How To Negotiate For Nonrecourse Loans

At first blush, asking a lender for non-recourse financing seems like someone asking for your first-born child – weird and awkward. But in today’s economic and real estate climate, under the right conditions, non-recourse loans can make sense.  

Practically speaking, most commercial loans¹ are essentially “full recourse,” which means that because many lenders insist on personal guaranties, the guarantors are personally liable for the loan balance – meaning if the borrower defaults, the lender can sue the guarantor (and the borrower in some cases) for the unpaid balance, plus interest, and attorneys’ fees.  And the lender can pursue collection against the guarantor’s non-exempt assets, which typically includes bank accounts, wages, stocks, bonds, automobiles, and of course, real estate.

On the other hand, “nonrecourse loans” limit the lender’s recovery to the borrower’s pledged collateral and the borrower is not personally liable for the repayment of the debt. As a result, non-recourse loans are attractive to many investors because it limits their risk. Nonrecourse loans, however, do have certain disadvantages, including higher interest rates, stricter underwriting guidelines and requirements, and reduced flexibility in loan terms.

Nonrecourse loans can be attractive to lenders with the following conditions. First, because lenders are accepting the risk that the borrower may default, lenders will require collateral to cover the amount of the loan, and then some.  At a minimum, collateral includes a deed of trust secured against the property in priority position.  Second, lenders will underwrite the mortgaged property and related business to assess whether income generated from the property will support the debt service. Third, lenders will require detailed loan documents that provide the lender with oversight and control over the collateral if the borrower encounters financial troubles. And fourth, the loan documents will provide the lender with the right to foreclose non-judicially in the event of default, and default will be broadly defined well beyond non-payment, including for example, insolvency.  See Wells Fargo Bank, NA v. Cherryland Mall Ltd. Partnership, 812 N.W. 2d 799 (Mich. Ct. App. 2011).

Practice point: there is a recent trend for lenders to include nonrecourse “carve out clauses” within nonrecourse loans to preserve the lender’s ability to hold the borrower and guarantor personally liable for a portion of the debt or the entire debt if certain defaults occur.  Examples of default for these carve out clauses include diversion of insurance proceeds or security deposits, waste, environment issues, acts or omissions involving fraud or misrepresentations concerning loan application, untimely resolution of mechanic’s liens, inadequate repair/maintenance of the property, unpaid taxes, bankruptcy, default of ground lease, or breach of covenants regarding single purpose entity (SPE).  Some of these conditions have been broadly interpreted by the courts.  See e.g., Cherryland Mall Ltd. Partnership, 812 N.W. 2d 799 (Mich. Ct. App. 2011)(guarantor faces full loan amount due to insolvency); CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC (guarantor liable for full loan amount due to unauthorized second small mortgage, even though the borrower fully repaid the second mortgage); Steven Weinreb v. Fannie Mae, 993 N.E. 2d 223 (2013)(guarantor faces full liability, including prepayment penalty, due to recordation of mechanics liens).

Borrowers can increase their chances to achieve nonrecourse loans with the following steps: [1] Collateral - because the borrower is asking the lender to look solely to the collateral if default occurs, the borrower should offer appropriate collateral with value above the loan amount.  The more the merrier from the lender’s perspective.  [2] cash “lock box” – the borrower can offer to deposit cash into escrow to be released to the lender only upon default. The borrower can request a performance tie so that the cash will be released to the borrower when certain benchmarks are achieved (for example, when construction is complete). [3] Burn off provision with performance tie – if the lender declines to offer nonrecourse status out of the gate, the borrower can request that the personal guaranty “burn off” once certain benchmarks or conditions are satisfied (such as construction milestones), the idea being that the loan becomes fully nonrecourse once the project is complete and economically productive.  

In conclusion, nonrecourse loans can be an effective tool to get deals done as long as appropriate terms, conditions, and risk mitigation factors are included. But investors should thoughtfully count the cost and assess any requested commercial guaranties before concluding whether the loan is truly “nonrecourse.” If you or someone you know has questions regarding nonrecourse loans or any other commercial financing options, call Christopher Charles at Provident Law® or David Kotter at Integrity Capital.

¹ Most residential loans are automatically non-recourse by operation of law per A.R.S. § 33-814. See Baker v. Gardner, 160 Ariz. 98, 770 P.2d 766 (1988).