“Bad Boy” Provisions in Commercial Real Estate Transactions

Many long-term commercial loan transactions are essentially non-recourse except for certain carve-outs or “bad boy” provisions – describing events which, if they occur, can create partial (or even total) personal liability under the loan

Those of us who have been handling commercial real estate financing transactions for a long time can almost mentally track the evolution of these carve-outs – which started out as “if the place burns down and you steal the insurance money and go to Mexico” and evolved into a long laundry list of things that you can do to trigger personal liability for what, on its face, is a non-recourse loan.

My guess is that there are a lot of cases in the judicial system – not yet decided or reported – testing whether these provisions are enforceable. I happened to see a recent case out of New Jersey – CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC, 980 A.2d 1 (N.J. App.Div. 2009) – in which the appellate court held that a bad boy/carve-out provision was enforceable.

The case involved a $13 million non-recourse loan that contained carve-outs for, among other things, entering into subordinate financing secured by the subject property without the lender’s consent. During the term of the loan, the borrower obtained $400,000 in subordinate financing secured by a second lien on the property without the first mortgage holder’s consent. In less than a year, the borrower paid off this secondary financing but ultimately defaulted on the primary loan. After completing a foreclosure on the property, the lender brought suit against the borrower and the borrower’s principals (who had executed guaranties) for the deficiency. The defendants argued that the carve-out was unenforceable since, among other things, the lender had suffered no harm, as the secondary lien had already been satisfied.

In the trial court, the lender was granted summary judgment against the borrower and the borrower’s principals, who then appealed. The appellate court affirmed the grant of summary judgment, finding that the carve-outs were unambiguous and part of a commercial transaction negotiated by sophisticated parties. Furthermore, the fact that the default was later cured did not alter the fact that the bad boy provisions had already been triggered, potentially affecting the property and adversely affecting the lender’s security therein.

The court’s decision seemed to turn on the level of sophistication of the parties and the fact that the default was a voluntary act. Also, the damage, or potential damage, to the lender’s interest was clear. On the other hand, the more recent laundry list of bad boy provisions often includes such acts as seeking bankruptcy protection or contesting the appointment of a receiver during a foreclosure – actions that are arguably statutory rights (federal or state) and maybe looked at differently than a simple contract violation.

I am almost certain that cases challenging the validity of those types of provisions will be litigated, and I am curious to see what the result will be.