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A Potential Pitfall in Non-Recourse Loans

Non-recourse borrowers may, through no fault of their own, find themselves on the hook for more than they had bargained for

Like many states, Arizona allows real estate secured lenders to sue commercial borrowers personally for a "deficiency judgment" if a loan goes into default and the foreclosure sale does not bring enough to pay the balance due on the note. Competition among lenders (among other factors) has given rise to the increasingly common practice of offering "non-recourse" loans to borrowers whose projects and track records can justify the risk that, in the event of a default, the real property collateral may not cover the entire indebtedness.

However, as demonstrated by a recent case from a federal court in Illinois, non-recourse loans are not without their possible pitfalls to borrowers. So-called "bad-boy provisions" (i.e., carve-outs) of non-recourse loans invariably require borrowers to remain personally liable for certain "bad acts," such as environmental contamination, misappropriation of funds, fraudulent misrepresentation, waste, and other types of serious defalcations.

In the Illinois case, Heller Financial Inc. v. Lee, the lender had made a $9.9 million "mezzanine" loan to a limited partnership, its corporate general partner, and their respective principals, secured only by the principals' equity interests in each entity borrower. Together with a $34.2 million first trust deed loan from another lender, the mezzanine loan was used to finance the purchase of a hotel. Although the mezzanine loan was non-recourse, a carve-out made each borrower personally liable for breaches of a covenant prohibiting further liens against the hotel property.

Unknown to any of the borrowers, a third-party management company permitted various tax and mechanics' liens - totaling $820,000 - to be filed against the property. The mezzanine lender gave notice of default to each borrower, accelerated the $9.9 million note, eventually conducted a foreclosure sale of the equity interests, and later caused the hotel to be sold as well. The proceeds of sale were insufficient to pay off the mezzanine note, and the lender sued two of the individual borrowers for the "deficiency."

In their defense, the borrowers argued that:

  • they could have cured the default and reinstated the note by simply paying the $820,000 in liens;

  • under the circumstances, the lender's actual damages were only $820,000; and

  • the non-recourse clause essentially provided for a type of liquidated damages greatly exceeding actual damages and amounting to a "penalty", rendering the clause unenforceable.

The court rejected this argument presumably because the borrowers in fact had not cured and reinstated. Confining itself to a reading of the loan documents, the court analyzed the contract as requiring the borrowers to repay a loan that unquestionably had benefited them, and ruled that the non-recourse carve-out did no more than permit the lender to recover what had now become its actual damages - here, the balance due on the note after application of the sale proceeds.

In our experience, carve-outs have become broader and more expansive over the past five years or so. When the practice of creating bad-boy carve-outs to otherwise non-recourse loans began, the carve-outs were limited to pretty serious acts - for example, pocketing fire insurance proceeds and fleeing to Brazil - but they are no longer limited to such extreme cases.

It would appear that the concept of true non-recourse liability is simply not as palatable to the lending industry as it perhaps once was. In that light, and especially in view of the holding in the Heller case, it is very important to focus on the carve-outs from non-recourse liability in each set of loan documents. If possible, the borrower should negotiate against any type of "springing" liability for the full amount due on an accelerated note, where (as in Heller) a default may trigger actual damages that are less than the accelerated balance of the note.

The safest way to accomplish this result would be through a provision requiring the lender to give the borrower sufficient opportunity - before commencing foreclosure proceedings - to cure any default that could give rise to a right of acceleration and personal liability under the bad-boy provisions.

If that protection cannot be negotiated, Arizona borrowers can still rely on the statutory right to reinstate a defaulted loan by curing the default during the 90-day period before a trustee's sale (assuming the lender elects the trustee's sale route).

In either event, borrowers will do well to keep in mind that "non-recourse" does not always mean "non-recourse," and that even non-recourse borrowers may, through no fault of their own, find themselves on the hook for much more than they thought they had bargained for.