Copyright 2010, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate–Mortgage Lending, October 2010
A lender sometimes makes a commercial real estate mortgage loan on a non-recourse basis to a borrower where the borrower has a proven track record and its asset has a value that is significantly higher than the loan amount. The essence of a non-recourse loan is that, upon the occurrence of a default by the borrower, the lender may look solely to the mortgaged property securing the debt. The lender will not be able to recover from or realize on the borrower's personal assets to satisfy liabilities arising under the loan. The lender's recourse is only to the mortgaged property, even if the lender suffers a deficiency after a sale of the property.
NON-RECOURSE LOAN CARVE-OUTS
It is rarely the case that lenders will accept nonrecourse provisions in commercial real estate loans without exceptions. Instead, lenders strive to restrict and qualify non-recourse provisions by identifying circumstances which trigger an exception to the otherwise non-recourse nature of the loans. In other words, under those circumstances, the borrower would have personal liability. The lender's ability to include in the loan documentation an extensive list of carve-outs or exceptions to the non-recourse provisions for certain enumerated events or egregious behaviours by the borrower is very much a function of market conditions and the negotiating strength of the parties. The specified exceptions result in personal exposure to the lender beyond the borrower's interest in the collateral when such events or "bad acts" occur. Lenders have managed to expand the scope of the non-recourse carve-outs over time.
From the perspective of lenders, non-recourse carveouts protect the value of their collateral. Lenders are naturally concerned with actions or events that may result in loss or dissipation of the collateral, and desire to mitigate or deter these risks that may adversely impact recovery. This is consistent with their legitimate interest in realizing the full value of the collateral.
FULL RECOURSE OR EXTENT OF LOSS
The scope of the liability imposed on the borrower will vary. In non-recourse loans, some "bad boy" provisions have the effect of converting the non-recourse loan to a full recourse loan such that the borrower becomes liable for the full amount of the loan. Other exceptions impose liability to the extent of the amount of losses or damages suffered by the lender arising from the occurrence of the exception, allowing the lender to recover specific amounts.
PROHIBITED BORROWER ACTIONS
The borrower may be constrained from taking certain actions. These actions conceptually fall into various categories on the basis of the risks that the exceptions are intended to address. Lenders, because of their view that these risks are of most concern, take the position that borrowers should become liable for damages or lose exculpation from personal liability altogether in the following areas:
Diminution of Collateral Value. Waste is a standard non-recourse exception. It describes the situation where the borrower has allowed the physical condition of the property to deteriorate. This exception reflects the lender's concern that waste will diminish the value of its collateral and impair its security. Along the same theme is the borrower's failure to maintain and repair the property. From the lender's perspective, another risk is the borrower's failure to pay real property taxes, resulting in the loss of priority of the lender's mortgage lien.
Diversion of Collateral or Proceeds. Equally detrimental to the lender is the diversion of the collateral or its proceeds by the borrower. Non-recourse provisions, therefore, have long included standard exceptions for the misapplication of insurance or expropriation proceeds, misappropriation of tenant security deposits or prepaid rents, removal or disposition of personal property or fixtures constituting the collateral from the mortgaged property, and the diversion of rents or other income of the property.
Material Misrepresentation or Fraud. Another carveout typically included in non-recourse loans relates to liability for material misrepresentation or fraud on the part of the borrower.
Environmental Contamination. The majority of mortgage lenders insist on full recourse to the borrower for environmental problems associated with the property and a breach by the borrower of the environmental covenants and warranties. Insofar as it relates to environmental contamination, the lender is less focused on culpability on the part of the borrower than on risk allocation. The lender asserts that as between the lender and the borrower, the risk should be borne by the borrower.
Violation of Prohibitions Against Transfer of Ownership or Subordinate Financing. A borrower faces full recourse liability if it violates restrictions on sale of the property or interests in the borrower or on secondary financing as described in the loan documentation (commonly referred to as due-on-sale and due-on-encumbrance clauses). These carve-outs stem from the lender's view that it is exclusively within the borrower's control to refrain from such prohibited acts so as to avoid full recourse.
Bankruptcy of Borrower. Another basic exception which will trigger full recourse liability for the repayment of the loan is the filing for bankruptcy by the borrower. The protection afforded by this exception is intended to prevent the borrower from delaying or hindering the lender's ability to enforce its security by declaring bankruptcy.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.