"Bad Boy"/Bad Acts Guarantees in Real Estate Finance
16 February 2021
16 February 2021
Real estate finance in the UK and European markets is almost exclusively conducted on a non-recourse basis. In most cases, lenders make their loans available to one or more special purpose vehicles holding real estate assets, bank accounts into which income from those assets is collected and having the benefit of contractual rights relating to those assets (including, for example, rights under collateral warranties and other construction agreements). The result is a "clean" borrower group, with lenders being able to quantify the extant liabilities in those entities with some precision and maintain maximum flexibility on enforcement (as "clean" SPVs are more easily sold).
With a few limited exceptions, such as development finance transactions, lenders will not usually have access to any credit support outside of the borrower group and as a consequence, the terms of the loan documentation will drive at preserving asset value and controlling the flow of rental income. But contracts can easily be breached. The consequence of such a breach (at its most severe) would be proceedings founded principally in breach of contract, for which damages would be the likely remedy. Any such claim would ordinarily be limited to the assets of the borrower group, meaning a successful claim isn't likely to give the lenders access to any "new money". This can be problematic when asset prices fall and lenders find themselves holding loans with uncomfortably high LTVs, as SPV borrowers are not likely to see a significant disincentive in non-compliance with the terms of their financing documents.
In other lending markets, most notably the United States, lenders have responded to this risk by requiring sponsors to provide a "Bad Boy" Guarantee1. These guarantees2 started life purely as providing protection against the losses a lender would suffer from truly "bad acts", such as wilful breach of the finance documents, fraud, misappropriation of funds etc. Although no doubt subject to negotiation, guarantees of this nature are unlikely to have been particularly controversial – most sponsors would not have found it too egregious to guarantee that its wholly owned special-purpose subsidiaries would refrain from acting criminally or fraudulently and, ostensibly, that they would "do what they said they would". But as with all such things, the scope of these guarantees has gradually increased and sponsors may now find these guarantees extending to a lengthy list of loosely drafted "bad acts", some of which don't look that "bad" at all.
Bad Boy Guarantees are not a common feature of the UK and European real estate lending markets. In vanilla real estate finance transactions lenders in these markets have typically been comfortable to lend at conservative LTVs with recourse limited to a typical SPV security package (comprising "all asset" security from the borrower(s) (where possible), security over shares in the property owning vehicle(s), and security over bank accounts, contracts and receivables related to the asset(s)). The rapid rise of non-bank lenders in the REF markets of the UK and Europe in recent years, including debt funds and private equity lenders who may be willing to take on transactions traditional lenders are unwilling to finance, has meant that sponsors may find themselves being asked to provide a Bad Boy Guarantee where the terms of a deal demand additional credit support. Although still the exception rather than the rule, the following are some circumstances where a Bad Boy Guarantee may be requested:
Bad Boy Guarantees can take broadly three forms:
The Loss Guarantee approach is the most common. However, given Bad Boy Guarantees are not in widespread use in the UK and European markets and have developed in a somewhat ad-hoc fashion elsewhere, it is no surprise that there is no consistent approach to their content or drafting. This, combined with the understandable caution with which sponsors will approach these types of guarantees, can result in fierce and lengthy negotiation.
The definition of "Bad Acts" is central to assessing the strength and efficacy of a Bad Boy Guarantee. Some examples of "Bad Acts" may include:
It should be noted that there is no settled consensus on what constitutes a "Bad Act" and much will depend on the bargaining strength of the parties and the specific risks of the transaction at hand. If the Combined Guarantee approach is used, not only will the list of Bad Acts be up for debate, but also which of them constitute "really bad" Bad Acts (i.e. those that will trigger the full recourse aspect of the Bad Boy Guarantee).
Lenders and sponsors alike should carefully consider the proposed terms of any Bad Boy Guarantee at an early stage, preferably when the financing term sheet is being negotiated. The breadth of options on the table for this type of guarantee means that it is easy for parties to proceed with entirely different expectations as to what the Bad Boy Guarantee will cover and when it can be called. In particular, Lenders and sponsors considering using a Bad Boy Guarantee in a transaction may wish to give some thought to the following points in setting the scope of such a guarantee:
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1. "Bad Boy" guarantee is the term used most often in practice, although market participants may know these guarantees by other rather less memorable monikers, such as "Bad Acts guarantees", "non-recourse carve-out guarantees", "carve out guarantees" or "springing recourse guarantees" (or variations on that theme).
2. These guarantees may be more properly described as indemnities (and indeed will often be drafted as a guarantee and indemnity) but we will use the term "guarantee" in this note for ease of reading.