Hotel Bankruptcy: Owner Liability Under Nonrecourse Carve-Out or “Bad Boy” Guaranties
By Julian Gurule Associate Attorney, Milbank, Tweed, Hadley & McCloy LLP | March 09, 2014
I. Nonrecourse Carve-Out Guaranties
Although each property has its own financing structure, hotel financings are generally nonrecourse, which means lenders can only look to their collateral, namely the real property itself, for satisfaction of their claims. If a loan is fully nonrecourse, the property owner has no personal obligation to repay the hotel's loans. Often, however, the lender will require the owner to provide a guaranty that is triggered upon the occurrence of certain specified events, such as (a) the borrower entity's failure to maintain single-purpose entity status, (b) entering into new financings or junior loans, or (c) its filing for bankruptcy.(1) Thus, despite the fact that the underlying loan is nonrecourse, the owner may face substantial personal liability if any carve-out defaults are tripped.
From the lender's perspective, the nonrecourse carve-out guaranty serves two functions. First, it creates a clear disincentive for the owner to take actions that may be adverse to the lender's interests (e.g., filing a chapter 11 petition or diverting funds that must be applied in a specified way under the loan documents).(2) Second, in the event that the borrower, as controlled by the guarantor, acts in a way that falls within the terms of the nonrecourse carve-out, the guarantor presents an additional source of recovery for the lender.
II. Are Nonrecourse Carve-Out Guaranties Enforceable?
Nonrecourse carve-out guaranties are generally enforceable. Courts will often treat the guaranty as a simple contractual obligation entered into between the owner and the lender. Particularly where the owner is a sophisticated party with substantial experience in real estate transactions, courts will hesitate to deny the lender the benefit of its bargain. For example, in Bank of America v. Lightstone Holdings, David Lichtenstein ("Lichtenstein") and Lightstone Holdings, LLC ("Lightstone"), together with a consortium of investors, partly financed their acquisition of the ESH hotel chain through $1.9 billion of mezzanine debt issued to third-party investors in June 2007.(3) As part of the loan transaction, and as additional security for the lenders, Lichtenstein and Lightstone provided a personal guaranty of up to $100 million to the lenders in the event that any of the borrowers commenced a voluntary bankruptcy case.((4) In June 2009, the borrowers filed voluntary chapter 11 cases and the lenders sued Lichtenstein and Lightstone on the guaranty.(5) The court held that the guaranty was enforceable and found Lichtenstein and Lightstone personally liable for the full $100 million guaranty.(6) In its reasoning, the court noted that Lichtenstein and Lightstone were sophisticated distressed real estate investors and that similar guaranties are common in commercial mortgage transactions.(7)
While a borrower's bankruptcy case plainly subjects a lender to the type of risk that nonrecourse carve-out guaranties are designed to protect against, the occurrence of seemingly less consequential events may also trigger personal liability under a guaranty. In some cases, liability has been imposed on the guarantor even when the lender is arguably unharmed by the event in question. For example, in Princeton Park Corporate Center v. SB Rental, the borrower's principals provided the lender with a nonrecourse carve-out guaranty, which made the loan fully recourse against the guarantors in the event that the borrower failed to obtain the lender's prior written consent to any subordinate financing encumbering the property. Three years later, the borrower procured a $400,000 loan secured by a junior mortgage on the property without obtaining the senior lender's consent.(9) Although the borrower repaid the subordinate loan seven months later without issue, when the senior loan later went into default, the senior lender asserted that the unapproved subordinate financing caused the senior loan to become fully recourse against the guarantors.(10) The court held that the guarantors were liable on the guaranty, reasoning that the loan and guaranty were part of "a commercial transaction negotiated between business entities with comparable bargaining power," and that the unambiguous language of the guaranty provided for the guarantor's liability in the event of an unapproved subordinate financing.(11) The court also rejected the guarantors' argument that they should not be liable because the lender was not harmed by the subordinate loan, which was quickly repaid. The court reasoned that: