A BORROWER S PERSPECTIVE ON THE CARVE-OUTS TO THE NON-RECOURSE PROVISIONS IN LOAN DOCUMENTS. Mark A. Senn *

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1 A BORROWER S PERSPECTIVE ON THE CARVE-OUTS TO THE NON-RECOURSE PROVISIONS IN LOAN DOCUMENTS Mark A. Senn * OVERVIEW A dollar borrowed is a dollar earned. A dollar repaid is lost forever. -- The Developer s Code After mentioning two related issues and a way by which unintended liability may arise, this discussion considers three kinds of exculpatory provisions: A provision that states positively the only liabilities for which the borrower is liable. The borrower prefers this provision. A provision that revokes the exculpation in its entirety in certain circumstances. The borrower tries to avoid this provision. A provision that creates personal liability to the extent of the lender s loss in certain circumstances. The borrower negotiates those circumstances and endeavors to include within them the circumstances allowing revocation of the entire exculpation. RELATED PROVISIONS AND UNINTENDED LIABILITY UNDER THE NON-RECOURSE PROVISION There are two provisions that are akin to carve-outs but not commonly considered carve-outs and are not considered in this discussion. They are: Recourse until lease-up requirements are met. The borrower is fully liable until prescribed debt service coverage is achieved. Recourse for the top or bottom dollars of a loan. The borrower is liable for some part of the loan. This kind of loan goes directly from the closing into the litigation that endeavors to construe its terms. The minimal promissory note requires payment of principal and interest. Most promissory notes require payment of other amounts: late charges, prepayment or yield maintenance premiums, default interest, and attorneys fees. The security documents (such as the mortgage or deed of trust, security agreement and assignment of rents) impose further costs on the borrower: real estate taxes, insurance, repair and maintenance, and amounts advanced by the lender to protect the property encumbered by the security documents. * Mark A. Senn (J.D., Boalt Hall, 1972) is a member of Senn Lewis & Visciano, P.C., Denver, Colorado. This discussion has benefited immeasurably from the suggestions of the author s partner Fredric J. Lewis. -1-

2 A thorough non-recourse provision in the promissory note and security documents exculpates the borrower from liability for repayment of any of these amounts. The borrower knows that it can default with impunity. However, unless the exculpation is complete, the borrower has unintended liability. EXAMPLE: If the non-recourse provision provides that there is no liability to repay principal and interest, the borrower is still liable to pay the lender s attorneys fees in foreclosure under the usual form of promissory note and all the amounts (such as real estate taxes) due under the security documents. In the ensuing discussion, the exculpation is presumed to be complete, and the borrower s only liability arises from the carve-outs. A POSITIVE STATEMENT OF THE BORROWER S LIABILITY Instead of a promissory note that creates liability and eliminates liability with the risk that liability may inadvertently remain, the borrower prefers that the promissory note state simply what the lender can and cannot do in the event of a default. EXAMPLE (Borrower s Form): If a default occurs, the lender can only foreclose. The lender cannot seek a personal judgment against the borrower. The promissory note should go on, the borrower says, to provide only areas of personal liability. EXAMPLE (Borrower s Form): However, the lender can seek a personal judgment for real estate taxes that accrue after the borrower receives notice of default under the promissory note. This formulation of a positive statement of the lender s sole recourse and the borrower s liability was common when non-recourse provisions began. The borrower knew exactly the obligations for which it was personally obligated. Since many lenders suffered unanticipated losses under this formulation, it gave way to other provisions. REVOCATION OF EXCULPATION IN CERTAIN CIRCUMSTANCES Many lenders terminate the non-recourse provisions in their entirety if certain defaults occur; those are usually defaults over which the borrower has control. For example, one lender s form of promissory note provides that it becomes fully recourse if: (1) the property is further encumbered; or (2) the property is sold; or (3) a bankruptcy is commenced, or the borrower asserts a claim against the lender (or in any way hinders the lender s enforcement of its remedies); or (4) a fraud has occurred; or (5) the environmental representations are untrue when made or become untrue. The borrower hopes to convince the lender that these defaults should not be grounds for loss of the non-recourse provisions. The lender responds that these defaults are for the most part the borrower s voluntary acts and that the borrower can comport itself so as to maintain the nonrecourse provision. To the borrower, this sounds like punishment for bad behavior. Culpability should not govern its exposure, says the borrower; the lender should only be entitled to recover -2-

3 what it has lost. Since it is difficult as a moral issue but not so much as a business issue to argue for exculpation in the face of conscious wrong-doing, the lender often prevails on its claim for a loss of recourse in the event of the borrower s culpable conduct. Sale or Encumbrance The borrower does not believe that its loan should be recourse and that its lender should be able to sue on the note without foreclosure in some states if the property is encumbered or sold. If it accedes to such a provision, the borrower should insist that it be allowed to make immaterial conveyances that benefit the property (such as utility easements), or conveyances among affiliated entities comprising the borrower, or conveyances of minor interests without a change in control, and that a mechanic s lien or a second lien for improvement of the property or for capture of some of the equity in the property as a result of appreciation should not be considered encumbrances for those purposes. The borrower believes that the lender is protected against any other encumbrances or sales because they are defaults giving rise to the right to foreclose. Bankruptcy and Claims by the Borrower The borrower may doubt whether the ipso facto provisions of the Bankruptcy Code allow an increased liability on account of the commencement of a bankruptcy proceeding, and it may wonder whether the loss of the non-recourse provisions is an unenforceable penalty. If the lender can get relief from stay and sell the property for the loan amount, what has the lender lost? The borrower submits that its liability should not exceed the lender s loss, and that the lender s remedies for bad faith filings protect it. Certainly, the borrower does not want any liability on account of bankruptcy proceedings commenced against it by third parties, including the lender. Some lenders want to revoke the non-recourse provisions if the borrower asserts a claim against the lender (such as for lender liability or usury) or opposes foreclosure. Since it is hard to imagine a borrower succeeding in one of its claims but losing to the lender s claim of recourse, the most likely outcome seems the borrower s loss on both its claims and the lender s claim. The borrower believes that the lender is adequately protected by rules proscribing frivolous or groundless litigation. An ethical dilemma may lurk in a provision allowing recourse in the event of a bankruptcy or claim against the lender. A general partner of a limited partnership (or other control person having a fiduciary duty to investors) is caught between its duty to commence a bankruptcy if it is necessary to preserve the limited partners (or other investors ) investments, or to assert a good faith claim against a lender, and its risk of recourse if it commences a bankruptcy. Fraud The borrower is willing to assure that it has not committed fraud by means of a deliberate, intentional or willful falsehood. It is much more circumspect if the term misrepresentations is used in lieu of fraud. Misrepresentations may be immaterial or innocent (as in the delivery of mistaken documents prepared by third parties) or negligent (if the borrower is found to have a duty to have determined the accuracy of a statement). -3-

4 Breach of Covenants or Misrepresentations Regarding Environmental Matters Lenders uniformly shift the risk of the environmental condition of the property to the borrower; this carve-out is often embodied in a separate environmental indemnity agreement. The borrower believes that loss of non-recourse protection in its entirety is drastic if the property is contaminated. The borrower does not want the lender s damages to exceed the balance of the loan. Although clean-up costs could exceed the loan, the borrower wants those costs quantified before the lender puts itself in a position to be liable for them, for example, by foreclosure. This seems to be a prudent step from the lender s perspective because it is minimizing its damages and the amount of an unsecured loan it will have. Moreover, if the lender can recoup its loan from a sale of the property as contaminated, why should the borrower create excess value for the lender? The borrower wants to be certain that is liability ends after foreclosure, appointment of a receiver, or permitted sale. The lender may insist that the borrower remain liable for breaches that occurred before foreclosure. The borrower may insist on the right to do an exit environmental assessment and to have no liability that does not appear on that assessment. In addition to liability on account of contamination and perhaps overlapping it liability may be imposed for misrepresentations about the environmental condition of the property. The borrower will usually have no better idea about the environmental condition of its property than what it reads in the site assessment, but the borrower will often be required to make absolute warranties about it. The borrower cannot be fairly exposed to loss of its exculpation on account of an unwitting misrepresentation that the lender s compelled it to make in an effort to avoid risk to the lender. Moreover, the borrower s exposure to recourse may far exceed its cost to cure the breach. Last, the representation may be true when it is made, but it may become untrue as a result of circumstances beyond the borrower s control, for example, migration from a neighboring property or dumping by a stranger. The borrower may have liability on account of contamination and again on account of its misrepresentation about the environmental condition of the property. The misrepresentation may seem to support the loss of the non-recourse provision because it is false and culpable even though it is innocent and unforeseeable. The borrower may insist that it loses non-recourse protection only if it willfully contaminates the property. LOSS OF EXCULPATION TO THE EXTENT OF THE LENDER S LOSS In addition to the carve-outs discussed in Revocation of Exculpation in Certain Circumstances, there are other carve-outs and responses to them. These carve-outs create liability for damages and do not vitiate the entire non-recourse provision: Misapplication of insurance or condemnation proceeds. Failure to deliver security deposits and prepaid rents to the lender. Waste: Failure to discharge liens against the property. -4-

5 Failure to insure the property adequately. Failure to comply with laws. Failure to maintain the property. Removal of personal property Failure to pay taxes and insurance. Failure to pay the lender s other expenses under the loan. Loss of the property through RICO or forfeiture statutes. Generally speaking with regard to the carve-outs, the borrower does not want any liability in excess of the lender s loss, it does not want liability for amounts that the property could not support, and it does not want any liability after the appointment of a receiver or after a foreclosure or (at the very least) after a sale after foreclosure. These qualifications pertain to all the carve-outs. Misapplication of Insurance or Condemnation Proceeds The borrower prefers to limit its liability to its use of the proceeds of casualty losses or condemnation in violation of the security instruments. If misapplication means something else, the borrower wants to know about it. The borrower believes that it must apply the proceeds according to the security documents, but that it may use any undirected or excess proceeds as it wishes. Failure to Deliver Security Deposits and Prepaid Rents to the Lender The borrower prefers to indemnify the lender against claims for security deposits and prepaid rents and to have the opportunity to defend a tenant s claim for them. In many states the lender has no duty to refund the security deposit or prepaid rent of a tenant after foreclosure because the covenant to return the deposit or rent is personal and does not run with the land. The borrower does not want the lender to create good will by passing out security deposits and prepaid rents at the borrower s expense. Waste Waste can be of several kinds: permissive or commissive, meliorative or destructive. For example, adding a building is meliorative waste for which the borrower does not want recourse, if there is any. Instead of the vague word waste, the borrower prefers liability only for borrower s willful acts that permanently reduce the value of the property. There are several subtopics or examples of waste that may appear. The borrower s specific responses to the respective carve-out are: -5-

6 Failure to discharge liens against the property: The borrower prefers notice and an opportunity to defend the lender against these claims. Some may not affect the priority of the loan, and some may be the responsibility of a general contractor or tenant from whom payment should be sought. Failure to insure the property adequately: If a casualty occurs, the borrower does not want liability if it has insured the property as the lender required. Failure to comply with laws (such as the Americans with Disabilities Act) that require improvements to the property: The borrower wants the opportunity to contest the need to comply. This is certainly true of legal requirements arising after the loan is made. Failure to maintain the property: This is much stricter than liability for waste, and readily susceptible to fair-minded disagreement. Is the borrower liable for latent construction defects that the lender s engineer did not observe when the loan was made? Removal of personal property: The borrower wants the latitude to discard or replace obsolete property without risk. Failure to pay taxes and insurance: If the lender has required escrows for taxes and insurance, the borrower will not want to be liable for the amounts it has paid. The borrower does not want to be liable to taxes accruing or special assessments payable in installments for which approved tenants are liable. If the borrower agrees to be liable for real estate taxes, for how long after a default or after foreclosure will it remain liable? Failure to pay the lender s other expenses under the loan: The borrower believes that these are the lender s cost of doing business. If it loses that argument, the borrower wants these to be reasonable and it wants them to be only identified expenses for which it is liable under the security documents. If the lender is liable to incur a transfer tax in connection with a sale of the property after foreclosure, the borrower wants liability only if the sales price does not cover the transfer tax. Loss of the property through RICO or forfeiture statutes: The borrower can hardly expect the lender to suffer because of the borrower s criminal conduct of which the lender is unaware. OTHER PROVISIONS Other Damages The borrower would like to preclude the lender from seeking special, consequential or punitive damages. -6-

7 Protection of Other Parties The borrower wants a clear expression that no limited partners, shareholders, or beneficiaries, or managers, officers or directors (in their capacities as such) have liability for repayment of any obligation to the lender. This is important because of the lender s possible claim of improper distributions or ultra vires acts. The lender will usually insist upon recourse allowed by relevant partnership and corporate status. The creation of a single purpose entity which the lender often requires may seem to make these carve-outs immaterial. After all, one might wonder, the entity only has what it has and no more. There is usually not an entirely satisfactory response because the general partner of a limited partnership may have assets from other projects and the lender often requires a financially responsible member of a limited liability company to assure performance of the carve-outs, especially environmental indemnities. CONCLUSION The carve-outs are often divided into culpable and non-culpable defaults. The culpable defaults are borrower s acts, such as fraud or the commencement of bankruptcy. The lender proposes that the occurrence of one of those defaults end the non-recourse provisions entirely. The borrower does not believe it should be liable for any cost that the property cannot support. Putting aside the question whether the lender s recourse should be different on account of culpability, one can wonder whether the distinction is clear. For example, if the property has cash flow problems, why should the borrower be penalized for commencing bankruptcy to save the property instead of giving the property back to the lender so it can invest more money? The difficulty of making distinctions between culpable and non-culpable defaults is often underscored in the provisions regarding the environmental condition of the property; the borrower may be compelled to make a representation that is false (although not known or knowable to the borrower) or becomes false (without any act or omission by the borrower) and that seems culpable and deserving of the loss of exculpation. The carve-outs in many lenders documents try to impose recourse liability for real estate taxes, insurance, and maintenance and to excuse the borrower only from the payment of principal and interest. Put differently, under those documents the borrower must maintain sufficient cash flow to pay all other expenses of the property or be personally liable for them. The lender and the borrower differ on the question whether the borrower can default the day after the loan closes and have no further liability. -7-

8 BIBLIOGRAPHY Barnes, John E., Don t Sound the Death Knell for Nonrecourse Lending Yet: A Proposal for Determining a Nonrecourse Lender s Standing Under the Uniform Fraudulent Conveyance Act, 49 The Business Lawyer at 669, February 1994, discussing Travelers Ins. Co. v. 633 Third Assocs., 973 F.2d 82 (2 nd Cir. 1993). Edwards, Charles L., Commercial Mortgage Loan Commitments: A Borrower s Perspective, Probate & Property, July/August 1994 at 28. Fingersh, Jack N., Borrower s Retained Rights in Loan Documents and a Brief History of Carve Outs in the Exculpatory Clause, The Rise After the Fall Real Estate in the 90s, ACREL, Spring Jones, Richard D. and Thompson, Robert A., Outline for Workshop on Current Issues Confronting Lenders: Focus on Rollovers and Restructuring, The Rise After the Fall Real Estate in the 90s, ACREL, Spring Russman, Mortgages: Nonrecourse Financing vs. Action for Waste, 23 Real Est. L Rep. 5, Oct. 1993, at 6, discussing Travelers Ins. Co. v. 633 Third Assocs., 973 F.2d 82 (2 nd Cir. 1993). St. Claire, Frank A., Nonrecourse Debt Transactions: Limitations on Limitations of Liability, 19 Real Est. L. J. at 19 (1990). Thompson, Robert A. and Smith, Brian D., Negotiating Loan Transactions, in Commercial Real Estate Transactions Handbook, (3d ed. 2000). -8-