Traditional Guaranties Compared to Non-Recourse Carve-Out Guaranties

I love the television show Its Always Sunny in Philadelphia.  When The Gang has interactions with the legal system, it is often for absurd things like avoiding liability for parking tickets because they were trapped in a hotel closet during the World Series, or establishing liability for injuries to a party-goer’s eye during a bath salts-fueled wedding.  The Gang also sometimes relies on their own fake trials that take place in the bar, where they adjudicate the propriety of eating cold cereal in a car, for example.  Other times, they make it to actual court (or binding arbitration) for situations that real people may encounter in real life, such as divorce, which one of them (or which of their many enemies) has legal title to a foreclosed home, or who has priority over disputed claims to a lotto ticket.  There are many references to Bird Law, which is an actual thing.

If the reader is wondering what IASIP has to do with liability under a written guaranty, the answer is “not much.”  I just wanted to illustrate that all sorts of disputes make it into courtrooms.  Some of those disputes are nearly certain to lose, like The Gang’s parking ticket defense.  Likewise, in Tennessee, if a debtor is sued for a financial obligation evidenced by a guaranty governed by Tennessee law and signed by the debtor in Tennessee, the guaranty will almost certainly be enforced as against the guarantor.  As we detail in great depth in our treatise, Tennessee Section, The Law of Guaranties:  A Jurisdiction by Jurisdiction Guide to U.S. and Canadian Law, a link to which is available at our website, www.mbslawtn.com/attorneys, Tennessee law reads guaranties harshly against the guarantor, whether the guaranty be for payment and/or performance of obligations.  Fundamentally, of course, a guaranty is a contract of “secondary liability” under which the guarantor has an obligation to pay only upon default by the primary obligor.  But when a Tennessee guaranty has the right language and that payment obligation is triggered, it is generally very difficult to avoid that liability.  Most of the cases refusing to enforce a guaranty have some version of facts where lack of notice, marriage and divorce, forgery, fraud or other malfeasance is involved.  The strong enforceability of a properly drafted guaranty is one reason why they are so commonplace in construction and business loans where the owner(s) of the builder or business are entity(ies) or natural person(s) that has/have the assets satisfactory to pay the loan.

But recent years have seen the development of non-recourse carve-out guaranties, or so-called “bad boy guaranties,” which are often executed by natural persons when the borrower is a special purpose entity.  Originally, the carve-outs included things like fraud, waste, willful misrepresentation, misappropriation of funds, theft, arson and other activities or omissions that contain some measure of intent, malice or bad faith.  Over the years, the concept of non-recourse carve-out guaranties has expanded to include a lot of the things—called “springing recourse”—that would traditionally constitute events of default on a promissory note and trigger the guarantor’s liability on a traditional recourse guaranty, anyway.  These springing recourse items include things like:  borrower’s payment default, voluntary or involuntary Bankruptcy of the borrower or an affiliate thereof, borrower’s assignment for the benefit of creditors, appointment of a receiver, recordation of mechanic’s and materialmens’ liens, borrower’s failure to acquire insurance, repair property or pay real estate taxes, and any impairment of any lien.   

Accordingly, Ernie and I have, on occasion, been a little skeptical of these non-recourse carve-out guaranties because (a) they sometimes eviscerate the most important and valuable enforcement mechanism available to a lender; (b) they are more complicated than traditional guaranties, and therefore are more susceptible to expensive (though unlikely to succeed) court challenges; and (c) the “carve-outs” are often so wide-ranging that in the end, the non-recourse feature is not really non-recourse at all—that is, it would have been easier, and much less expensive, to just have a regular guaranty if the carve-outs are so broad that they swallow up the non-recourse feature and functionally make the guaranty a full recourse guaranty.  Of course, lenders compete with each other for borrowers’ business, and when the scale of the construction project or business enterprise reaches a certain point, non-recourse carve-out guaranties are inevitably part of the deal.

When negotiating the terms of a traditional guaranty or a non-recourse carve-out guaranty, practitioners should be aware of the pros and cons of each type, whether the non-recourse guaranty is so sufficiently broad that it should be characterized as a recourse guaranty, as well as the tax treatment for recourse liability and any subsequent workout that includes debt forgiveness.  As always, if any reader of these e-mail blasts has any questions about the world of guaranties, take a peek at out treatise, linked at our website, www.mbslawtn.com, or shoot us an email at mikeschwegler@mbslawtn.com, lisarosado@mbslawtn.com and erniewilliams@mbslawtn.com.  Similarly, if you want to make sure your form guaranties are updated to current law, want to prepare new recourse or non-recourse loan documents, or need to prepare loan documents for a specific transaction or loan, give us a call at (615) 372-0993.

Next week’s e-mail blast won’t be about Bird Law (I wish), but should be about something equally interesting.  Right now, I’m thinking about so-called “mortgage putback litigation.”

Michael Schwegler