A Surprising and Risky Trend in Commercial Real Estate Lending Practices by Shea A. Smith, CPA

Posted on February 03, 2016 by Shea Smith

There was a time when non-recourse financing for commercial real estate projects protected borrowers against personal liability for a loan gone bad. Lenders would look solely to the underlying assets of the project to recover losses when a loan defaulted. However, as times have changed, so too have these protections. An increasing number of non-recourse loan agreements now include carve-out provisions that essentially turn non-recourse debt into a recourse loan, for which the borrower holds personal liability for repayment. Today, these provisions, known as bad-boy guarantees, often cover actions beyond the borrower’s control that may send a loan into default. As a result, borrowers are often surprised to be caught in a lender’s crosshairs and personally liable.



Bad-boy guarantees were once included in non-recourse loans solely to protect lenders from borrowers who knowingly or intentionally committed specific bad acts, such as fraud, misappropriation of funds or breach of an environmental representation. When a borrower performed any of these egregious acts, the lender had a claim against the borrower personally to recoup losses.


Today, however, the pervasiveness of bad-boy guarantees in commercial financing has expanded to cover a wider range of breaches, including single-purpose entity covenant violations, impermissible transfers or bankruptcy.  Moreover, under various state laws, the courts have enforced these provisions without much interpretation, instead basing their rulings on the sophistication of the parties and the specific terms of the agreements.


As a practical example, consider the 2011 case of Wells Fargo Bank, N.A. v. Cherryland Mall, in which the Court of Appeals of Michigan found the borrower liable for a $2.1 million deficiency claim on an $8 million non-recourse loan due to a violation of a standard single-purpose entity (SPE) covenant.  When the real estate market declined in 2009, Cherryland became insolvent. Despite the borrower’s lack of a voluntary or willful “bad-boy” act, the court ruled that the SPE covenant clearly required Cherryland to remain solvent and deemed the borrower personally liable for the debt.


All Bad Boy Guarantees are Not Created Equal

Borrowers must understand that there is a distinction between above the line and below the line acts that will result in significantly different levels of liability. Above the line acts will result in a guarantor being held liable for only the actual losses the lender incurred as a result of a “bad act,” whereas below the line acts will trigger liability for the entire amount of the loan.


Key Takeaways

It behooves borrowers to evaluate personal guarantees as soon as they start negotiating new debt. They must carefully review the term sheet and be sure they understand the language and full scope of a lender’s bad boy guarantees before signing with their agreement. Some items that are in the borrower’s best interest to consider include the following:


  1. Recognize the difference between above the line and below the line acts and negotiate terms so that below the line guarantees are reserved for the most egregious “bad-boy” acts, such as fraud or misrepresentation;
  2. Do not agree to recourse provisions triggered by general single-purpose entity covenants, especially those relating to adequate capitalization and solvency;
  3. Try to exclude from carve-out provisions acts by third parties, such as those caused by environmental issues and tenant lease terminations, which may be outside the borrower’s control;
  4. Seek to limit non-recourse carve out provisions to traditional “bad boy acts” that require bad intent or self-dealing by the borrower.  It is vital that real estate professionals engage both an accountant and real estate attorney early in the debt negotiation process to avoid an unpleasant surprise if something goes wrong with the deal in the future.

About the author: Shea A. Smith, CPA, is a director with Berkowitz Pollack Brant’s Audit and Attest Services practice, where he provides accounting, audit and consulting services for privately held businesses in the real estate, construction, manufacturing and retail industries. He can be reached in the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at