Bad-Boy GuaranteesThe commercial real estate market is being hobbled by billions of dollars in distressed debt, and some experts are pointing to a provision in many loans — a so-called bad-boy guarantee — that they say is to blame for a large part of the backlog.
In previous down cycles, when the market was readjusting after a boom, real estate companies would declare bankruptcy to extricate themselves from troubled deals. This time around, many commercial mortgages included provisions that held developers personally liable for the loan if their companies filed for bankruptcy. As a result, foreclosures, in which the competing interests of many parties often play out in lengthy court battles, are now typical.
“Because of the bad-boy guarantees, we have unquestionably had far fewer bankruptcies then we would have had, and than we saw in the 1990s,” said David M. Neff, a co-chairman of the hotels and leisure practice at the law firm Perkins Coie, who is based in Chicago.
The Creation of the Bad-Boy GuaranteesThe bad-boy guarantees, also known as springing guarantees, began appearing in the 1980s, but it was not until the early 1990s that they became conspicuous. “In the last down cycle in the 1990s, lenders would go to foreclose on a property, and the day before, the borrower would suddenly file for Chapter 11,” said Raymond N. Hannigan, a partner in the New York law firm Herrick, Feinstein.
Lenders began insisting on the provisions to prevent Chapter 11 filings, which they disliked for, among other reasons, the protections they afforded borrowers, the costly litigation involved and the fact that decisions were often up to the whims of a judge.
But while foreclosures — in which the developer typically hands over a property’s keys and walks away — have been considered preferable to bankruptcies, many borrowers and even some lenders are now having second thoughts. This is because many commercial loans that originated in the recent boom involved a multitude of lenders with competing interests. Getting these parties to agree in a foreclosure process has been difficult.
In a bankruptcy, on the other hand, distressed properties can be sold without the lenders agreeing unanimously. “Thus you avoid the holdout problem and individual creditors engaging in brinkmanship trying to get the best deal for themselves,” said Gregg L. Weiner, a partner in the law firm Fried, Frank, Harris, Shriver & Jacobson who represents many borrowers.
In December, $61.5 billion in commercial mortgage bonds were delinquent, the highest amount ever recorded, according to the research firm Trepp. With billions of dollars in troubled loans that must be resolved through restructurings, bankruptcies or foreclosure actions, some commercial real estate experts say that borrowers are likely to mount pressure to overturn bad-boy guarantees to pave the way for additional Chapter 11 filings.
“If lenders are logical and would rather resolve issues instead of litigate, then they will consider ways to modify the constraints that their borrowers may have originally agreed to,” said Michael Pomeranc, a developer and a partner in the Thompson Hotel Group, who has signed several loan documents that included bad-boy guarantees.
Since the market crash, some lenders have engaged in a game of “extend and pretend” with troubled developers, where they extend their loan agreements past the maturity dates to keep them from defaulting in the hope that the economy will improve and the loans will be repaid. As a consequence, the loans are not recorded as distressed though they may be in fact.
Starting this year, many extensions will expire and “lenders are going to have to finally work out these loans and as a result, bad-boy guarantees are going to come under much more scrutiny,” said William M. O’Connor, a partner in the law firm Crowell & Moring, who represents borrowers.
Critics of the guarantees say lenders have handcuffed borrowers by expanding the provisions beyond their original intent. “While the bad-boy guarantees were originally intended to focus on truly bad-boy acts, over time lenders couldn’t help themselves,” Mr. Weiner said.
In one recent case, ING Real Estate Finance and Swedbank sued the developers of a stalled Midtown hotel and condominium project over a $145 million loan. The developers, Aby Rosen and Michael Fuchs, whose RFR Holding owns Lever House and the Seagram Building, took out the loan with their partners in 2007 to build a 64-story Shangri-La Hotel at 610 Lexington Avenue.
By 2009, the hotel project had stalled and they were late paying a $278 million real estate tax bill. They paid the lien 19 days later, but the lenders asserted that the delay had activated the bad-boy guarantee and that they had to pay millions of dollars in penalties from their personal accounts.
The judge, who expressed incredulity at the terms of the guarantee, dismissed the claim.
In the vast majority of cases involving guarantees, the judges have ruled that they can be enforced. Perhaps the most visible case involved the Blue Hills Office Park in Canton, Mass. The developer was accused of transferring $2 million into an account and failing to notify the lender of the funds. The lender successfully sued the company’s principals for $10.77 million under the bad-boy guarantee.
These court cases are nothing more than “borrowers trying to change the rules of the game in midstream,” said Mark Weibel, a partner in the law firm Thompson & Knight who is based in Dallas and represents lenders. “It is borrowers who are not complying with their loan documents — this is what is causing the mire.”
Still, a growing number of market players say that something must be done to allow bankruptcies to go forward.
“These guarantees can be an impediment to getting a sensible restructuring of commercial real estate loans,” said Andrew A. Lance, a partner in the law firm Gibson, Dunn & Crutcher who represents both borrowers and lenders. “We either need an alternative way to properly incentivize borrowers or get clarity that servicers can waive guarantees without risk of being sued.”
Source: The New York Times
Written by: Julie Satow