Bad Boys Get Spanked: New York Courts Uphold Recourse Guaranties

Introduction

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 Guaranties

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.

Bankruptcy Provisions

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...