For many of todays small to medium hoteliers one of the most difficult challenges with regard to growth is the ability, or lack thereof, to guarantee construction and other loans. Large hoteliers frequently have the asset base or liquidity to provide the required guarantees, or have a long tested relationship with their financial partners and can obtain non-recourse construction and other types of loans. Recourse for a higher-end, flagged hotel may put the sponsor’s entire life’s work at risk. For this reason, many in the hotel industry seek non-recourse construction and permanent financing.

Borrowers need to understand that, where construction is concerned, non-recourse, more often than not, means after certificate of occupancy has been issued. During construction the sponsor will be required to provide a “warm body” guarantor. It is also likely a completion bond will also have to be provided. CMBS and some other forms of debt are non-recourse.

Borrowers must understand that the term “mortgaged property” may include much more than just the real estate being pledged as collateral. It is important to note that most non-recourse loans include exceptions (or “carve-outs”) within the loan documents that result in full-recourse liability to the borrower and /or guarantor when certain “bad-boy” behaviors exist. Examples of these behaviors are (i) fraud or intentional misrepresentation by the borrower; (ii) waste occurring to or on the mortgaged property; (iii) gross negligence or criminal acts of the borrower that result in the forfeiture, seizure or loss of any portion of the mortgaged property; (iv) misapplication or misappropriation of rents, insurance proceeds or condemnation awards received by the borrower after the occurrence and during the continuance of an event of default; and (v) any sale, conveyance, mortgage, grant, bargain, encumbrance, pledge, assignment or transfer of the mortgaged property, or any part thereof, without the prior written consent of the lender.

These limited guaranties were initially intended to keep borrowers and their principals honest. In cases where the bad act was particularly egregious, such as filing a voluntary bankruptcy action or interfering with the lender’s foreclosure action, the loan would become full recourse to the borrower and/or the guarantors. These guarantees were specifically intended to prevent the principals of the borrower from diluting the value of the collateral or performing certain actions that undermine the lender’s enforcement rights. “Bad boy” guaranties are pretty much ubiquitous in today’s commercial mortgage financing transactions, but the actual carve-out provisions themselves tend to vary from lender to lender. What was once a straightforward list of limited “bad” acts has often expanded into provisions designed to cover nearly every conceivable instance where a borrower could go astray. For this reason, it is prudent for borrowers to understand the scope of its lender’s proposed “bad boy” guaranty before signing the term sheet or loan commitment. Each of the “bad” acts (and their corresponding level of liability) should be carefully reviewed at the outset of negotiations to ensure that the borrower and/or guarantors are aware of the potential liabilities.

Many real estate loan term sheets and loan commitments refer to the lender’s “standard recourse carve-out provisions,” while failing to delineate the particular events or actions that can trigger personal liability in an otherwise non-recourse loan transaction. Ask any contemplated lender for a copy of its standard “bad boy” guaranty for review during the term sheet or commitment phase. The terms of the “bad boy” guaranty can frequently be negotiated at this juncture. Achieving consensus will help simplify and speed the closing process. Also guarantors can make an informed decision at the outset of negotiations before tendering any loan deposits. Hiring an attorney with a strong command of commercial real estate law to review and help negotiate these provisions can often be a worthwhile investment.

Two additional issues to consider:

If a mezzanine loan is part of the capital stack things may get complicated. If triggered by prescribed “bad” acts, “bad boy” guarantees require the borrower and/or guarantor to be personally liable for damages to the lender, or alternatively, converts an otherwise non-recourse loan into a full recourse loan impacting the borrower and/ or guarantor. In either result, lenders will have the right to seek significant personal liability against the borrower and/or guarantors, so it is essential that borrowers and/or guarantors have complete control over the potential triggering acts. The mortgage lender and the borrower and/or guarantors should take care to ensure that the “bad” acts of a foreclosing mezzanine lender do not trigger a personal liability. Guarantors should require the mezzanine lender and/or a credit entity affiliated with the mezzanine lender to indemnify the borrower if the “bad boy” guaranty is triggered by the acts of mezzanine lender. This transfers the liability under the guaranty to the mezzanine lender, and creates an inducement for the mezzanine lender to not trigger the guaranty. It is essential that borrowers and guarantors ensure that their guaranty obligations terminate when managerial power is transferred. Most first lien lenders will favor this action, as it should help prevent a foreclosing mezzanine lender from putting the company into bankruptcy or from violating the “bad boy” provisions.

In the case of default forgiveness of debt may have meaningful tax implications:
Violation of a “Bad Boy” provision may cause the debt to be reclassified as recourse. If, after this conversion, the lender forecloses, the lender can then look to the debtor and/ or guarantor for satisfaction of any deficiency balance. If the borrower and/or guarantor is fortunate enough to have some or all of the balance forgiven, there may be significant tax implications. Federal and local taxing authorities may classify forgiveness of debt on the part of the lender as income. A good tax accountant can help borrowers and/or guarantors evaluate potential tax issues.

Non-recourse loans usually involve “bad boy” carve outs. During the loan application and approval process debtors are frequently enthusiastic and pleased to get financing, (especially non-recourse); and especially in light of the events of 2008 and its aftermath. It is important to understand when, and under what circumstances a loan is non-recourse. Granted, as a small to intermediate borrower, your ability to amend the terms and conditions of the carve outs may be limited, however at the very least It is important to understand specific actions and situations that may cause the debt to become recourse. As a corollary it is critical to understand “bad boy” covenants in the loan agreement as well as potential ramifications associated with any breach.