminal misconduct, gross negligence, diversion or misrepresentation of company assets, or security or advance deposits;
- (b) improper or unauthorized payments, distributions or “management fees” to principals after an event of default or which cause an event of default;
- (c) unauthorized transfers or encumbrance of assets covered by a mortgage, security agreement or negative pledge on the assets of the borrower,
- (d) interference with the lender’s efforts to realize on its collateral, such as interference with a lender’s efforts to collect rents from tenants under an assignment of leases and rents or opposing a lender’s motion for relief from stay in bankruptcy;
- (e) failure to cooperate with the lender’s efforts to retrieve and liquidate its collateral;
- (f) failure to meet tax obligations resulting in the recording or issuance of tax liens against the assets of the borrower (especially when cash flow was available to make the required tax payments);
- (g) so-called “waste” or intentional destruction or damage to the borrower’s assets as well as theft;
- (h) failure to maintain insurance coverages resulting in an uninsured casualty loss by the borrower; and
- (i) failure to use loan proceeds to pay charges for labor or materials that can resulting in liens on the assets of borrower and other losses.
The typical provisions triggering full liability for repayment of a loan include (a) a voluntary bankruptcy filing by the borrower or contingent guarantor or involuntary filing “encouraged” by the borrower or contingent guarantor (although these provisions may not be enforceable as violative of public policy in some bankruptcy jurisdictions); (b) certain negative covenant violations such as transfer of assets or restricted payments; and (c) if the borrower or contingent guarantor opposes the lender’s exercise of rights and remedies and such opposition is found to be unwarranted, meritless or frivolous. In the end, the scope and breadth of an NRG is often the subject of significant negotiation between lender and obligors.
In addition, the NRG should address what level of proof is required for the NRG to come into play. Must fraud be proven in a court of law before liability arises? If so, what level of proof should be required? While the ordinary level of proof in a civil litigation matter is the “preponderance of the evidence”, in some states proving actual fraud requires “clear and convincing evidence” of fraud which is a more stringent standard. Is a lender entitled to seek prejudgment remedies and thus obtain security for its potential claim against a contingent guarantor premised only on the lender’s assertion of a claim or does the lender first have to obtain a court adjudication of improper conduct by the contingent guarantor? Must the contingent guarantor be the party directing or participating in the wrongdoing for liability to arise or is the occurrence of wrongdoing by the borrower, even without the contingent guarantor’s knowledge or direct involvement, sufficient?
Because the scope of an NRG can be such a broad and complex concept, it helps if the lender’s loan commitment letter or term sheet clearly spells out the scope and circumstances that will give rise to contingent liability under the NRG. The greater the level of detail contained in the loan commitment, the less room there is in negotiating loan documents or for disagreements about what circumstances give rise to liability. As with other deal terms, in order to avoid confusion and misunderstandings with a borrower and to minimize negotiation of the NRG (and thus reduce legal fees on both sides), it is important to clearly specify in the loan commitment or term sheet which recourse carve-out provisions the lender intends to include in its loan documents. These provisions typically matter greatly to the non-recourse guarantor, and a sophisticated borrower may have its counsel review and negotiate such language in the commitment letter.
As you consider the potential necessity for, and/or scope and extent of an NRG, it may be helpful to consult with counsel early on in the process to sharpen the focus of what is warranted for the particular loan at issue. Hackett Feinberg, P.C. is always ready, willing and able to provide advice in this area and sample language for commitment letters, term sheets and NRGs.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.
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