We have from time to time tackled topics involving guaranties in a commercial loan transaction due to their importance in underwriting a loan. In this article, we discuss so-called “springing guaranties,” a type of guaranty that we encounter more often in commercial real estate financing compared to other asset-based or commercial and industrial loans. But first…a quick refresher!
A guaranty is similar to an insurance policy in that it provides the lender with additional coverage against risk of loss in case of a borrower’s inability to repay a loan in full or in case of a deficiency following the lender’s action on the collateral securing a loan. The value of an insurance policy differs depending on the risks it covers and the extent of the payout upon the occurrence of a covered event. Likewise, a guaranty’s value differs depending on the events it covers and the extent of the guarantor’s liability upon the occurrence of a guaranteed obligation. The type of guaranty should be adapted to the specifics of a transaction, taking into account the creditworthiness of the borrower, the value of the collateral to be provided, the loan amount, the interest rate, and in the case of construction financing, the risks inherent in a particular project.
Guaranties come in different “flavors” and they can be generally categorized into unlimited or limited, and absolute or conditional guaranties:
- An absolute guaranty is immediately effective upon closing the loan, without any further action required other than the occurrence of an event of default. An absolute guaranty is a guaranty of payment[1] and, therefore, it is independent from the borrower’s performance or any defenses that the borrower might have against the lender. Although most absolute guaranties provide for unlimited liability for the guarantor, it is not unusual for a lender to limit the liability of a guarantor under a guaranty by agreeing to a cap equal to a specific dollar amount or a specific percentage of the loan balance.
- A conditional guaranty goes into effect upon the occurrence of a contingent event. While a conditional guaranty can be a guaranty of payment, it can also be a guaranty of collection.[2] The conditions that serve as the trigger for the guaranty can sometimes be quite creative; however, the following are the most common types of conditional guaranties:
- A completion guaranty (in the context of a construction loan) is triggered if the borrower fails to properly complete lien-free construction of a project.
- A debt service guaranty commits the guarantor to cover any unpaid debt service when the borrower fails to do so.
- A carry guaranty is typically used in commercial real estate loans and is triggered if the borrower fails to pay various operating costs for a mortgaged property such as accrued interest, taxes, insurance, maintenance costs, and other expenses.
- A springing guaranty is triggered upon the occurrence of any of a list of particular events clearly delineated in the guaranty. An example of this group are non-recourse carve-out guaranties, sometimes still referred to as “bad boy” guaranties.
Springing guaranties exist in the realm of conditional guaranties and the contingent events that can cause them to “spring” into effect span the range of “bad” acts, such as fraud or misrepresentation, gross negligence, misappropriation or misuses of loan proceeds, unauthorized payments or distributions, unauthorized transfers, or encumbrance of assets, to other events such as the borrower’s filing for voluntary bankruptcy, failure to comply with financial covenants, violation of single-purpose entity (“SPE”) requirements, or failure to comply with other key covenants in the loan documents.[3] Depending on the triggering event, the level of liability of the guarantor tends to be proportional to the damage suffered by the lender in that the guarantor may be liable only for the indemnification of the actual losses incurred by the lender. Upon the occurrence of some acts or events, however, the guarantor may become liable for the full repayment of the outstanding debt. Springing guaranties, when utilized for a loan without other types of guaranties, generally apply to stabilized properties with solid economics.
Because of the contingent risk of liability to a guarantor, springing guaranties are generally regarded as a deterrent rather than actual security for repayment of an obligation. When used as a risk-shifting mechanism, springing guaranties are intended to incentivize the guarantor (which is typically a principal, primary shareholder, parent company, subsidiary (if any), or affiliate of the borrower), to ensure that the borrower complies with its obligations under the loan documents so as not to trigger the guaranty. Despite its limited nature, a lender may consider the availability of a springing guaranty as a credit enhancement which, in addition to being a possible additional source of repayment, also functions to keep the borrower in check and may help to prevent strategic defaults or voluntary bankruptcy filings. A borrower is often in favor of a springing guaranty structure since it may mean more favorable financing terms and, provided all goes well, limited recourse and liability for the guarantor.
A springing guaranty (or any guaranty for that matter), however, is only a benefit to the lender if it is enforceable. The extent to which springing guaranties are enforceable has expanded following the global financial crisis, and courts around the country appear to be more open to holding guarantors fully liable for indebtedness under springing guaranties depending upon the factual situation. While we focus on Massachusetts law in this article and our inclusion of the cases below does not constitute legal advice, the following are some examples of recent court decisions which, among other points, generally found the particular guaranties enforceable (with some exceptions):
- Insolvency and SPE covenants:
- In Wells Fargo Bank, N.A. v. Cherryland Mall L.P., the Michigan Court of Appeals held that a full-recourse guaranty was properly triggered upon the borrower’s failure to pay debt service because it contravened the SPE covenants in the mortgage (requiring that the borrower remain solvent and pay its debts and liabilities when they became due).
- In Wells Fargo Bank, N.A. v. Palm Beach Mall, LLC, a Florida Court of Appeals, however, held that a springing guaranty was not triggered even though the borrower used funds from its equity member (the guarantor on the loan) to pay its debts and liabilities, therefore bypassing the SPE covenant in the loan documents requiring the borrower to pay its debts and liabilities out of its own funds and assets.
- Bankruptcy filings:
- In Bank of America, N.A. v. Lightstone Holdings, LLC, the Supreme Court for New York County held that the borrower’s voluntary bankruptcy filing (even though it may be viewed as an act properly within that entity’s fiduciary duties to its equity holder) triggered full recourse of the guaranties.
- In 111 Debt Acquisition Holdings, LLC v. Six Ventures Ltd., the Court of Appeals for the Sixth Circuit held that even though only one of three guarantors caused the borrower to file a bankruptcy petition, all three guarantors were liable under their guaranties which provided for personal liability of the guarantors “if any guarantor consents to, aids, solicits, supports or otherwise cooperates or colludes to cause… or fails to contest” a bankruptcy filing by the borrower.[4]
- License agreements as part of the mortgaged property:
- In E. Robert Co. v. Signature Properties, LLC, the Connecticut Supreme Court held that the cancellation of a parking license agreement, which was included in the “mortgaged property,” constituted a transfer of a property interest, therefore resulting in full recourse liability of the guarantor.
- Contesting lender’s enforcement of remedies:
- In Bank of America, N.A. v. Freed, the Illinois appellate court held that the guaranty properly sprung into full recourse because the guarantors’ appeal of the trial court’s appointment of a receiver qualified as contesting or opposing the lender’s exercise of remedies in connection with the appointment of a receiver for the mortgaged property.
- Failure to pay property taxes and other liens:
- In G3-Purves St., LLC v. Thomson Purves, LLC, a New York appellate court enforced the full-recourse provisions in a guaranty on a $20 million loan based on the borrower’s failure to pay less than $250,000 in real estate expenses which resulted in the imposition of tax, environmental and mechanics liens.
Regardless of the specific triggering conditions in each springing guaranty, a guaranty is a contract, and therefore, it is important to always be mindful of matters of contract formation, perhaps most importantly, whether the guarantor is receiving adequate consideration in exchange for the guaranty.[5]
The case law referenced above emphasizes the need for clarity as to which events cause a springing guaranty to go into effect. Prior to preparing a term sheet or commitment letter for a loan, a lender should decide on the scenarios in which the guarantor will become liable and the extent of that liability. To the extent any specific recourse carveouts are enumerated in a term sheet or commitment letter, care should be given to note that the list is not exhaustive and is not limited to “bad acts,” because some triggering events by a borrower or guarantor may not be intentional. The lender should copy the guarantor in any notices of default sent to the borrower, as well as obtain the consent of the guarantor on any amendments to the loan documents. These actions will aid in pre-empting any defenses from the guarantor down the road regardless of any customary waivers that a well-crafted guaranty should contain.
Legal counsel to the parties play a crucial role in addressing these issues and in considering any jurisdictional nuances that might apply. We at Hackett Feinberg have decades of experience in matters of commercial finance and our team is always available to be a sounding board in the early stages of deal discussions and to advise our clients (on either side of the transaction) diligently toward a successful closing.
[1] A guaranty of payment is a promise to pay the underlying debt if the borrower defaults, without requiring that the lender first pursue the borrower without success.
[2] A guaranty of collection is a promise to pay the underlying debt if: (i) the borrower defaults, (ii) the lender began a proceeding against the borrower, and (iii) the lender was unable to obtain payment despite diligently pursuing the collection of the debt.
[3] For more on recourse carve-out guarantees, please refer to our issue of “Why Do We Care About Non-Recourse Guaranties.”
[4] For more on joint and several guaranties, our “Why Do We Care About Joint vs. Several Guaranties” offers a primer on that topic.
[5] This topic is further discussed in our “Why Do We Care About Consideration for Guaranties” article.
This communication is for informational purposes only and is not legal advice on any specific facts or circumstances. In addition, the firm undertakes no obligation to update the information discussed in the foregoing article.