Nonrecourse Loans: Borrowers are still unaware of risk to becoming recourse

Last winter, I wrote about the state and federal court cases that were decided a year or so ago that rendered many so-called nonrecourse loans subject to higher likelihood of becoming full recourse to the borrower and guarantors.  Many owners of multi-family housing projects, shopping centers and other commercial property such as hotels finance their projects with CMBS loans that are nonrecourse to the borrower and guarantor for any deficiency balance, absent any "bad act" on the part of the borrower or guarantor.

It was always understand that the "bad act" had to result from an affirmative act, or omission to act, on the part of borrower or guarantor in order to trigger to full recourse by the lender against the borrower or guarantor for outstanding loan balance. The court decisions in Michigan last year turned this assumption on its head.  While the Michigan legislature passed legislation to counter the court cases, the precedent established by these decisions is still out there and may be adopted by courts in the other 49 states in future cases. 

With the flagging economy and the related depression of real estate values, many properties are failing to produce sufficient income to make the mortgage payments, keep the reserves funded and otherwise maintain the property in a pristine condition. This often isn't the result of a conscious decision on the borrower's part, rather the unfortunate outcome of a sluggish economy. 

Lenders, however, are in the unenviable position of watching their loan portfolio deteriorate and looking for solutions to stem the bleeding.  They don't really want to be saddled with the projects.  One solution is to go after the guarantor claiming a "bad act" has occurred and thus the guarantor has to pay off the loan. These are commonly known as "bad boy" provisions. Since the provisions are drafted rather broadly, a court can pretty much interpret them however it wants.

What I've seen in the past year is that many borrowers and their legal counsel appear to still be unaware of these risks and are not taking steps to negotiate the loan agreement, specifically the sections addressing separateness covenants and the "bad acts", more aggressively.  While lenders remain resistant to changing these provisions very much, most will entertain some limited modifications to clarify that there has to be more action on the part of the borrower or guarantor than just being the victim of a bad economy.  Borrowers and guarantors who don't try to negotiate some curbs on these "bad acts" provisions are exposing themselves to unnecessary risk.
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