Daily Development for Wednesday, April 27, 2010
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Husch Blackwell Sanders
Kansas City, Missouri

MORTGAGES; GUARANTEES; “BAD BOY” CLAUSE:” N.Y. court construes springing guarantee narrowly in favor of guarantors, saving them $60 million deficiency.  Court further suggests that not all events that literally would trigger a “bad boy” clause will do so - it depends upon expectations of the parties.

ING Real Estate Finance (USA) LLC v. Park Avenue Hotel Acquisition LLC, 2010 Westlaw 653972 (2/24/10)  (Unpublished)

This unreported New York case is important because, in the context of a major financing with professionally negotiated and prepared documents, a court will not give the lender the benefit of a springing guarantee as an exception to the non-recourse nature of the original debt where the events triggering the guarantee are of little consequence, short duration, and do not injure the interest of the guarantor.

The main part of the case, however, focused on an interpretation of the interaction between the “cure” provisions of the loan agreement and the “bad boy” clause.  The “bad boy” clause listed a large number of events that might trigger recourse liability, among them the incurring of any additional debt or a lien obtaining priority over the secured lien.  A separate default clause, which also prohibited additional debt and liens obtaining priority, provided a cure opportunity - in this case 30 days.

Following default on the $145 million mortgage, the borrowers also failed to make a tax payment in the amount of $279,000.  Lenders promptly pointed to this event as a trigger for recourse liability under the “bad boy” clause.  But the borrowers paid the taxes, with accrued interest, in less than 30 days.  Lenders claimed that this didn’t matter, since the “bad boy” clause provided for no cure. 

The court held that it was necessary to reconcile the default clause, which permitted cure, with the “bad boy” clause, which didn’t.  It stated that under New York law “the terms of a guaranty are to be strictly construed in favor of a private guarantor.”  The court concluded that necessarily the cure periods provided elsewhere in the agreement controlled whether the events to which they applied could be used as a trigger for the “bad boy” clause.  Thus, since the tax defalut had been cured within 30 days, and the senior lien thereby removed within 45 days, there could be no claim of recourse liability.

The court also noted that New York will not attempt to collect on a tax lien for at least a year, so lender’s position was in scant jeapordy.

This was the holding - but additional language in the opinion is also worthy of considerable note - even though it represents only the view of one judge.  This is because it follows the New Jersey appeals court decision in CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC, A-6307-07T2, 2009 WL 2431530. (N.J. Super. App. Div. 2009); August 11,  2009, which delighted lenders when it held that a relatively inoffensive event two years before default nevertheless triggered the bad boy clause in that loan - following the language of the documents exactly and finding no forfeiture or penalty problems.

Here, the closing language of the New York court expresses a quite different view:

“Finally, "[a] commercial agreement, of course, should not be interpreted in a commercially unreasonable manner or contrary to the reasonable expectations of the parties" . . . . Immediate liability for the entire debt is not a reasonable measure of any probable loss associated with the delinquent payment of a relatively small amount of taxes. Here, pursuant to [the bad boy clause], plaintiffs would have moving defendants potentially liable for the entire debt of up to $145 million if the Borrower is just one day delinquent in paying a dollar in property taxes or any other debt for which a lien may be imposed. Such an unlikely outcome could not have been intended by the parties, sophisticated commercial borrowers and lenders aided by competent counsel at the time of the drafting, and is impermissible under New York law]. . .  ["The rule is now well established. A contractual provision fixing damages in the event of breach will be sustained if the amount liquidated bears a reasonab
le proportion to the probable loss and the amount of actual loss is incapable or difficult of precise estimation. If, however, the amount fixed is plainly or grossly disproportionate to the probable loss, the provision calls for a penalty and will not be enforced."] [citations omitted] .

Comment 1: The editor believes that the fundamental objective of “bad boy” clauses is to enforce behavior rather than to insure that the lender is fully paid.  As a consequence, the editor believes that as against the mortgagor, “bad boy” language acts as a penalty for default and should be evaluated by liquidated damages analysis.

Comment 2: The problem is more acute when it comes to guarantors.  Such parties may or may not have any control over the behavior of the lender leading to behavior subject to a “bad boy” clause, and thus, the clause may have no impact on protecting the lender from the prohibited acts.  Still, the guarantor gets stung with a potentially huge liability.  The editor has believed that courts in general are not particularly sympathetic to guarantors, and so he’d pretty much concluded that the invocation of “bad boy” liability was just viewed by the courts as a gamble that was lost.  But the court’s far more protective language here may give guarantors some hope based upon close reading of the documents with the intent of the parties in mind, even though the editor still has a hard time seeing a penalty in the case of guarantors. 

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