The Second Department's recent decision in G3-Purves Street v. Thomas Purves1 clarifies New York law on the enforceability of " bad boy" guarantees in nonrecourse loans.2
To protect themselves against the risk of default on the nonrecourse loans that are frequently used to finance commercial real estate development, lenders frequently bargain for limited personal guarantees by the principals to be effective if specific events, termed "springing recourse events" or "nonrecourse carve outs," occur. These events generally include failing to maintain the property, permitting the property to become encumbered by other liens, interfering with the lender's enforcement of its rights against the property, or filing a bankruptcy petition by a borrower in what is intended to be a bankruptcy "remote" structure.3
Courts in other jurisdictions have generally upheld the enforceability of bad boy guarantees.4 New York law was less certain, and in one recent New York County Supreme Court case5 the court declined to enforce a bad boy guarantee for what the court considered an immaterial default from a delay in paying taxes when due. In G3-Purves Street, the Second Department upheld the enforceability of the bad boy guarantee and rejected the guarantors' argument that a bad boy guarantee was essentially a liquidated damages provision that imposed an unenforceable penalty. Thus, it now appears that New York courts will also enforce nonrecourse carve outs against the guarantors, a welcome development for both lenders and borrowers in the commercial context. This article explores the court's reasoning in G3-Purves Street and discusses the practical implications of this decision.
Factual Background
In G3-Purves Street, Thomson Purves financed the development of a property in Long Island City, N.Y., through a $13,000,000 mortgage-backed loan from G3-Purves Street.6 The loan was supported by a Guaranty of Recourse Obligations executed by Baruch Singer and David Weiss, the principals of the borrower. The liabilities under the loan agreement were generally nonrecourse to Singer and Weiss, except upon the occurrence of enumerated "springing recourse events," which included the mortgaged property becoming subject to other liens, the borrower incurring other debt, or the borrower or guarantors failing to pay debts as they became due. Under the guaranty, the guarantors agreed to pay all of the debt due to the lender if a springing recourse event occurred. The loan agreement and guaranty contained no materiality threshold for the springing recourse events. Thus, for failing to pay even a relatively modest real estate tax, the guarantors could become liable for the entire loan.
The borrower allegedly violated the terms of the agreement by failing to pay approximately $90,000 of real estate taxes, failing to pay two Environmental Control Board liens of $650, and failing to pay a mechanics claim of $148,000. Based upon these defaults involving $238,650, the lender accelerated the debt and commenced an action to foreclose on its mortgage and recover a deficiency judgment against the guarantors. Although the original loan balance was for $13,000,000, the lender sought $20,000,000 for the principal, unpaid contract interest, default interest, exit fees, and other costs and expenses.
At the trial level, on the parties' cross motions for summary judgment, the guarantors argued that the guaranty was essentially a liquidated damages provision imposing an unenforceable penalty because it allowed for full recourse liability against the guarantors if any of the delineated acts occurred, no matter how minor the default. The Supreme Court rejected the defendants' argument, and found that the bad boy guarantee in the loan was enforceable. The defendants appealed, making the same argument before the Appellate Division, namely that "the remaining balance on the loan was grossly disproportionate to the amounts of the liens that had been filed against the subject property," and therefore the obligation to pay the loan as a consequence of the failure to pay the taxes was an unenforceable penalty. The Appellate Division affirmed the Supreme Court's decision, noting that nonrecourse carve outs had previously been held enforceable as against a partnership borrower and its partners,7 and holding that the carve-out clause was not a liquidated damages provision and was enforceable.
Analysis
Given the recent economic turmoil and well-publicized declines in real estate values, it is not surprising that there have been several recent cases in other jurisdictions involving the enforcement of bad boy guarantees in nonrecourse loans. Nor is it surprising that guarantors have sought to avoid personal liability by arguing that bad boy guarantees of nonrecourse loans are unenforceable penalty clauses, just as the defendants in G3-Purves Street did. Courts have rejected the penalty argument on two basic rationales: (1) The clauses address liability rather than damages;8 and (2) the clauses only provide for actual damages, not stipulated or predicted damages.9
Looking to the decisions of the Superior Court of New Jersey10 and the Northern District of Illinois,11 in its G3-Purves Street opinion the Second Department concluded that "the subject provision of the guaranty does not provide for liquidated damages, as the loan agreement only provides for the recovery of actual damages incurred by the lender."12 This is because, rather than fixing the amount of damages, the bad boy guarantees simply establish who is responsible for repaying the outstanding loan. The carve-out provision merely permits the lender to pursue the individual guarantors in addition to foreclosing on the property. Thus, instead of serving as a penalty, "when read in conjunction with the loan agreement" the bad boy guarantee "operates to define the terms and conditions of personal liability as opposed to affixing probable damages."13
The Second Department also followed the reasoning of other courts, which have held that bad boy guarantees are not unenforceable penalties because they only provide for actual damages. The court observed that "the guaranty does not provide for liquidated damages, as the loan agreement only provides for the recovery of actual damages incurred by the lender, to wit, the debt remaining on the unpaid loan at the time of default, which is an amount fixed by the terms of the loan and is not speculative or incalculable."14 Following a default under a nonrecourse loan with a bad boy guarantee, the lender may only recover the amount outstanding on the loan. The later a default occurs in the repayment period, the lower the amount of the outstanding debt, and the lower the amount a guarantor may be held personally responsible for. The damages are dictated entirely by the amount of the loan outstanding, not by the inclusion of any nonrecourse carve-outs or bad boy guarantees, thus supporting the court's position that carve-outs only provide for actual damages.
The Second Department's ruling rejecting a liquidated damages/penalty analysis in enforcing a bad boy guarantee is important in light of a recent New York County Supreme Court decision in ING Real Estate Financial (USA) v. Park Ave. Hotel Acquisition,15 where the court declined to enforce a bad boy guarantee. In that case involving a $90 million mortgage loan, the borrower failed to pay $300,000 in real estate taxes that were due on July 1, 2009, but promptly corrected the error, paying the taxes 19 days later on July 20, 2009. Thus, the court had to determine whether a 19-day delay in paying taxes was enough to trigger the full recourse obligation, making the guarantors fully liable for the loan.
The court determined that the default was remedied within the applicable contractual cure period. As an aid to the construction of what were argued to be ambiguous cure provisions in the applicable agreements, the court relied on the principle that a contract should be "interpreted in a commercially reasonable manner."16 In support of its conclusion that the grace period should be applicable, the court cited to Truck Rent-A-Center v. Puritan Farms 2nd,17 the leading Court of Appeals authority on liquidated damages, for the proposition that immediate liability for the entire amount of the loan was not a "reasonable measure of any probable loss associated with the delinquent payment of a relatively small amount of taxes." The court also commented that the plaintiffs "would have moving defendants potentially liable for the entire debt…if the Borrower is just one day delinquent in paying a dollar in property taxes," thereby suggesting that a liquidated damages analysis was appropriate in determining the enforceability of the nonrecourse carve outs.18
Subsequent to the court's decision in ING Real Estate and prior to the Second Department's decision in G3-Purves Street, other trial level courts had upheld the enforceability of bad boy guarantees in nonrecourse loans.19 In two cases where the lender sought to enforce the personal liability of the guarantors based on the filing of bankruptcy petitions by the borrowers, Justice Melvin L. Schweitzer in the Supreme Court, New York County, rejected the argument that bad boy guarantees constituted unenforceable penalties.20 However, in those cases, the court found that the parties had waived the right to argue that the guaranties were unenforceable penalties, and in discussing the merits said only that such agreements had been upheld in New York state and federal court.21 Thus, prior to the Second Department's decision in G3-Purves Street, it had been unclear whether other New York courts would follow the rationale in ING Real Estate Financial, or adopt Schwietzer's view as expressed in Garrison and Lightstone Holdings.
Subscribe to New York Law Journal
