Guarantors Remain Liable for “Carve-out” Obligations, Despite Non-recourse Loan

Introduction

Believe it or not, guaranty contracts mean what they say.  If a guarantor agrees to reimburse a lender for misappropriated security deposits, unpaid taxes, and the cost of enforcement, then – not surprisingly – courts will hold the guarantors liable for these expenses.

In Investors Warranty of America, Inc. v. Arrowhead Business Center, L.P., the guarantors signed a limited guaranty contract obligating them to pay up to $350,000 if the borrower defaulted on the $5,250,000 commercial loan secured by an office building in Peoria.  In addition to this capped amount, the guarantors agreed to pay for certain “carve-out” expenses, including misappropriated security deposits, unpaid taxes, and costs of enforcement.  These types of “carve-out” guaranty contracts are sometimes referred to as “bad-boy” guaranties since liability only attaches if “bad” acts occur.  “Bad-boy” guaranties are thought to encourage cooperation by the borrower and guarantors if the loan goes into default.  These “bad-boy” or “carve-out” guaranties are rarely addressed by appellate courts, which makes the Investors decision somewhat of a rarity.

Case Summary

In Investors, the loan documents required the borrower and guarantors to pay for: (i) misappropriated security deposits, (ii) unpaid taxes, and (iii) for all costs of enforcement unless the borrower agreed “in writing” to transfer the property to the lender.  When the borrower defaulted, the lender sued the guarantors to recover not only the $350,000 cap, but also for the misused security deposits, the unpaid taxes, and the cost of enforcement.

i.          Security Deposits

The guarantors argued that the security deposits were “rents” that could be used for any lawful purpose.  Since the borrower used the security deposits for legitimate business expenses, the guarantors claimed that there was no “misappropriation.”  However, the loan documents specifically excluded security deposits from the definition of “rents” and expressly provided that security deposits would be held “in trust” for the lender.  The court followed the plain language of the contracts, and held the guarantors liable for the missing security deposits.

ii.         Unpaid Taxes

As for the taxes, a receiver appointed over the property paid the 2009 taxes out of the operating account instead of the borrower’s tax escrow account.  The receiver subsequently reimbursed the operating account from the escrow account.  The lender came out of pocket to pay the 2010 taxes.  The guarantors argued, convolutedly, that because the receiver paid the 2009 taxes out of the operating account such that (for a time) money remained in the tax escrow account, they should not be liable for the 2010 taxes.  The flawed argument ignored the economic reality of the situation, and the court correctly held the guarantors liable for the 2010 taxes.

iii.        Costs of Enforcement

Last, the guarantors argued that they should not be held responsible for the costs of enforcement because they fully cooperated with the trustee’s sale, and even stipulated to the appointment of a receiver.  The court again looked to the loan documents to dismiss this argument.  The loan documents provided that the guarantors would be liable for costs incurred unless the borrower “agreed in writing” to transfer the property to the lender.  There being no such agreement, the court appropriately held the guarantors liable for all enforcement costs.

Take Away Points

To avoid costly litigation over carve-out obligations, know what the guaranty contract says and expect a court to enforce it according to its terms.  By challenging the plain language of the guaranties in Investors, the guarantors may have increased their own costs and the “costs of enforcement” that they will end up having to pay to the lender.