Bad Boys, Bad Boys, Whatcha Gonna Do: After Credit Suisse v. Boespflug Enforces a "Bad Boy" Guaranty, It May Be What the Bank Wants You to Do

Commercial real estate projects are typically financed with non-recourse mortgage loans for tax reasons. If the borrower defaults, the lender’s sole recourse is to foreclose on the mortgaged property to recover on any balance owed under the loan; it may not recover against the other assets of the borrower or its principals. This financing arrangement may create uncertainty for lenders, who are understandably concerned that the borrower and its principals may misuse the loan proceeds, thereby jeopardizing the lender’s full recovery in a foreclosure. This concern, coupled with rating agency pressures resulting from the increased securitization of commercial real estate loans, has led to the widespread use of non-recourse carve-outs, also known as “bad boy” guaranties. Generally, a “bad boy” guaranty provides for full-recourse liability against the guarantor if the borrowers, their principals or both commit certain “bad” acts that threaten the value of the mortgaged property. Examples of non-recourse carve-outs include:

• losses for fraud or intentional misrepresentation;
• losses from the misappropriation of rents;
• losses from the failure to pay taxes;
• allowing further encumbrance of the mortgaged property without the lender’s consent;
• transfers of secured property without the lender’s consent; and
• the borrower filing a voluntary bankruptcy petition.

A recent case, applying New York law and involving the enforceability of a “bad boy” guaranty, demonstrates that while a lender may not be able to prevent a borrower’s principals from committing all bad acts that threaten the value of the mortgaged property, the lender may be able to keep the borrower out of bankruptcy. In Credit Suisse v. Boespflug,[1] a court addressed the enforceability of a “bad boy” guaranty that imposed recourse liability for the primary lender’s actual damages against the borrower’s majority principals for committing all but one bad act prohibited by the guaranty. Had the borrower voluntarily filed for bankruptcy, the other “bad boy” clause, which was not breached, would have triggered full recourse liability on any deficiency owed under the underlying loan.

This case is initially significant because the primary lender did not have to foreclose on the mortgaged property before it enforced the guaranty, thereby expediting its recovery. But more importantly, this guaranty actually kept the borrower from voluntarily filing for bankruptcy because it would have imposed a higher penalty for doing so.

Facts

In Boespflug, a borrower obtained a $250 million loan from multiple lenders to build a resort. The non-recourse loan was secured by the real property on which the resort was located and by the fixtures and personal property located within the resort. Additionally, one lender (“the primary lender”) required the two majority principals of the borrower to execute a non-recourse guaranty, which contained a New York choice-of-law clause. The three-part “bad boy” guaranty, however, contained certain carve-out provisions that would trigger recourse liability.

Under the gauranty’s first provision, the majority principals would be personally liable “for any actual loss, damages or expenses (including reasonable attorney’s fees and disbursements), suffered or incurred by [the primary lender] or any lender arising from” numerous bad acts. Among others, personal liability would be triggered if the borrower (1) misappropriated funds; (2) transferred secured property without authorization; (3) failed to continue operating as a Single Purpose Entity; (4) incurred further indebtedness without authorization; (5) allowed a lien on any collateral for a period of more than 10 days; or (6) failed to pay real property taxes to the extent that there were sufficient funds to pay. A breach under this provision, however, would not trigger recourse liability against the majority principals for a deficiency on the underlying loan.

However, a breach of the guaranty’s second provision would trigger full personal liability on all obligations under the loan agreement. Under the second part of the personal guaranty, the majority principals would become personally liable on the entire loan obligations if the borrower filed a voluntary petition for bankruptcy or voluntarily sought protection from any similar federal, state or foreign reorganization law.

The guaranty’s third provision was an enforcement clause, which provided that the borrower’s majority principals “agree[d] to reimburse [the primary lender] for, and hold [the primary lender] harmless from and against, any and all losses, damages, claims, costs or expenses (including reasonable attorneys' fees), deficiencies and liabilities incurred, suffered or sustained by [the primary lender] . . . as a result of, arising out of or in connection with the enforcement of this Guaranty.” Thus, this clause simply provided that the majority principals would be personally liable for the primary lenders’ costs arising from enforcing the guaranty.

Less than two years after entering into the loan agreement, the borrower defaulted on the loan, and the lender initiated a state court proceeding (1) to foreclose on the secured property, (2) to determine any deficiency owed by the borrower or its subsidiaries, and (3) to appoint a receiver. While the state court action was still pending, the primary lender brought suit in federal court to enforce the personal guaranty against the majority principals.

In the federal court action, the primary lender alleged that the guaranty’s first provision was breached when the majority principals (1) failed to deposit funds into a bank account that was secured by the primary lender; (2) caused the borrower’s subsidiaries to merge with and into the borrower; (3) permitted over $13 million in mechanics’ liens to be filed against the resort; (4) allowed a $780,000 mortgage to be recorded against the resort; and (5) failed to pay property taxes. The primary lender did not seek damages for the deficiency on the underlying $250 million loan. Rather, the complaint only demanded the actual damages resulting from these alleged breaches of the personal guaranty from the majority principals.

In response, the majority principals filed two motions. The majority principals first moved to dismiss the claim for a lack of diversity jurisdiction, alleging that the primary lender was suing as a conduit for the unnamed lenders, or alternatively, to dismiss it for failure to join any indispensable parties—the other lenders. In the alternative, the majority principals moved to require the primary lender to identify the unnamed lenders and requested a more definite statement of any claims these unnamed lenders had against the majority principals.

The majority principals’ second motion also sought to dismiss the lender’s claims. The majority principals argued that under New York’s mortgage deficiency statute, the primary lender was barred from simultaneously foreclosing on the property and collecting on the personal guaranty. The majority principals asserted that the primary lender was required to foreclose on the property and obtain a deficiency judgment before it could enforce the personal guaranty.

Decision

The district court adopted the magistrate judge’s recommendation[2] that both motions be denied, with minor modification. The decisions on both motions relied on the fact that this was a dispute only between the primary lender and the majority principals over the personal guaranty, not the mortgage.

Majority Principals’ First Motion to Dismiss for Lack of Diversity Jurisdiction or Failure to Join Indispensable Parties, or in the Alternative, Motion for More Definite Statement

Regarding the first motion, the district court held that the primary lender was not acting as a conduit for unnamed lenders because the primary lender was the only lender who executed the personal guaranty with the majority principals and was suing only for damages that it, and not the other lenders, had suffered as a result of the alleged breach of the guaranty. Therefore, the primary lender was the only lender who had a right to sue under the guaranty and was acting to enforce its contractual rights. Thus, diversity jurisdiction existed because the primary lender was a New York citizen and the majority principals were both Idaho citizens. The court next rejected the argument that the unnamed lenders were indispensable parties because those unnamed lenders were not parties to the personal guaranty and could not assert claims under it. Finally, the court rejected the majority principals’ request for a more definite statement because it was unnecessary as a result of the primary lender’s standing to assert claims on its behalf.

Majority Principals’ Second Motion to Dismiss

The district court also denied the majority principals’ second motion to dismiss, rejecting the majority principals’ argument that under New York Real Property Actions and Proceedings Law §§81-1301 and 1371, the primary lender had to foreclose and obtain a deficiency judgment before it could enforce the guaranty. Under §81-1371, a mortgage creditor must move for leave to enter a deficiency judgment during the foreclosure action.[3] Moreover, the debtor who is personably liable under the mortgage must be named in the foreclosure action.[4] Under New York law, when a creditor fails to make a motion for a deficiency during the foreclosure action, it is assumed that the sale price fully satisfied the mortgage debt; therefore, the creditor has no right to further payment from the debtor. Section 81-1317(3) bars a creditor who failed to first obtain a deficiency judgment from subsequently enforcing a personal guaranty on the underlying mortgage.[5] The majority principals argued that the guaranty-enforcement action was barred because the primary lender had simultaneously sought to foreclose on the resort and enforce the personal guaranty.

The district court adopted the magistrate judge’s recommendation and held that these statutes, and the New York court’s interpretations of them, were inapplicable to the dispute over the personal guaranty. The magistrate judge noted that the primary lender was not seeking to collect on the deficiency owed under the loan. Rather, the primary lenders sought damages resulting from the alleged breaches of the personal guaranty. Although the damages were related to the underlying mortgage, the damages arose out of the breach of the personal guaranty, which was a separate contract from the mortgage. Therefore, because these damages were separate and distinct from any deficiency that may be owed, the New York statutes were inapplicable and did not bar the primary lender from pursing its claim against the majority principals.

The district court, however, rejected the magistrate judge’s alternative grounds for denying the motion. The magistrate judge had opined that the New York statutes, even if applicable, would not have barred the primary lender from simultaneously foreclosing on the resort and enforcing the guaranty because the resort was located outside of New York State.[6] Rejecting this argument, the district court concluded that had §81-1301 applied, it would have barred the simultaneous enforcement of the guaranty and foreclosure because both actions were brought in the same state.[7] Thus, had the New York statutes applied, the primary lender would have been unable to enforce the guaranty. The district court also rejected the magistrate judge’s assertion that the primary lender might obtain a double recovery if the foreclosure sale produced a surplus. This statement, which suggested that the proceeds from the foreclosure sale could pay damages resulting from the breach of the personal guaranty, was inconsistent with the determination that the personal guaranty damages were separate and distinct from any deficiency that may result from the nonpayment of the loan. Notwithstanding its modifications, the district court still denied the second motion to dismiss.

Discussion

This case may be more instructional because of what did not happen rather than what the court ultimately held. Although the majority principals breached several clauses in the personal guaranty, the borrower never voluntarily sought the protections of the bankruptcy law or any other similar state or foreign reorganization law. This then raises the question: Why? The likely answer seems to be that the majority principals faced far greater economic consequences from filing bankruptcy—full personal liability for any deficiency owed on the underlying loan—than they did from their alleged breaches of the first clause of the guaranty: only the primary lender’s actual damages. This seems to be the result of some very practical considerations on behalf of the primary lender.

First, the personal guaranty limited the majority principals’ personal liability for every bad act, except for the borrower voluntarily filing for bankruptcy, to the primary lender’s actual damages. This would seem, on its face, to be a poor decision on the primary lender’s part, considering the majority principals’ subsequent alleged breaches. Courts have routinely enforced “bad boy” clauses for breaches similar to those in the first provision of the guaranty in this case.[8] Moreover, a New York appellate court has enforced a similar bankruptcy “bad boy” clause.[9] It seems odd that the primary lender would structure the guaranty in a way that would forego a potential multi-million dollar judgment against the majority principals. Yet this may not be as strange as it appears at first glance. Had the primary lender obtained a judgment against the majority principals for the full deficiency, they likely would have personally filed for bankruptcy, which would have severely limited the primary lender’s ability to fully collect its judgment. Moreover, had the guaranty provided for full personal liability on the deficiency, the primary lender would have been forced to finish the foreclosure proceeding before it commenced the action to enforce the guaranty. By limiting its recovery to the actual damages for the breach, the primary lender could obtain a judgment against the majority principals much faster because it was not forced to foreclose on the resort first. It is still uncertain whether a lender, such as the primary lender in Boespflug, would actually be able to recover anything under the judgment on the guaranty. The lender, however, may be able to use the judgment to pressure the majority principals into agreeing to the foreclosure in exchange for a liability release. This leverage allows lenders to foreclose more quickly and prevent continued mismanagement.

Second, and more importantly, the personal guaranty created different levels of liability for different bad acts. The primary lender benefited from using a guaranty that imposes greater consequences for the majority principals if the borrower filed for bankruptcy than it did for the other bad acts: The borrower never filed a voluntary bankruptcy petition. Although the threat of the dreaded “new value” exception to the absolute priority rule, which allowed equity-holders to retain their ownership interests in an entity owning a building without paying all of the creditors in full by providing minimal capital contributions under a chapter 11 plan, has become extremely difficult to successfully implement in single-asset bankruptcy cases because of decisions like Bank of America National Trust & Savings Ass’n v. 203 North LaSalle Street Partnership[10] and In re Greystone III Joint Venture,[11] a lender still faces potential pitfalls in bankruptcy. First, bankruptcy provides the protections of the automatic stay, which both hinders a lender’s ability to foreclose expeditiously on the collateral and creates the risk of further devaluation resulting from mismanagement. Second, bankruptcy law can create uncertainty for a lender’s security agreement because of the Bankruptcy Code’s avoidance and claw-back provisions.[12] For example, a lender with a valid mortgage outside of bankruptcy may risk losing its mortgage as a result of a preference action.[13]

Even though courts have consistently enforced “bad boy” guaranties, borrowers continue being bad boys. It may be the simple fact that no matter what lenders do, desperate developers will breach their guaranties and risk personal liability in the hopes of a brighter tomorrow. That being said, Boespflug seems to suggest that although a lender may not be able to prevent a borrower’s principals from engaging in all types of misconduct, it may be able to keep the borrower out of a bankruptcy court. A lender who prevents the borrower from filing for bankruptcy can minimize its losses by more quickly foreclosing on the property.

The guaranty in Boespflug, however, did not totally eliminate the threat of bankruptcy. In an interesting twist, the majority principals did not own the borrower directly; rather, they owned the borrower through investment entities. In an effort to get the protections of bankruptcy without incurring full personal-recourse liability on the underlying loan, the majority principals had the investment entities, and not the borrower, file. While the majority principals had hoped to use the automatic stay as a shield to prevent a foreclosure while they tried, ultimately in vain, to obtain alternative financing, the case was dismissed after eight months in bankruptcy as a bad-faith filing.[14] This type of action is exactly what the primary lender had sought to prevent. The primary lender may have been able to prevent this filing had it put in a clause that triggered full recourse liability for any deficiency against the majority principals if they allowed the investment entities to file a voluntary bankruptcy petition. It is unclear whether a “bad boy” clause directed at the conduct of a borrower’s underlying investors, and not the borrower itself, would be enforceable. However, courts have enforced all other “bad boy” clauses. Moreover, preventing investment entities from filing relates to the underlying loan because it allows the lender to foreclose against the property with less time and expense—the same purpose of borrower bankruptcy “bad boy” clauses. This is not to say that bankruptcy “bad boy” clauses are, or even can be, completely effective. A clause that triggers recourse liability against a principal for filing personally may be seen as an unenforceable pre-petition waiver of the right to file bankruptcy. At the end of the day, this may not be a monumental problem because the lender will likely be able to successfully argue that any bankruptcy filing by the investment entity or principal was in bad faith.

Conclusion

Boespflug illustrates the utility of a “bad boy” guaranty that creates different economic consequences for different bad acts. Boespflug is important because the court’s holding allowed the primary lender to enforce the personal guaranty against the majority principals without first foreclosing on the mortgaged property. Yet the real lesson of Boespflug may be that a guaranty that only provides full recourse liability for the borrower filing a voluntary bankruptcy, while limiting the recourse liability of the principals to the lender’s actual damages for every other prohibited bad act, will actually keep the borrower out of bankruptcy. Therefore, although a lender cannot prevent developers from being “bad boys,” a well-written non-recourse carve-out may be able to prevent them from doing something the lender really does not want them to do.