Finance--The Demise of the Nonrecourse Loan

Though its burial may be premature, the nonrecourse real estate loan may be dying a slow and -- for borrowers -- painful death.

Through the 1980s, the nonrecourse loan was a cornerstone of real estate financing. Typical loan documents provided that upon default, the lender waived his right to seek a monetary judgment against the borrower and its partners.

The lender's recourse was limited to foreclosing on the real and personal property constituting its collateral. Assuming the loan was properly underwritten, the lender anticipated that the collateral would have sufficient value to cover its debt.

But with the collapse of the real estate market at the end of the decade, significant flaws in this approach to lending became apparent. The values of many properties plunged below their debt; and although the lender's recourse to the collateral property was its sole remedy, in many instances its attempts to take control of the property or foreclose were thwarted by laws favorable to borrowers and enforced by bankruptcy courts protective of debtors.

Arcane laws governing perfection of assignments of rents enabled borrowers to retain property income after a default. Through bankruptcy reorganizations, borrowers could retain the title to the property -- over the lender's objection -- and in fact reduce the amount of the lender's debt.

And even if the reorganization ultimately proved unsuccessful, bankruptcy could cost the lender dearly in legal and other fees, and delay the lender's ability to control its collateral -- all of which upset the fundamental premise of the non-recourse loan: that the lender gets the keys upon default, quickly and cleanly before the rents disappear, tax liens are filed or other adverse conditions develop.

As lenders now cautiously re-enter the real estate financing market, their loan documents reflect the lessons learned.

Although there has been limited new lending by financial institutions, "new and improved" nonrecourse provisions now attempt to redress what the financing market viewed as abuses of the nonrecourse privilege.

Nonrecourse provisions have always had exceptions for "bad acts" such as fraud, misappropriation of funds, environmental problems and the like. But the nonrecourse provision of the '90s are rife with new and far-reaching exceptions, reflecting a sophisticated understanding of the potential pitfalls of bankruptcy and perfection issues.

Consider the following exceptions to nonrecourse provisions, many of which are likely to be found in the next loan documents to cross your desk:

• Liability for all rents received after a default under the loan that are not applied to the loan or expenses directly related to the property;
  
• Liability for unpaid real estate taxes;
  
• Liability for security deposits not paid to the lender;
  
• Liability for any mechanics and other liens filed against the property;
  
• Liability for the borrower's failure to maintain the property or perform its obligations under leases to the extent there is sufficient income;
  
• Liability for costs and expenses incurred by the lender in any successful foreclosure action;
  
• Liability for costs and expenses incurred by the lender in any bankruptcy case where the case is dismissed or converted to a Chapter 7, or where the automatic stay is lifted; and
  

Liability for interest after the filing of any bankruptcy proceeding.

The intent of these new exceptions is clear: make it expensive for the borrower to do anything but immediately turn over the keys to the lender after a default has occurred.

But even these broad new exceptions may fall far short of the mark. While they create an exception to the nonrecourse nature of the loan, the liability they impose generally reaches only to the borrower, a "single asset" entity, and to its general partners, often corporations with few assets independent of their interests in the borrower. In bankruptcy, these new liabilities will fare no better than the underlying debt.

Ultimately, the lender's only real protection is to impose these liabilities on a party who both controls the borrower and has sufficient assets to make these liabilities a genuine stick.

This may take the form of a "springing guaranty," which imposes liability on a principal of the borrower in the event of a bankruptcy filing or other action to contest the lender taking control of the collateral. This approach allows the lender to pursue its claims in a separate proceeding outside of bankruptcy.

But when the pendulum swings this far, and principals of the borrower are exposed to personal liability for exercising their legal rights, can it really be said that the nonrecourse loan is still alive and well?