Who Gets the Kickback From "Bad Boy" Carve Outs in Loan Documents?

As the uncertainty resulting from the Cherryland and Gratiot cases, holding that non-recourse carve outs in real estate mortgage loans are enforceable against borrower and guarantors, continues, it is important for borrowers and guarantors and lender to incorporate the intent of the parties with respect to non-recourse carve outs in the loan documents.

A recourse loan allows a lender, following a foreclosure upon the collateral, to seek a deficiency judgment against a borrower and guarantor. However, the majority of commercial real estate loans are non-recourse, meaning that upon an event of default, lender’s recourse against the borrower and guarantor is limited to the collateral, subject to certain non-recourse carve outs or “bad boy” carve outs, provided in the loan documents, which, upon the occurrence thereof, triggers recourse against the borrower and guarantor.

Non-recourse carve outs are divided into limited recourse events and full recourse events. Limited recourse events are those for which a lender’s recourse is limited to its losses, such as fraud or material misrepresentation, misapplication of rents following an event of default, or gross negligence or willful misconduct. Full recourse events are, among others, a voluntary bankruptcy, a collusive involuntary bankruptcy or a prohibited transfer.

In Cherryland, the court held that borrower’s failure to pay the mortgage (a non-recourse event) violated the loan documents’ SPE covenant to remain solvent (a full recourse event), resulting in the borrower and guarantor being liable for a deficiency judgment. In response, the Michigan legislature passed the Non-Recourse Mortgage Loan Act of 2012, which, among other things, negated solvency covenants in non-recourse loans as unenforceable.

The Maryland Courts have not yet weighed in on the findings of the Cherryland and Gratiot cases. In Maryland, guaranties are strictly construed between the parties using the plain language of the agreement. Accordingly, proper drafting of the non-recourse carve outs in loan documents is essential to avoid some of the pitfalls identified in the Cherryland case.