Two recent New York cases have provided additional clarity with regard to the enforceability of “recourse carve-out” (or “bad boy”) guaranties in commercial mortgage transactions. The two cases-Bank of America, N.A. v. Lightstone Holdings, LLC, July 14, 2011, Case No. 601853 (Lightstone) and, UBS Commercial Mortgage Trust 2007-FL1 v. Garrison Special Opportunities Fund L.P., March 8, 2011, Case No. 652412 (Garrison)-were decided by the New York Supreme Court (which is a trial level court, despite the court’s name) in New York County (Manhattan), and were decided by the same judge, Justice Melvin Schweitzer. In both cases, the lender was awarded summary judgment for the amount it sought to recover.
These decisions are significant for several reasons. First, the courts dismissed arguments that recourse carve-out guaranties violate public policy or are unenforceable penalties. Second, the courts ratified a common provision of the carve-out guaranty-that a voluntary bankruptcy filing triggers full recourse. Finally, the courts found that the guaranties were suitable for determination on summary judgment.
Recourse carve-out guaranties are required by lenders in most commercial real estate loans, whether the loans are portfolio loans or are securitized in the CMBS market. Because the borrowers are single purpose entities (SPEs) whose only asset is the real estate being financed, the guaranties seek to make a principal of the borrower-a “warm body,” that is, an individual or entity with financial assets other than the mortgaged property-responsible if certain bad acts occur. The carve-out guaranty is intended to be a deterrent to the borrower’s control parties, who might have economic or other reasons-such as the prospect of an attractive settlement-to harm the collateral or interfere with the lender’s bargained-for enforcement. There are two categories of “bad acts” in most of the carve-out guaranties in the marketplace: (i) those, such as diversion of rents or waste of the property, that give rise to the guarantor being liable for the lender’s damages, and (ii) those more serious transgressions for which the guarantor becomes liable for full repayment of the loan.
Both the Lightstone and the Garrison cases involved the full recourse provisions of a carve-out guaranty, triggered by a voluntary bankruptcy filing. In Lightstone, the borrower and its principal, David Lichtenstein, purchased Extended Stay Hotels with substantial mezzanine financing, secured by membership pledges. The borrower and Mr. Lichtenstein executed a guaranty stating that the mezzanine debt became fully recourse up to a specified cap of $100 million if the borrower or its affiliates filed a voluntary bankruptcy petition. In June of 2009, a voluntary bankruptcy petition was filed by the borrower (a mezzanine loan borrower) as well as by the underlying property owners, and the lender demanded payment by the guarantor of a $100 million liability pursuant to the guaranty.
In the Garrison case, the facts were somewhat unusual in that the recourse guaranty in question was delivered pursuant to workout discussions between the lender and the guarantor, who had acquired the property after the loan was in place. In connection with the workout discussions, UBS agreed to a forbearance period in return for a guaranty from Garrison that it would be fully liable for the loan if a voluntary bankruptcy filing occurred. After Garrison commenced a UCC foreclosure, the borrower filed for bankruptcy, thus triggering the guaranty.
Failed Substantive Arguments Against Enforcement
In both Lightstone and Garrison, the guarantors argued that the recourse guaranty violated public policy or constituted an unenforceable penalty. The “void as against public policy” argument had three prongs. First, it was argued that the bankruptcy provision in the guaranty violated public policy due to the possibility that it would cause a conflict of interest between the guarantor’s fiduciary duty to the borrower’s creditors and the guarantor’s self-interest. The argument suggests that a guaranty tied to another entity’s bankruptcy thwarts the public policy purposes of the Bankruptcy Code. It aims to apply the reasoning behind Section 365(e) of the Bankruptcy Code-prohibiting “ipso facto” clauses, which condition termination or default under an executory contract on the commencement of a bankruptcy case-to situations where the party seeking to avoid enforcement of the contract is not a party to the bankruptcy case. However, the Court in Garrison compared the situation to a typical parent-subsidiary guaranty and rejected any claim that public policy considerations should override the contract.
Second, the bankruptcy provision was alleged to be violative of public policy because it rewarded a lender’s aggressive tactics to secure an especially favorable deal not available in bankruptcy, thereby further exacerbating the already distressed commercial real estate market. Third, the defendants claimed that the guaranty constituted a penalty as it sought to punish the defendants for committing bad acts. The Garrison court rejected these arguments, declaring that the Court was not the proper venue to address the actions of an aggressive lender and that it would not “rewrite the rules relating to commercial real estate financing,” instead leaving such action to the legislative or executive branches. The Lightstone court concurred, stating “there is no public policy that would authorize defendants to walk away from their contractual obligations.”
The defendants’ argument that the guaranty represented a penalty was similarly unsuccessful. In each case, the Court found that the defendants, in the guaranty document, had knowingly and explicitly waived the right to raise this defense and that this waiver would be enforced because the defendants were sophisticated real estate investors familiar with these guaranties and the waivers they contained. Further, even if the defense had not been waived, the Court found it to be unavailing because the guaranty, in the words of the Garrison court, was an element of “legitimate financing arrangements with respect to real estate transactions and have been upheld in New York State and federal court.”
Failed Procedural Arguments
Procedural arguments were also central to each of the defendants’ cases. Both cases were decided on summary judgment under New York Civil Practice Law and Rules (CPLR) Section 3213. This statute, entitled “Motion for Summary Judgment in Lieu of Complaint,” allows plaintiffs to file for summary judgment at the outset of the litigation “[w]hen an action is based upon an instrument for the payment of money only or upon any judgment.” The defendants in both cases argued that the recourse guaranty was not suitable for this accelerated procedure because it contained other obligations, including performance obligations, as well as provisions that required reference to extrinsic documents. But the Court in both cases found that for purposes of the specific lawsuit-which demanded payment for the specific act of a voluntary bankruptcy filing-the guaranty was an instrument for the payment of money only, notwithstanding that the guaranty included other provisions which did not qualify as “payment of money only” provisions.
One must be mindful of the limitation of these rulings, particularly with regard to the summary judgment ruling. Neither case addressed a “damages” provision in the recourse guaranty being enforced. In fact, the Lightstone court suggested that, if damages were at issue, the expedited summary judgment statute might be unavailable. Also, because the determination of whether the guarantor was liable under the guaranty was limited to whether or not a voluntary bankruptcy had been filed, both courts did not need to address whether interpretation of provisions in the underlying loan agreement or other documents was necessary. A case where the court needs to go outside of the four corners of the guaranty document would be a more difficult one for summary judgment purposes.
Borrowers and lenders in New York and elsewhere should take note of these two recent decisions. It is now apparent that recourse guaranties and the bankruptcy provisions therein will likely be enforced by courts, notwithstanding public policy objections. Moreover, where a clear trigger—such as a voluntary bankruptcy filing—appears in the guaranty, parties should anticipate that the guaranty can be enforced on an expedited basis.
*This article will appear in the October 2011 issue of Pratt’s Journal of Bankruptcy Law.