“Bad boy” guaranty developments

 The term “bad boy” guaranty is used in certain circumstances to describe a guaranty to be provided – usually by individuals, not an entity – subject to certain triggers for liability (such as insolvency) in connection with, most often, real estate financing. Traditionally, it was widely believed that a “bad boy” guaranty was a contingent liability 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 prevailed when asking the courts to enforce properly drafted “bad boy” guarantys, on the basis that the terms are clear and have been negotiated by sophisticated parties. Courts have rejected 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 illustrated the problems which may arise from these agreements. In particular, Wells Fargo Bank, N.A. v. Cherryland Mall Ltd. Partnership, 295 Mich. App. 99, 812 N.W.2d 799 (2011) (“Cherryland 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 assumptions 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, 2015 and titled “Guarantee of Qualified Non-Recourse Financing” (“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 admitting 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 criticism 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 considered to be subject to contingencies – such as the guarantor’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 guaranty to be liable, undermining the “qualified nonrecourse financing” treatment of the loan under IRC Section 752 and the related regulations; and

(c) If treated as a recourse liability, only the partner which bears risk of loss on the liability 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 “Memorandum”) clarifying its position 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 financing or transfer of the secured property, (2) the borrower files a voluntary bankruptcy petition, (3) any person in control of the borrower files an involuntary bankruptcy petition against the borrower, (4) any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower, (5) the borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding, (6) any person in control of the borrower consents to the appointment of a receiver or custodian of assets, or (7) the borrower makes an assignment for the benefit of creditors, or admits in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they come due.Although the Memorandum should not be cited as legal authority for the position contained therein, it does provide clear guidance in determining the IRS’ position on these issues. The result of this guidance is that the IRS Office of Chief Counsel has again taken a position that is consistent with the IRS’ historical treatment of the “bad boy” guarantys and the expectations of parties to such a financing transaction. Troy Rider is a partner at Barley Snyder. 

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