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Borrower’s Objection to Lender’s Application for Receiver Results in Guarantor’s Full Liability on Construction Loan under Non-Recourse Carve-Out Guaranty

Finance Alert | March 4, 2013
By: Devon Morrissey and Steven Ostrow

In a recent decision, the Appellate Court of Illinois upheld a judgment for full repayment of a loan against guarantors pursuant to a non-recourse carve-out provision of a guaranty. The guarantors argued that the carve-out provision was vague and unenforceable, and that the sole purpose of the provision was to compel their immediate performance by discouraging the parties from taking any action against the lender. They also argued that it was unenforceable as a penalty. As the issue was one of first impression in Illinois, the court followed the growing trend among other jurisdictions and found the non-recourse carve-out provision valid and enforceable.

BACKGROUND

Joseph Freed and Associates, LLC (Borrower) obtained a $205M construction loan (Loan) from Bank of America, N.A. (Lender), guaranteed by the Borrower’s President and parent corporation. The guaranty limited the guarantors’ liability to $50.3M, subject to certain carve-out provisions that would convert the non-recourse guaranty into a full recourse guaranty if triggered. One of those carve-outs required full repayment of the Loan if “the Borrowers contest, delay or otherwise hinder any action taken by the Agent or the Lenders in connection with the appointment of a receiver for the Premises or the foreclosure of the liens, mortgages or other security interests created by any of the Loan Documents” (the No Contest Carve-out).

After the Borrower defaulted on the Loan, the Lender initiated foreclosure proceedings against the property and sought judgment against the guarantors for $50.3M . The Borrower contested the foreclosure and the court’s appointment of a receiver, after which the Lender sought recovery of the full amount of the Loan from the guarantors, relying on the No Contest Carve-out. The trial court entered judgment against the guarantors for the full amount of the Loan and the guarantors appealed, challenging the validity of the No Contest Carve-out.

REASONING

The guarantors first argued that the No Contest Carve-out was vague, ambiguous and overly broad by its terms. The guarantors claimed that the provision failed to alert the Borrower as to the specific acts that would trigger full recourse liability. The court, however, disagreed and found that the guarantors’ appeal of the trial court’s appointment of a receiver clearly qualified as an act to “contest, delay or otherwise hinder any action” in connection with the appointment of a receiver, and therefore that the terms of the provision were not vague.

The guarantors next argued that the No Contest Carve-out was an unenforceable penalty, contending that there was no correlation between the additional money owed and the actual damages suffered by the Lender. The guarantors maintained that the only purpose of the No Contest Carve-out was to secure their performance by discouraging them from taking any action against the Lender. As the issue was one of first impression in Illinois, the court examined decisions from other jurisdictions, including New Jersey and New York, that found similar non-recourse carve-out provisions enforceable. The Court relied on those decisions and reasoned that the No Contest Carve-out was not a liquidated damages clause because it provided for only actual damages, namely the full amount remaining on the Loan at the time the Borrower breached. Further, the court explained that the No Contest Carve-out did not prohibit the guarantors from contesting the appointment of a receiver or exercising their due process right to defend themselves against foreclosure. Rather, by contesting, the guarantors forfeited their exemption from full recourse liability and became obligated to repay the entire outstanding balance of the Loan.

The Illinois court reached its decision by following the growing trend among other courts to uphold non-recourse carve-out provisions. Broad carve-outs that trigger full or partial recourse against creditworthy guarantors remain one of the most effective ways to deter a borrower from engaging in bad acts and litigation strategies (including seeking bankruptcy protection) that may reduce the value of collateral and hinder and delay the prompt enforcement of a lender’s remedies. It is critical for parties to carefully negotiate, with the assistance of legal counsel, the scope of carve-outs to non-recourse guarantees, whether the guarantees are made at loan inception or are required as part of a post-default loan modification or workout.

If you have any questions regarding recourse against guarantors on a new or non-performing credit, please contact Devon Morrissey (morrisseyd@whiteandwilliams.com; 215.864.6313) or Steve Ostrow (212.714.3068; ostrows@whiteandwilliams.com).

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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