What flavor is your loan guaranty?

Like ice cream flavors, personal loan guaranties come in an ever increasing array of different types. Seemingly gone are the days of the vanilla, full recourse variety.

In response to the fallout from the Great Recession, today’s borrowers are now seeking out lenders who are willing to accept “limited” recourse guaranties as a way to minimize their personal exposure from a failed real estate venture. While traditional “non-recourse” guaranties have been around for many years (especially for permanent financing on large retail and apartment projects), many of the traditional non-recourse “carve outs” triggered personal liability even where the guarantor did nothing intentionally wrong, such as when “cash flow” deficiencies or “insolvency” events occurred.

Today’s sophisticated borrowers are demanding more flexibility, and creativity, from their lenders, and want to significantly limit their personal liability from the various risks associated with a real estate venture. Most of the limited guaranties previously appeared in the “hard money” lending environment, and are partially a consequence of the lender’s marketing approach. However, many institutional lenders (including banks) are now offering limited recourse options in their pricing. This is because some borrowers are willing to pay higher up front fees and higher interest rates in order to eliminate some of the potential recourse liabilities, and thereby shift the risk to the lender. In these situations, the specific wording of the recourse exculpation becomes a focal point of negotiations, and requires that the lender’s loan proposal or commitment letter be explicit as to the limitations or “carve outs” that are being offered.

In a recent appellate decision, Wells Fargo Bank N.A., as Trustee v. Palm Beach Mall, LLC, 2015 WL 5712341 (Fla. 4th DCA 2015), a guarantor’s deficiency liability in excess of $30 Million was at stake. At the center of the dispute, the Florida Fourth District Court of Appeal was called upon to interpret a personal guaranty which imposed liability for the “gross negligence or willful misconduct” of the borrower. In applying New York law, the Florida court determined that the wording of the guaranty required a “deliberate” act by the guarantor that was “tortious in nature” in order to trigger the guaranty liability. The Court further ruled that, without more, intentional acts aimed at protecting the borrower’s economic interests did not trigger any such liability. For example, the Court ruled that the borrower’s decision to “de-lease” the shopping mall and position it for redevelopment (by only entering into new leases with “Mom and Pop” tenants, with shorter terms), did not rise to the level of “gross negligence or willful misconduct” in the management of the mall. Even coupled with rodent problems in the food court; cancelling leases without payment of required termination fees; and removal of signage because the owner no longer wanted its name associated with the mall, such “bad boy” behavior did not rise to the level of the tortious conduct needed to trigger the non-recourse carve out for “gross negligence or willful misconduct.”

Moreover, due to some drafting ambiguities, the Court ruled that the “insolvency” event contemplated in the guaranty was not triggered. The Court held that, absent a specific intent to the contrary, the “equity insolvency” test would be applicable under New York law, as opposed to the “balance sheet” test. Because the parent company of the borrower made capital contributions to allow the borrower to continue to pay its debts as they became due, the Court ruled that the borrower was not insolvent at the relevant times, even though the market value of its assets was far exceeded by its debts.

As the forms of limited guaranties used in the marketplace vary greatly from lender to lender (and from market to market), lenders, borrowers and their attorneys need to pay very close attention to the specific wording used and need to carefully discuss the potential consequences of each “carve out” so that there are no misunderstandings (or disappointed economic expectations) at a later time. In general, a loan guaranty is a contract like any other, and, as such, is subject to all the rules of interpretation applicable to ambiguities in drafting. While many lenders and borrowers want to focus on the front end of the business deal, and “just get it closed,” careful attention must be paid to any limitations or “carve outs” in the guaranty. Otherwise, the guaranty may not turn out to be as tasty if the ice cream curdles at a later date.