"Bad Boy"/Bad Acts Guarantees in Real Estate Finance

Context

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.

Bad Boy/Bad Acts Guarantees – the answer?

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:

• complex transactions where entities connected with the sponsor take on numerous roles in the transaction (such as where the borrower, developer and another lender to the group (lending on arms' length terms) are under common control) meaning the sponsor is an "axis" of risk;
• hybrid debt-equity transactions, where a Bad Boy Guarantee may support obligations in both finance and equity documentation (such as joint venture agreements);
• transactions where it is not possible, or not economically sensible, to take a full security package over all assets (e.g. portfolio transactions in jurisdictions where the grant of a mortgage comes with a significant tax or notarial cost) or where certain assets are slated for disposal shortly after financial close;
• financing of non-performing loan portfolio acquisitions, where full asset level security in one or more jurisdictions may be incompatible with the intended workout strategy; or
• occasionally, transactions at higher-than-usual LTVs.

Anatomy of a Bad Boy Guarantee

Bad Boy Guarantees can take broadly three forms:

• a guarantee of all of the secured liabilities that is suspended until the occurrence of one or more trigger events (a so called "springing guarantee"). If one of these "Bad Acts" occurs, the loan effectively becomes a recourse loan for the duration of the remaining term (the "Recourse Guarantee");
• a guarantee of losses arising as a consequence of any act or omission of the borrower group or the sponsors that is a "Bad Act" (the "Loss Guarantee"); or
• a combination of both approaches, where the "Bad Acts" are divided into the 'bad' (which trigger a guarantee of losses) and the 'really bad' (which trigger the full guarantee of all secured liabilities) (the "Combined Guarantee").

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.

Bad Acts

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:

• a wilful breach of any representation, undertaking or covenant in the Finance Documents. This may also extend to breaches or misrepresentations arising out of recklessness or breach of duty;
• any distribution of funds or other payment in contravention of the permitted payments regime in the Finance Documents;
• fraud or malfeasance;
• any disposal or encumbrance of assets other than in a manner expressly permitted by the Finance Documents;
• taking any steps to petition or file for an insolvency procedure;
• any attempt to obstruct the exercise of any rights of the Secured Parties under any Finance Document (including any power of attorney) or any attempt to dispute the validity, enforceability or priority of any security, guarantee or Finance Document or any amounts thereunder; or
• any rescission or repudiation of a Finance Document (or perhaps, a Transaction Document).

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).

Things to consider

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:

• which type of guarantee is proposed – a Recourse Guarantee, a Loss Guarantee or a Combined Guarantee?;
• clearly set out the Bad Acts that will trigger payments or performance under the Bad Boy Guarantee. If the Combined Guarantee approach is being used, establish which acts will trigger full recourse and which will trigger liability for losses only;
• irrespective of the type of guarantee used, it may be appropriate to cap liability at a proportion of the debt outstanding or by reference to a fixed exposure;
• consider the impact of local law, including directors' duties (including under any applicable insolvency legislation). Bad Acts that are triggered by the borrower being placed into an insolvency procedure are not uncommon but may be problematic if: (a) the directors of the guarantor and the borrower are the same individuals and the terms of the guarantee are such that a conflict could arise between the duties owed to each company/their creditors; and (b) directors are required by applicable law to use certain insolvency procedures in certain circumstances and the guarantee may prevent them from doing so;
• consider whether insolvency-related Bad Acts make pursuing restructuring solutions difficult;
• how will the financial position of the guarantor be assessed – an ongoing guarantor financial covenant (such as liquidity or net asset value) will usually be appropriate;
• what reporting is required under the guarantee and how frequently does it need to be provided? Lenders will be keen to ensure this gives them an adequate picture of the financial position of the guarantor but sponsors will need to ensure any reporting is in line with operational requirements;
• consider when the guarantee should come to an end – if the Bad Boy Guarantee is intended to provide credit support for specific issues, sponsors will want to ensure the guarantee is expressed to come to an end automatically when those risks are neutralised. Sponsors should consider making it clear that the guarantee comes to an end on enforcement (without prejudice to any pre-existing claims) or on exercise by any mezzanine lender of any intercreditor acquisition right. The Sponsor is unlikely to be willing to remain on the hook when it no longer controls decision making;
• if the borrower is a joint venture, consider whether the sponsors should give a joint guarantee or each sponsor should give a Bad Boy Guarantee on the same terms and if so, whether those guarantees should carry joint and several or several liability. Contribution agreements should also be considered where joint and several guarantees are used; and
• finally, consider governing law (not all guarantees are created equal) and whether a judgment of any relevant court can be easily enforced in jurisdictions where the guarantor's assets are located.

About Ashurst

At Ashurst, our market-leading expertise, seamless multi-disciplinary approach and commercial focus allows us to carry out the most complex and often pioneering transactions in the real estate market.

Our team advises on all aspects of real estate activity including high-profile acquisitions and divestments, asset management, large-scale development schemes, real estate finance, funds, joint ventures, construction, planning, environment and tax advice. We also advise on major urban regeneration projects, the real estate aspects of energy, resources and infrastructure projects, property financing transactions, public private partnerships and private finance initiatives. 

<sub>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.</sub>