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Unexpected Personal Liability for Hotel Loans

Most commercial mortgage loans, other than construction loans, are nonrecourse to the Borrower, subject to exceptions which are usually referred to as "carve-outs". Originally, carve-outs applied to actions of the borrower that contradicted the borrower's covenants in the loan documents or were inconsistent with norms of ethical behavior, and were often referred to as "bad boy" acts. But carve-outs have evolved to include liability for many entirely innocent actions of the borrower.

Over the years, loans that were consolidated into collateral for commercial mortgage backed securities drove a steady expansion of the exceptions to nonrecourse. Lenders that don't securitize their loans have followed suit by adopting many of the same exceptions, so that today most institutional lenders include an expansive list of exceptions that go far beyond the initial protections against "bad boy" actions of the borrower. With rare exceptions, courts find that the liability of borrowers and guarantors under carve-outs is enforceable.

The carve-outs should be negotiated at the loan application stage. The typical lender term sheet will say that the loan will be nonrecourse, subject to the lender's "standard" recourse carve-out provisions. It is important to get a copy of the "standard" provisions before signing the term sheet, and before making any good faith deposits. The lender will be much more flexible in negotiating the carve-outs before it has an indication that the borrower is committed to the deal. Once the borrower has signed the term sheet, the lender will consider most of the detailed provisions of their form loan documents to have been accepted by the borrower, including the nonrecourse carve-outs. It then becomes an uphill battle to get any significant concessions from the lender.

The borrower is usually a special purpose entity whose only substantial asset is the hotel business and the real estate on which it is situated. So, recourse liability is not a significant issue for the borrower entity because the hotel business and real estate are already encumbered by the loan security instruments. However, lenders require that one or more individuals or entities personally guarantee any recourse obligations that arise due to an exception. Thus, it is the assets of the guarantors that become exposed to liability under the carve-outs.

Navigating the pitfalls of personal liability under a hotel loan presents more issues than under a typical real estate loan. A hotel property involves an actively managed business and a loan secured by a hotel includes a breadth of collateral that is much more comprehensive than that required for a loan secured by an office, retail, industrial or apartment property.

The guiding principles in reviewing exceptions to nonrecourse provisions should be first to assure that the exceptions are clear, and second that the borrower has complete control over the actions or inactions that will trigger recourse. For a hotel loan, the borrower should carefully review any loan document provision under which actions of the hotel manager or franchisor could create recourse to the guarantor's assets. For example, cooperation of the hotel manager is often required for the borrower to comply with covenants for periodic financial reporting, payment of taxes and keeping the property lien free.

The typical nonrecourse loan has 15 or more carve-outs, including the borrower's fraud, intentional misrepresentation, gross negligence or willful misconduct, criminal acts, misapplication of insurance proceeds or condemnation awards, misapplication of rents following a default or retention of rents paid more than one month in advance, failure to deliver security deposits to the lender following a default, refusal to allow inspections of the property or property records, failure to deliver periodic financial reports to the lender, and payments to affiliates of the borrower following a default. These types of carve-outs are generally within the control of the borrower and, with minor revisions which are regularly accepted by lenders, the associated personal liability risks can be sufficiently mitigated.

Understanding the effect of each of the carve-outs can be challenging for a loan secured by a hotel property, due to the management intensive nature of the business that is operated on the property. Hotel owners need to pay attention to carve-outs that pertain to financial reporting and "waste", because the borrower needs to stay in control of the conditions addressed by each.

The carve-out for losses incurred due to the borrower causing "waste" of the collateral property appears to be innocuous on its face, but can result in personal liability for virtually any management decision that arguably causes a detriment to the property. The borrower should limit the carve-out to intentional "physical" waste of the property. Courts have found personal liability of guarantors in a number of cases in which the carve-out was not so limited.

In one case, a lender alleged that the borrower's decision to change the hotel flag from Holiday Inn to Clarion constituted waste. The court found that the change of flag did not constitute waste, but noted that changing a flag under a different set of circumstances could be considered waste, which would have resulted in personal liability for the guarantors. Guarantors may also become personally liable if the loan documents include a carve-out for the borrower's breach of its affirmative covenant to not change the brand or manager without lender approval, which is typical in hotel loans.

The borrower's counsel should also assure that the borrower does not covenant to remain solvent or to pay its debts and liabilities as they become due. In a well-publicized case, the court found personal liability of the guarantors when a borrower became insolvent due largely to market conditions. Similarly, a number of other carve-outs pertain to failure of the borrower to pay property related expenses such as taxes and insurance premiums, and to pay contractors and material suppliers who have lien rights against the property. These "failure to pay" type of carve-outs can be modified to provide that the carve-out will not be triggered if revenue generated by the property is insufficient to make the payments. In other words, the borrower and the guarantors are not responsible to come out of pocket to make the payments if operation of the property does not result in revenues sufficient to make the payments.

Trigger of a carve-out results in liability of the guarantors to the extent of any losses suffered by the lender which arise out of the triggering event. In addition, guarantors may become personally liable for the entire loan if the loan becomes fully recourse due to the occurrence of any "springing recourse" event. The springing recourse events relate to, (i) the single purpose entity restrictions on the borrowing entity, (ii) subordinate financing, (iii) sale of the property or an interest in borrower, (iv) filing a voluntary petition in bankruptcy or consenting to an involuntary petition or appointment of a receiver, (v) making an assignment for the benefit of creditors or admitting to insolvency, or (vi) obstructing an enforcement action filed by the lender. Although liability exposure is considerable on the occurrence of a springing recourse event, the borrower is generally in control of the conditions that cause the event, so the guarantors can avoid personal liability if the borrower doesn't take any of the prohibited actions. Still, the borrower should revise these provisions by, (i) further defining subordinate debt, (ii) further defining what constitutes admitting insolvency and providing that the admission must be used in connection with the filing of an involuntary petition in bankruptcy, and (iii) excepting admissions to the lender of inability to make monthly debt service payments.

In one case, when the borrower made a late payment of a property tax bill, the lender argued for full springing recourse on the premise that the resulting tax lien constituted additional "indebtedness" on the property, because the loan documents broadly defined indebtedness to include any obligation secured by a lien. The borrower prevailed, due to the court's application of certain cannons of contract interpretation and the small amount of the tax lien relative to the loan amount. However, the decision could have gone either way, and the expansive definition of indebtedness in the loan documents may have given the lender's legal counsel greater confidence to pursue the matter than if the definition had excluded non-consensual liens.

The guarantors will also be exposed to personal liability for environmental contamination discovered on the property, under (i) a separate environmental guaranty in which the environmental guarantors (usually the same persons as the carve-out guarantors) indemnify and defend the lender against all environmental related losses, and (ii) an environmental covenant in the security instrument, the breach of which triggers springing recourse for the entire loan. Borrowers need to understand the environmental related risk exposures of the property, because lenders are generally not receptive to changes in the lender's environmental covenants and guaranty.

In addition to revising springing recourse and carve-outs provisions, counsel should pay close attention to the borrower's affirmative covenants, representations and warranties in the loan documents to assure that the covenants can be performed and the representations and warranties are accurate. A faulty representation could result in personal liability under the standard carve-out for intentional misrepresentation.

It is important that the owner pays attention to the exceptions to the nonrecourse carve-outs, springing recourse provisions and affirmative covenants, representations and warranties in a hotel mortgage loan, in order to prevent unintended exposure to personal liability.

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This article is merely a brief comment regarding its subject matter, for informational purposes only. It is not intended to be comprehensive, create an attorney-client relationship with the reader, or serve as a substitute for legal advice.

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