Sunday, July 15, 2007

Bad Boy Guaranty

Bruce Falby wrote an article in Real Estate Finance and Investment on the case of Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, as Trustee for the Registered Holders of Credit Suisse First Boston Mortgage Securities Corp., Commercial Mortgage Pass-Through Certificates, Series 1999-C1, and CSFB 1999­C1 Royall Street, LLC.

Don't Mess With the Collateral: A Cautionary Tale

The significance of the case is that the court enforced a "bad boy" non-recourse carve-out guaranty against principals of a borrower.

Full guaranty of real estate loans is rare these days. However, lenders do generally require a bad-boy guaranty from principals of the borrower. The guaranty will trigger full recourse against the borrower and its principals in cases of fraud, misapplication of funds, transfers of the mortgaged property or other egregious behavior. Sometimes the guaranty will be limited to the amount of damages, rather than a full guaranty of the debt.

In the Blue Hills case, the borrower settled a zoning dispute with a neighboring property. The principals pocketed the $2 million cash settlement, rather than depositing the settlement into the borrower's account. With the zoning dispute settled, the neighboring property owner was able to complete its property. The single tenant of the borrower's property did not renew its lease and moved into the neighboring property. With no tenant and no rent payments, the borrower stopped making payments on its mortgage loan and the lender foreclosed.

The lender was not happy to find out that the principals pocketed the $2 million rather than making it available to the borrower to pay the mortgage loan.

The court found that under the language of the loan documents the $2 million settlement for the zoning dispute was part of the collateral for the mortgage loan. Therefore, the borrower and principals transferred a portion of the collateral in violation of the loan documents. As drafted, the bad boy guaranty made the principals liable for the full amount of the debt in the case of an unauthorized transfer of any portion of the collateral. Therefore the principals were liable for the $17.5 million loss of the lender.

This case is the first I have seen that enforced a bad bay guaranty. It should be no surprise that it was found to be enforceable. The case also makes it clear that the collateral for a mortgage loan can be more than just the real estate, in this case, a lawsuit affecting the property.

By messing with the collateral, the principals turned their $2 million windfall into a $17.5 million loss.

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