Restructuring

Contributed by Christopher Linden and Will Hueske
In the complex world of structured real-estate finance, lenders are constantly trying to reduce their risk exposure while borrowers seek to reduce their cost of capital.  One way in which parties achieve these somewhat competing goals is through the use of non-recourse carve-out guaranties, or as they are more affectionately referred to, “bad boy” guaranties.  Although these guaranties vary in their terms, typically they involve the borrower’s principal(s) guarantying the borrower’s obligations.  In most cases, the guaranty operates in two steps: (1) upon the occurrence of certain enumerated events (for example, filing a voluntary petition under the Bankruptcy Code or further encumbering the collateral), the previously non-recourse obligation becomes “fully recourse” and (2) upon conversion, the guaranty “springs” into existence and the guarantor (typically the borrower’s principal) becomes fully liable for the debt.  These provisions are designed to discourage the borrower or the guarantor from engaging in any of the “bad boy” acts.  There isn’t much case law on “bad boy” guaranties because, until the most recent crash of the real estate markets, they were not frequently triggered and even less frequently challenged in court.  Two recent trial court decisions in New York, however, shed some light on how “bad boy” guaranties stand up when challenged.
In UBS Commercial Mortgage Trust 2007-FL1 v. Garrison Special Opportunities Fund L.P., Case No. 654212 (MLS) (N.Y. Sup. Ct. March 8, 2011), the Supreme Court of New York found a “bad boy” guaranty valid and enforceable.  In mid-2007, UBS Real Estate Securities Inc. loaned $107 million to a group of investors  for the purpose of acquiring office buildings in the Virginia suburbs of Washington, DC.  In late-2007, needing additional financing, the borrowers’ equity owner obtained a mezzanine loan in the principal amount of $31.5 million, secured by a pledge of 100% of the membership interests in the Borrowers.  As a condition to the primary lenders agreeing not to foreclose on the property, the mezzanine lender unconditionally guarantied “payment and performance of obligations or liabilities of borrower to lender to the extent such obligations and liabilities arose after acquisition of all or any part of the ownership interest in borrowers by” the mezzanine lenders.  According to its terms, this “bad boy” provision would be triggered by a voluntary bankruptcy filing by the borrowers.  The mezzanine lenders completed a UCC foreclosure and acquired 100% of the ownership interests in the borrowers and the borrowers then filed a voluntary petition in the United States Bankruptcy Court for the Southern District of New York.  When Garrison, the former mezzanine lender/now equity owner and guarantor, refused to make payment on the guaranty, the primary lenders filed suit in New York using a rarely invoked, expedited procedure called summary judgment in lieu of complaint.
Although the underlying dispute centered on the enforceability of the “bad boy” guaranty, the court was required to decide a threshold procedural issue regarding whether the dispute could be adjudicated via summary judgment in lieu of a complaint.  Under CPLR 3213, a plaintiff may accelerate the litigation process by immediately moving for summary judgment “when an action is based upon an instrument for the payment of money only.”  The court found that the guaranty fell within this definition and proceeded to decide the summary judgment motion.  Although relatively uncommon, since the Garrison court allowed this expedited procedure to be used in the guaranty context, guarantors may face this procedure more frequently.
Next, the court addressed the parties’ arguments relating to the enforceability of the “bad boy” guaranty.  The defendant initially attempted to characterize the guaranty as an unenforceable in terrorem contract provision because it sought “to punish and penalize . . . without ascertaining whether the complainant has even suffered any damages.”  The court, however, pointed to one of the guaranty’s provisions in which the defendant effectively waived any right to assert a defense to payment of the obligation.  The court reasoned that the mezzanine lender/guarantor was a “sophisticated distressed real estate investor” and that the guaranty is a “common feature in commercial mortgage loans” and such guaranties “almost uniformly contain language which makes them unconditional and waives the right to assert defenses, and therefore held that the guarantor had validly waived its right to assert as a defense that the guaranty was a penalty.  In dictum, the court opined on whether the “bad boy” guaranty was in fact an unenforceable penalty and concluded that it was not because guaranties are “legitimate financing arrangements with respect to real estate transactions and have been upheld in New York State and federal court.”
Finally, the Garrison court addressed the defendant’s argument that “bad boy” guaranties are void as against public policy because they create a scenario where the guarantor’s personal interest in avoiding liability may prevent the guarantor from discharging its fiduciary duties to the borrower’s creditors in a distressed situation.  The court tersely dispensed with this argument, likening the situation to the common scenario where a corporate parent guaranties the debt of a subsidiary.  Accordingly, the state court granted the plaintiff’s motion for summary judgment in lieu of a complaint.
In contrast, an earlier decision by the same court in  ING Real Estate Finance (USA) LLC  v. Park Avenue Hotel Acquisition LLC, 26 Misc. 3d 1226(A), 2010 WL 653972 (N.Y. Sup. Feb. 24, 2010), applied a commercial reasonability standard in rejecting a “bad boy” clause as a grossly disproportionate and unenforceable penalty.  Similar to Garrison, in April of 2007 the borrower, Park Avenue Hotel, secured a non-recourse loan in the amount of $145 million through mortgages on a commercial property.  The loan was then guarantied by various parties, whose obligations were only triggered by certain “Full Recourse” events, including incurring any “Indebtedness” other than unsecured trade debt less than 90 days past due.  The definition of “Indebtedness” in the agreement included “obligations secured by any Liens, whether or not the obligations have been assumed.”
In April of 2009, ING Real Estate sent a notice of event of default to Park Avenue for missing a payment, and then moved to foreclose on the underlying property.  At the time of the filing, however, the property was undeveloped and worth only a fraction of the secured debt outstanding.  Realizing their undersecured position, ING Real Estate then amended its complaint to include the guarantors, arguing that Park Avenue had been 19 days late in making a certain real estate tax payment to the IRS in the amount of $278,759, which briefly created a tax lien on the property, thus triggering “Indebtedness” and “full recourse” liability for the remaining $90 million under the guaranty.  The court observed that two provisions in the guaranty were apparently in conflict on whether the lien actually triggered “full recourse” liability.  One section  allowed for a thirty-day cure period upon the filing of any lien before any recourse could occur, while another called for full recourse immediately upon an occurrence of “Indebtedness,” which had clearly been triggered by the tax lien.  Employing the canon of construction that specific provisions will control over contradictory general provisions, the court held that the specific act of “Indebtedness” at issue, the filing of a tax lien, was excepted from the general “full recourse” provision, and that Park Avenue had cured the tax obligation within the 30 days allowed to it.
The court additionally held that a commercial agreement should not be interpreted in a commercially unreasonable manner or contrary to the reasonable expectations of the parties.  Observing that, under the view of ING Real Estate that the tax lien triggered full recourse liability, the guarantors could be liable for up to $145 million for just a single day’s tardiness in payment of property taxes or any other debt for which a lien may be imposed, the court held that such an outcome could not possibly have been intended by the parties and was impermissible under New York law.  The court viewed this “bad boy” clause and its attendant “grossly disproportionate” consequences as an unenforceable penalty and refused to hold the guarantors jointly and severally liable for the Park Avenue debt.
After Garrison and Park Avenue Hotel, at least in New York, a borrower has more clarity as to how courts will interpret “bad boy” guaranty provisions.  Garrison contains three important points regarding “bad boy” guaranties in New York: (1) “bad boy” guaranty claims may be pursued expeditiously by filing a motion for summary judgment in lieu of a complaint; (2) waivers of the right to assert defenses to the guaranty will be enforced, especially as between sophisticated parties; and (3) “bad boy” guaranties generally are not unenforceable penalties.  Park Avenue Hotel, however, sets limits on the last point, ruling that certain “bad boy” guaranties that would produce “grossly disproportionate” outcomes, such as $145 million in liability for 19 days’ delinquency on a $278,000 tax payment, will not be enforced.  Where the line between “grossly disproportionate” and fair can be drawn is unclear – what is clear though, is that as the world of structured real-estate finance continues to evolve, “bad boys” are comin’ for you.