Non-Recourse Carve-Outs

Referred to colloquially as “Bad Boy Carve-outs”, a list of actions or guarantees that may result in the borrower or guarantor taking on partial or full recourse liability for the loan. These actions initially were limited in scope to “bad acts” such as theft or voluntary bankruptcy by the borrower, however over time the list of non-recourse carve-outs has grown to include acts which one may not consider wrongful (failing to permit property inspections or not paying real estate taxes).

Putting “Non-Recourse Carve-Outs” in Context

Case Study: James River Apartments

Old Dominion Realty Partners, a real estate private equity firm, acquired James River Apartments, a 200-unit market-rate multifamily community in Richmond, Virginia, for $30 million. The acquisition was financed with a $21 million non-recourse loan from a regional bank. While the loan generally limits the lender’s ability to pursue recourse against the borrower, it includes non-recourse carve-outs that could make Old Dominion Realty Partners liable under certain conditions.

How Non-Recourse Carve-Outs Apply in This Context

Non-recourse carve-outs, often referred to as “bad boy carve-outs,” are specific actions or failures that could trigger partial or full recourse liability for the borrower or guarantor. In the case of James River Apartments, the loan agreement outlines several carve-outs, such as:

• Committing fraud or misrepresentation during the loan application process.
• Misappropriating property income, such as using rents for purposes other than property operations or debt service.
• Filing for voluntary bankruptcy protection.
• Failing to maintain required insurance on the property.
• Neglecting to pay property taxes, resulting in liens against the property.
• Refusing to permit property inspections as required by the loan agreement.

Example of a Potential Non-Recourse Carve-Out Violation

During a challenging period, if Old Dominion Realty Partners were to misallocate property income to cover unrelated operational expenses for another asset in their portfolio, this act could trigger a non-recourse carve-out. The lender could then hold the sponsor personally liable for the loan balance or specific damages caused by the breach.

Alternatively, failing to pay property taxes on James River Apartments might also trigger a carve-out, even if it was unintentional. This liability ensures that lenders have recourse in situations that jeopardize the property’s financial or legal standing.

Implications for Borrowers

• Risk Mitigation: Borrowers like Old Dominion Realty Partners must thoroughly understand the terms of non-recourse carve-outs to avoid unintentionally triggering liability.
• Operational Discipline: Sponsors must implement strong financial controls to ensure compliance with loan terms, particularly regarding the proper use of property income, timely payment of taxes, and adherence to insurance requirements.
• Negotiation Considerations: Borrowers should seek to limit carve-outs during loan negotiations, focusing the list on “bad acts” rather than expanding it to include routine operational failures.

Conclusion

This hypothetical scenario illustrates how non-recourse carve-outs protect lenders from specific borrower actions while still allowing borrowers to benefit from the general non-recourse nature of the loan. Borrowers must carefully adhere to the terms of these carve-outs to avoid triggering unintended liabilities, making them a critical consideration in structuring and managing real estate financing.