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When is a bad act, which triggers recourse on a mortgage loan, a good act for the lender?

Posted in Real Estate Development, Secured Lending and Finance

Borrowers and guarantors often ask mortgage lenders to not seek personal judgments against them and only look to the real property and other collateral for repayment of their loan in case of default.  If granted, the loans are commonly called “non-recourse” loans.  However, if even a lender grants such non-recourse, it will want certain exceptions for certain acts or omissions of the borrower and/or guarantor so that recourse against other assets of the borrower or guarantor is possible in those situations.

The acts or omissions commonly exempted from non-recourse involve what some call “bad boy acts.”  These include fraud, intentional misrepresentation, failure to pay taxes, misapplication of any insurance or condemnation proceeds, failure to maintain insurance, waste, failure to pay rents over to the lender if demanded, and causing and/or failing to remediate environmental contamination.  These acts represent some misconduct or misdeed by the borrower and/or guarantor which arguably affect the loan and/or the security for the loan.

Query whether the historic reluctance of courts to enforce guarantees against guarantors of mortgage loans, while partially ameliorated by enactment of a safe haven waiver of subrogation and other defenses available to guarantors after a non-judicial foreclosure sale in Civil Code §2938, can still impact a determination of whether or not a “bad boy act” exception to non-recourse exists?

For example, in GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC Holdings, LLC (2012) 204 Cal.App.4th 998, the appellate court reversed a judgment in favor of the mortgage lender based on a tortured reading of when a lease is terminated or canceled.  The non-recourse guaranty provided that there was recourse against the guarantor if, without the prior written consent of the lender, a lease of the property “is terminated or canceled”.  The facts of the case were simple. The single tenant went out of business, abandoned the property and ceased paying rent.  While these acts certain breached the lease and most people would think these acts result in a termination or cancelation of the lease, the appellate court found that the actual lease language allowed the lessor to terminate the lessee’s right possession in the event of a default under the lease and, as the lessor had not elected to terminate this possession right (the lessor/borrower just stopped making loan payments after the tenant default and did not seek any recovery from the tenant, who appeared judgment proof), the lease was not terminated under California law.  Consequently, according to the appellate court, the alleged “bad boy act” never happened so there was no recourse.

The appellate court clearly interpreted the non-recourse exception as being a “bad boy act” of the borrower when it found “both the borrower and the guarantor are liable only if the borrower engages in the specific bad acts. In the absence of such misconduct by the borrower, the sole security for the loans is the property.”  (emphasis added).  But what was the “bad boy act?”

The only bad act or misconduct of the borrower was not getting the permission of the lender to send a notice to the tenant terminating the lease because of the abandonment and rent default.  Would the lender really object if the borrower terminated the lease following the tenant’s abandonment and failure to pay rent?  Of course not, but under the appellate court’s interpretation, if asked for permission, the lender would have had to deny permission and then hope the borrower still sent a notice to the tenant terminating the lease any way in order to create the “bad act”.  While this may be technical “misconduct” by the borrower, it would certainly be a “good act” as far as the lender was concerned as it would then give the lender recourse against the guarantor.

On hindsight, if the intent of the lender was to have recourse if the tenant defaulted, it could have worded the exception to non-recourse to include any default by the tenant under the lease.  However, if a lender did this, would a court enforce recourse when the “bad boy act” was that of a third party (the tenant) not the borrower or guarantor?  Or would the lender have to create a potential borrower “bad act” by wording the exception to something like “failure of the borrower to bring suit against a tenant to enforce the borrower’s remedies under the lease” which would likely happen if a tenant was judgment proof and the borrower could not afford to bring a suit let alone pay installment payments on the loan?  The misconduct of not bring a lawsuit against a judgment proof tenant would then actually be a “good act” for the lender.