Whether you are the party seeking financing for a deal or you are the party with some cash and someone is seeking to borrow that money for a deal they are working on, the topic of personal guaranties is one that you, as a real estate investor, are sure to encounter frequently. When the borrower is relatively new to investing and the lender is more experienced and developed, a formal and broad personal guaranty is often unavoidable. However, as the borrower develops and the benefit to the lender and borrower become more equal, borrowers will often seek to avoid personal guaranties. This article covers two personal guaranty ‘alternatives’ that both borrowers and lenders should be aware of to help bridge the gap between a lender wanting a full guaranty and a borrower wanting none.
First, let’s discuss ‘bad-boy carve-outs’. While I’d love to tell you that this has something to do with the great buddy-cop comedy featuring Martin Lawrence and Will Smith, our subject matter is a bit more dry. Bad-boy carve-outs are a series of terms in a contract that would allow the lender to pursue the borrower individually when no general personal guaranty exists. In an instance where the lender wants to protect itself, but the borrower is unwilling to sign a personal guaranty, bad-boy provisions can be agreed to, stating that when the borrower does any of the listed ‘bad’ acts, the borrower then becomes personally liable to the lender. Some of the common bad-boy carve-outs are:
1) Acts of fraud by borrower;
2) Financial irresponsibility by borrower; and
3) Acts in breach of certain terms of the loan that increase the risk to the lender.
Bad-boy carve-outs are often drafted by the lender, and then can be negotiated by the parties. Ultimately, by using bad-boy carveouts, the lender is able to better protect itself and the borrower is able to truly control, by avoiding a specific list of “bad acts”, whether or not it becomes personally liable for the debt. This is a win-win!
Like bad-boy carve-outs, burn-off provisions can serve to balance the protection a lender is seeking with the more limited recourse a borrower desires. The concept behind burn-off provisions is that, during the lifespan of a secured loan, certain things may occur that naturally reduce the risk faced by the lender. These are often events that materially change the loan-to-value ratio (“LTV”), such as:
1) The payment of certain balloon payments;
2) The re-zoning of the secured property resulting in an immediate increase in value; or
3) Progress on construction or remodeling projects.
In the case of default AFTER such an event, the lender is more likely to be able to cover the loan value through foreclosure than prior to the event. Because of this, the lender may be more willing to terminate a personal guaranty, knowing that their risk of not realizing their full investment is reduced. With all that in mind, a borrower and lender can negotiate and document, in the loan documents, certain events that will allow the personal guaranty to be terminated. These terms are known as “burn-off” provisions. Sometimes, a burn-off provision can be as simple as a milestone with regards to LTV, such as “when LTV is less than 50%, the personal guaranty will terminate.” Other times, a burn-off provision can be a specific event, such as “when the property is re-zoned from industrial to residential, the personal guaranty will terminate.”
As you can see, by utilizing bad-boy carveouts and burn-off provisions, borrowers and lenders can compromise on personal guaranties in ways that accommodate the interests of both parties. At Phocus Law, we have extensive experience representing both borrowers and lenders in financing transactions, including the use of bad-boy carve-outs and burn-off provisions. We would love to help you in your next transaction!
by Michael J. “Mick” McGirr, Phocus Law