United States: Good Guys Beware: Five Things You Need To Know About "Bad Boy" Guaranties Before You Sign The Term Sheet

Oftentimes, when negotiating a non-recourse loan, the term sheet will provide that the loan will be secured by the lender's standard "bad boy" guaranty.  But what does this mean?  In most cases, it includes a much wider range of acts than you would think.  What was once a relatively short and simple list of bad acts has become a complex laundry list that can quickly turn your non-recourse loan into a full recourse loan. 

Because of the intricacies in the wording of bad boy guaranties, it is important for guarantors to understand the scope of the lender's proposed bad boy guaranty before signing the term sheet.  The following is a highlight of just a few of the things to look out for before agreeing to a bad boy guaranty: 

  1. Know What Carve-Outs Trigger Liability for the Full Loan Amount
    Most bad boy guaranties have two tiers of carve-outs: those acts that trigger liability for only the actual losses that are incurred by the lender as a result of the bad act and those acts that trigger liability for the entire amount of the loan.  Guarantors should try to negotiate the terms of the guaranty to provide that most of the bad boy acts will only cause the guarantor to become liable for the lender's actual losses (i.e., failure to pay taxes, violation of environmental laws and misapplication of insurance proceeds, condemnation awards or gross revenues).  Acts that result in liability for the full amount of the loan should be limited to only the most egregious acts. 
  2. Limit Bad Boy Acts to Acts by the Borrower and GuarantorNot Third Parties
    Acts by third parties should not trigger liability under a bad boy guaranty.  For example, while a voluntary bankruptcy filing may be considered, by some lenders, to be a bad boy act, a borrower cannot control involuntary bankruptcy filings against it and so an involuntary bankruptcy should not trigger liability under a bad boy guaranty.  Similarly, guarantors should try to exclude terminations of leases by tenants and environmental issues caused by other persons from the list of events constituting bad boy acts.  
  3. Thoroughly Review Single Purpose Entity Covenants
    Lenders typically include breaches by borrowers of their single purpose entity (SPE) covenants as bad boy acts.  Guarantors should carefully review each SPE covenant to determine whether it makes sense for a breach of such covenant to trigger liability under the bad boy guaranty.  SPE covenants can range from prohibitions on the dissolution, merger and sale of assets by the borrower to requiring the borrower to use separate letterhead.  Clearly, a guarantor's liability under the bad boy guaranty should not be triggered merely by the borrower's failure to use separate letterhead. 
  4. Watch Out for Requirements That the Borrower Remain Solvent
    Requirements that the borrower remain solvent are usually buried in the loan documents within a SPE covenant.  As discussed above, violations of SPE covenants often trigger liability under bad boy guaranties.  So if the borrower does not remain solvent, then the guarantor becomes liable.  The whole point of a non-recourse loan is to limit the borrower's liability to the mortgaged property if it becomes insolvent, so guarantors must pay special attention to the non-recourse carve-outs relating to solvency.  Some states have passed legislation to protect guarantors from liability resulting from these covenants by prohibiting triggers based on "post-closing solvency covenants" on the basis that they are against public policy, but until this becomes the practice in all states, guarantors need to be aware of this trigger. 
  5. Request Notice and Cure Rights  
    Guarantors should try to obtain notice and cure rights before they can be subject to personal liability under a bad boy guaranty.  This is particularly important if the bad boy acts trigger liability for the full amount of the loan.  Hopefully you will be able to successfully negotiate that most bad boy acts will only result in liability for the lender's actual losses.  But, if that is not the case and your liability for the entire amount of the loan can be triggered by a curable event (such as a mechanic's lien filing), then you should have the opportunity to cure the default. 

Because the scope of bad boy acts will vary from lender to lender, guarantors should request to see a copy of their lender's standard bad boy guaranty, and have it reviewed by their attorney, early in the loan negotiations when they will have the most leverage, particularly before giving the lender a "six figure" deposit check! 

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.

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