Lender Recourse in Non-Recourse Loans
Commercial mortgage loans traditionally have been non-recourse, with the lender agreeing to look solely to the real property securing the debt in the event of the borrower's default. The lender knows the borrower cannot abscond with the security and relies on the underwriting process to assure the adequacy of future rental income to pay operating expenses and service the debt. At a time when lender and borrower achieved a continuing relationship, it traditionally was assumed that if the borrower did default, he would agree to a negotiated remedy (such as a deed in lieu of foreclosure); or, if a foreclosure proceeding was begun, the borrower would not seek to unreasonably delay the process.
The 1980s changed the picture. Both borrowers and lenders, seeking to avoid heavy losses, sought to protect their respective interests in every way possible. Many borrowers facing foreclosure resorted to a bankruptcy petition, litigation alleging bad faith by the lender, or other delaying tactics that frustrated lenders seeking to gain possession of property or otherwise exercise their rights under the mortgage. Lenders discovered that the non-recourse mortgage had a serious defect: it failed to provide solutions to the practical problems of enforcing remedies after default.
The result was the development of "carve-out" provisions in non-recourse mortgages designed to assure a lender that a defaulting borrower will be forced to decide quickly either to perform under the mortgage or to abandon the property to the lender. Some examples of carve-out provisions are discussed below.
Initial Term Recourse
Personal liability by the borrower may be required during the initial years of the loan. This is particularly appropriate for newly constructed or distressed properties that are not expected to have a cash flow cushion (after operating expenses, debts and debt service are paid) for several years. An alternative approach is to require recourse until specified rental or net operating income (NOI) levels have been reached, as specified in the underwriting criteria of the lender. Again, the purpose is to protect the lender until he is satisfied the property can carry itself.
Top-of-the-Loan Recourse
Just as a cash flow cushion gives the lender assurance that debt service will be paid, an equity cushion gives the lender some assurance that in the event of a default, the property value will, at the least, equal the outstanding debt. A lender thus may require personal recourse for the top 10 or 20 percent of the initial loan amount, with liability declining as the loan is amortized. In drafting this type of provision, it should be clear that recourse will be reduced over time. Otherwise, the lender may take the position that the borrower is responsible for a specified dollar amount of the loan over its entire term.
Property Taxes and Mechanics Liens
When a lender agrees to look solely to the property for satisfaction of the mortgage, he does not intend to eliminate the borrower’s personal liability for property taxes and mechanics liens. Some courts, however, have construed non- recourse language to cover such obligations, with the result that a foreclosing lender will have no recourse against the borrower if forced to pay those obligations to the extent that they have priority over the mortgage lien). To avoid this result, the loan documents should make it clear that the non-recourse clause does not extend to these obligations.
Fraud or Misrepresentation
The borrower normally is required to make a number of representations in the loan documents—for example, the condition of the property, the absence of environmental contamination, and the terms of existing leases. The lender will require the borrower to assume personal liability in the event these representations turn out to be false. From the borrower’s point of view, it is important to clearly define what constitutes a misrepresentation or fraud. The borrower will seek to limit liability to situations of deliberate failure to disclose a fact known when the loan was made. This will exclude liability for negligent misrepresentation, which covers failure to disclose information the borrower should have been aware of. The distinction is particularly important with respect to environmental contamination. If the borrower is personally liable for losses due to contamination about which the borrower should have known, the borrower may have an open-ended obligation. In effect, this amounts to an allocation of risk to the borrower that may not be the intention of the parties.
Milking the Property
Finally, the lender will insist on personal liability for deliberate acts of the borrower in breach of the loan covenants or that reduce the value of the property. Examples include failure to pay property taxes on time, failure to maintain the property and receipt of advance rents from tenants. These acts sometimes are done when the borrower anticipates that the property soon will be lost to the lender. In addition, lenders may seek to "carve out" personal liability for borrowers if financial statements required by the mortgage are not filed promptly when due. Delayed reports often are an early warning sign of distress.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Anthony La Malfa is a Manager in the Real Estate and Hospitality Services practice in BDO Seidman’s New York office. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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