Real Property Law
Non-Recourse Carveouts and COVID-19 – New Challenges
The coronavirus disease 2019 (COVID-19) pandemic has caused borrowers and lenders to take a fresh look at certain loan document provisions, including everyone’s favorite, the non-recourse carveouts.
This article addresses some of the common carveouts and will evaluate some of the potential impacts – although still unsettled – that the COVID-19 pandemic may have on these carveouts in a variety of contexts that may not have been relevant in the past.
For instance, Lenders typically prohibit borrowers from incurring additional indebtedness, even if the security for that indebtedness is subordinate to the lender’s mortgage. Violations of these restrictions often lead to recourse to guarantors – including, sometimes by way of prohibitions against additional indebtedness being camouflaged in single purpose entity (SPE) covenants (i.e., as an indirect recourse event that may not be apparent to even the most careful borrowers and their attorneys).
Restrictions on additional indebtedness make good business sense, and also mitigate certain legal risks, so we are not going to try to argue against this very settled convention, at least in principle. Lenders sometimes permit borrowers to incur a small amount of unsecured debt without the lender’s consent, subject to certain restrictions – e.g., amounts not to exceed a small percentage of the existing lender’s loan amount, not evidenced by a promissory note, not outstanding for more than 60-90 days.
But loan documents typically do not allow for, or contemplate, obtaining Federal funding from programs such as the Coronavirus Aid, Relief and Economic Security Act (the CARES Act) that was enacted by Congress in response to the COVID-19 pandemic. The CARES Act established the Payroll Protection Program (the PPP) to help small businesses maintain their levels of employment through the pandemic. Accordingly, before borrowers obtain any such funding, they should carefully examine their loan documents to ensure it is permitted – otherwise they will need to obtain consent from the lender without violating their loan documents.
Most loan documents will contain a recourse carveout for borrowers or guarantors who seek bankruptcy protection or make an assignment for the benefit of creditors. Some variants of “or borrower or guarantor admitting in writing its insolvency or inability to pay its debts as they become due” is often part of the same carveout.
It is easy to imagine a scenario during the COVID-19 pandemic that may violate this carveout and result in recourse. For example, suppose a borrower sends an email to its lender including the following text:
Several of our tenants, some of whom were entitled to withhold rent due to an emergency order issued by the Governor, informed us that they will not be paying rent for the next three months. We will therefore be a little short on our next debt service payment, and of course we intend to make it up once our tenants resume paying full rent, and repay us for deferred rent.Times are tough for everyone, so we are sure you will understand. Let us set up a time to speak at your convenience.
A literal interpretation of those words (which is how the courts have generally interpreted recourse carveouts) sounds like an admission, in writing, of borrower’s inability to pay its debts when they are due.
Wise borrowers try to modify the carveout, asserting that it is vague and can lead to unintended, and negative, consequences, particularly because courts have given lenders a lot of latitude on this point. Borrowers will try to limit the text to statements made “in a legal proceeding,” and expressly permit “any admissions or discussions with lender.” These clarifications will enable borrowers to truthfully and accurately inform lenders of objective facts related to their collateral, as they are occurring, so that the parties have an opportunity to initiate a constructive dialog.
A related situation may occur when the property is generating insufficient cash flow. This might arise in several different contexts, including in SPE covenants (such as “borrower shall remain (and intend to remain) solvent”), the failure to maintain the property (e.g., physical waste to the property) or the imposition of mechanic’s liens. Due to several court decisions that strictly interpreted recourse carveouts, borrowers try to make exceptions in certain carveouts to address the possibility that, if the property generates insufficient cash flow, the borrower may be unable to pay certain expenses, such as, for example, real estate taxes. So long as the borrower promptly advises the lender of its inability to satisfy certain financial obligations, due a shortfall in rental revenue through no fault of the borrower, the borrower should not suffer any adverse consequences.
The COVID-19 pandemic has resulted in many situations like this in the past several months – in fact, more than at any other time in recent memory. The borrower did nothing wrong; and therefore, there is no good reason for a material expansion of its liability for repayment of a non-recourse loan.
While borrowers and lenders try to cope with unique issues resulting from the COVID-19 pandemic, everyone is encouraged to apply the lessons we are learning to seemingly routine recourse carveouts language. While we intend to provide guidance on some issues, we do not consider all issues that need to be evaluated in recourse carveouts, or loan documents generally, based on our shared COVID-19 pandemic experience.
If you have any questions regarding the COVID-19 pandemic and its implications, please contact a member of DLA Piper’s Real Estate Finance team or your DLA Piper relationship attorney.
This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.