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Real Estate Journal — Spring Preview — April 29 - May 12, 2016 — 3C
M id A tlantic
L egal S ervices By Troy Rider, Barley Snyder “Bad boy” guaranty developments
T he term “bad boy” guar- anty is used in cer- tain circumstances to
2015 and titled “Guarantee of Qualified Non-Recourse Fi- nancing” (“IRS Memo”), which related to a particular case involving a limited liability company that purchased and renovated hotels. The IRS Memo outlined an IRS position that the presence in a “bad boy” guaranty of various “triggers”, including specific “triggers” based on the borrower admit- ting its insolvency or ability to pay its debts as they come due or making an assignment for the benefit of creditors, would cause a non-recourse loan to be recharacterized as recourse. The real estate community
expressed concern and criti- cism of the IRS Memo because of its potential effects on what has been standard fare in real estate financings: (a) In the past, “bad boy” guaranty “triggers” were con- sidered to be subject to contin- gencies – such as the guaran- tor’s reluctance to cause the triggering event and become liable – which were thought to be unlikely to occur; (b) The IRS Memo suggested that the “bad boy” guaranty will cause the “partner” or LLC member providing the guar- anty to be liable, undermining the “qualified nonrecourse fi-
nancing” treatment of the loan under IRC Section 752 and the related regulations; and (c) If treated as a recourse li- ability, only the partner which bears risk of loss on the liabil- ity will have the tax basis and at-risk investment to claim losses in excess of its capital contribution. On April 15, 2016, the IRS released a general legal advice memorandum (the “Memo- randum”) clarifying its posi- tion on IRS treatment of “bad boy” guarantys. Under the Memorandum, if a partner’s guarantee is conditioned on the occurrence of certain typical
“triggers”, the guarantee will not cause the debt to fail to qualify as a nonrecourse debt and as “qualified nonrecourse financing” for purposes of the at-risk rules until such time as one of the triggering events actually occurs and causes the guarantor to become personally liable for the debt. This position is contrary to the IRS Memo but consistent with historical IRS treatment of “bad boy” guarantys. The list of “triggers” provided in the Memorandum include: (1) the borrower fails to obtain the lender’s consent before obtaining subordinate continued on page 20C
d e s c r i b e a guaranty to be provided – usually by individuals, not an entity – subject to certain trig- gers for lia- bility (such as
Troy Rider
insolvency) in connection with, most often, real estate financ- ing. Traditionally, it was widely believed that a “bad boy” guar- anty was a contingent liabil- ity that should be disregarded for purposes of determining whether the guarantor bore the economic risk of loss for the underlying debt because it was unlikely that the guarantee would ever be triggered. Since the “triggers” in the guaranty – such as filing bankruptcy and fraud – are within the guarantors’ control, they have been thought to be unlikely to “trigger” the guaranty. Generally, lenders have pre- vailed when asking the courts to enforce properly drafted “bad boy” guarantys, on the basis that the terms are clear and have been negotiated by sophis- ticated parties. Courts have re- jected claims that the “bad boy” guaranty is an unenforceable penalty, an invalid liquidated damage provision, a violation of public policy, good faith, fair dealing, etc. The “springing” nature of the guaranty has not been an impediment. However, as lenders have had difficult experiences, the list of “trigger” events in some “bad boy” guarantys has grown and become more creative. There have been a few notable court decisions which have illus- trated the problems which may arise from these agreements. In particular, Wells Fargo Bank, N.A. v. Cherryland Mall Ltd. Partnership, 295Mich. App. 99, 812 N.W.2d 799 (2011) (“Cher- ryland I”), rev’d on remand, 300 Mich. App. 361, 835 N.W.2d 593 (2013), found that a decline in collateral value rendered the borrower insolvent and triggered guarantor liability under a non-recourse guaranty, reversing customary assump- tions about the respective risks assumed by the parties. On February 5, 2016, the Internal Revenue Service Office of the Chief Counsel released its legal memorandum, Chief Counsel Advice (CCA) No. 201606027, dated October 23,
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