Bad Boy Guarantees – whatcha gonna do?

An import from the US Real Estate Finance Market, Carve-Out Guarantees - otherwise known as "Bad Acts" or "Bad Boy" Guarantees have become a feature in parts of the European REF market, in particular in the special situations lending space. Often contentious to negotiate, they have to date not been subject to litigation in the English courts. While we wait for any such case, this note considers whether such guarantees do in fact offer the credit support that investors expect.

Non-recourse lending

A general principle of real estate and other asset finance is that loans are provided on a non-recourse basis. The lender underwrites its investment based on the value of the assets, and the rights and cashflows attaching to those assets – but not the creditworthiness of the sponsor, to whom the lender does not usually have recourse in the event of non-payment. A Carve-Out Guarantee provides for circumstances in which the lender will have recourse to the sponsor – so called because it is a carve-out from the general principle of non-recourse – in the event of certain specified "Bad Acts" taking place. If the sponsor has been a "Bad Boy" – they shouldn’t get away with it.

When and why?

The Finance Documents will of course include a suite of lender protections, and the transaction security will provide the lender with legal and contractual rights in the assets themselves, enforceable following default by the borrower. However, for some deals the lender may need more than this, to protect against the risk of the borrower or sponsor taking some (potentially egregious) action to reduce the value of the lender's collateral, and/or the lender's ability to access it. This may include:

Special situations financing, particular development financings, which may be underwritten based on tight assumptions. Where the loan attracts a high payment-in-kind (PIK) interest rate – the equity can quickly be out of the money if assumptions are not met. At this point, the sponsor will have little incentive to ensure compliance with the terms of the finance documents;
Debt-equity deals, and/or other high loan-to-value (LTV) lending, where the lender is in practical terms taking equity risk;
Transactions where the sponsor (or its affiliates) have multiple roles – such as developer, asset manager, and intergroup lender as well as equity holder – in such cases the sponsor's influence will be across the deal and at different levels of the structure, so the lender will want to hold the sponsor to account;
Transactions where a full security package is not possible – for example where junior debt is provided in a structure without senior lender consent and provision of security would breach a negative pledge, or where jurisdictional requirements mean a high tax or notarial cost of taking a mortgage.

Bad Boy Acts

The triggers for sponsor liability will likely be heavily negotiated. Some items should be relatively uncontroversial, such as fraud and criminal acts. Other items will be controversial – for example the lender may seek to argue that certain specific Events of Default should be Bad Acts. The counterargument from the sponsor will be that the remedy for an Event of Default should be under the existing Finance Documents, not under a Carve-Out Guarantee.

Examples of Bad Acts include (among others):

Fraud or wilful misconduct;
Misappropriation of funds – such as application of cash other than as permitted by the Finance Documents;
Disposing of or granting security over assets other than as permitted by the Finance Documents;
Making a voluntary insolvency filing without the lender's consent – likely subject to a carve-out where there is a requirement to file within a certain time period, such as in Germany; and
Attempts to obstruct the lender from exercising its rights under the Finance Documents (e.g. by frustrating security enforcement) or attempts to rescind, repudiate or dispute the validity of the Finance Documents – perhaps subject to a good faith challenge carve-out.

The sponsor and its advisors will aim to ensure that the triggers are as limited and narrow in scope as possible, and that all trigger events are within the sponsor's control – avoiding any "hair triggers". They will seek to negotiate qualifying language that an act is only a "Bad Act" if it is "deliberate", "within the control of the sponsor", an act by a third party "in which the sponsor is complicit", or where the sponsor is "acting in bad faith".

The lender will generally want to make each limb of the "Bad Acts" definition as wide, clear and unarguable as possible. Resolving the tension between borrower and lender may make for some heated negotiation.

Two (or three) approaches

What is being guaranteed is also up for debate. The usual standard in the US is that the sponsor will guarantee the loss suffered by the lender as a result of the Bad Act. This conceptually appears reasonable.

Some lenders may however seek the guaranteed obligations to extend to all amounts owing under the finance documents, on the occurrence of a Bad Act. The borrower will understandably be concerned that this could amount to a full guarantee from the sponsor, by the backdoor. There may also be a question in this case as to whether the guaranteed obligations are principal and interest only or extend also to any minimum IRR or minimum multiple.

A middle ground is a "hybrid" Bad Boy Guarantee, where some Bad Acts will lead to a guarantee of the full debt, with other to a guarantee only of losses. Of course, in this situation there will be an argument about which Bad Acts are just "bad", and which are "very bad".

There is no real consistent or "market" position, and the outcome will depend upon the bargaining strength of the parties. Negotiations may well be tense, drawn out (and expensive). A lender is most likely to obtain a Bad Boy Guarantee that extends to all amounts owing under the Finance Documents in the riskiest deals, where the borrower has limited other options to obtain its financing – this is not uncommon in the special situations space. In a more competitive process for a more conservative deal, a hybrid or losses guarantee is more likely, if there is any such guarantee at all.

Other protections

Creative lenders and advisors are always expanding the scope of documentary protections, seeking to improve their deal leverage and learn from past experiences. The special situations world is constantly evolving, and we have also seen Bad Boy Guarantees include:

Key man provisions;
Financing exclusivity provisions; and
Release clauses akin to those commonly seen in intercreditor agreements.

What next?

So, a Bad Boy Guarantee has been signed, and the borrower / lender relationship has survived the difficult negotiations. All parties hope for a successful investment, and a comfortable future refinancing or repayment. But the fact that a Bad Boy Guarantee exists at all implies that the deal is probably not a vanilla one – so what happens when things go wrong? The loan is in default, and the occurrence of a "Bad Act" may be arguable…

Evidence

It will be a rare case where the occurrence of a Bad Act is very clear cut and easily evidenced. So the first hurdle for a lender will be to demonstrate that a Bad Act has in fact occurred. This will of course be more challenging when the relevant trigger includes qualifiers – it will probably not be easy to demonstrate that a sponsor has been "complicit" or done something "intentionally", even following a disclosure exercise in litigation. It may be something that the court will ultimately need to decide based on evidence presented to it – which is of course a long way down the line, and subject to litigation risk.

Further, for a losses guarantee, a lender will have to demonstrate what these losses actually are. This may require a lender to exhaust all other avenues of recovery, such as security enforcement - otherwise it would be impossible to quantify the loss. It is conceivable that a lender could take enforcement action – for example an enforcement sale of assets – with the proceeds being sufficient to repay the loan in full. In such case there would be no loss – so it may not be easy to establish the quantum of a claim at an early stage. This issue does not exist for a full guarantee.

In addition, where the full suite of Bad Acts can be seen as "too" wide and potentially a "catch-all", this could hurt the lender's position. Any potential ambiguity (or evidential issues) would likely be construed in favour of the sponsor – if the Bad Act triggers are so wide, why did the lender not simply get a full guarantee?

Other issues to consider

As with any other guarantee, a Bad Boy Guarantee must be reconfirmed if the underlying obligations are amended. If this is not done correctly, the guarantee could be challenged by the sponsor and determined to be invalid.
Risk of waiver of a Bad Act – there is a risk that certain action taken by the lender could amount to an implied waiver of a Bad Act, and an affirmation of the contract. This may particularly be the case in development finance transactions, where a lender has continued to fund after being aware of a Bad Act, without appropriately reserving rights or amending the Finance Documents.
Does the sponsor have any money?

+ A Bad Boy Guarantee is a practical last line of credit protection, and enforcement a practical last resort. If the sponsor has committed a "Bad Act", it is likely that their position has deteriorated, and they are in financial trouble. So, by the time lender needs to rely on Bad Boy Guarantee, there may be other competing claims against the sponsor, and potential insolvency or bankruptcy proceedings. The likelihood of material recovery may be low.

+The same applies at the time losses are quantified under a losses guarantee – at this stage in the process there may not be much value left in the sponsor.

+Accordingly, the lender will have to make the classic commercial assessment as to whether it is worth spending significant money (including legal fees) and significant time (probably senior management time) on enforcing a Bad Boy Guarantee, where there may be little return on that by way of financial recovery. The lender risks putting good money after bad, as its IRR on the relevant position continues to reduce.

The real value of a Bad Boy Guarantee is much more likely to be the threat of (rather than actual) enforcement – to ensure the "good behaviour" or "good faith" of a borrower. Again, a lender will have to weigh up in underwriting a deal how much of a real threat this is likely to be, and how much of an incentive it will be to the borrower to cooperate should the deal underperform and/or the relationships break down. Background checks and references on the sponsor can help with this assessment.

Conclusion

In general, where the borrower has institutional backing and the sponsor is an entity of substance, a Bad Boy Guarantee is more likely to be valuable. However, such a counterparty is only likely to agree to a fulsome "lender friendly" Bad Boy Guarantee in exceptional circumstances.

Where the sponsor is "non-institutional", with no real market reputation to protect, and with the majority (if not all) of their net worth tied up in the relevant financed project, the sponsor may have little practical concern about a Bad Boy Guarantee. If the deal is unsuccessful, they will be unsuccessful (and potentially bankrupt) anyway, and they may be prepared to try anything to avoid that, notwithstanding what documentary restrictions exist.

As discussed above, a lender may face potential enforcement challenges, and potentially limited financial recovery in practice. Litigation is likely to be required. A lender should therefore be mindful that a fulsome "all singing, all dancing" Bad Boy Guarantee, expensively negotiated and documented, may in certain circumstances have only cosmetic value.

Consider instead

While a full guarantee may not be acceptable to a sponsor, on some deals the sponsor may be prepared to give a limited guarantee. Consider whether a guarantee of an amount lower than the full debt, may provide more practical value than a Bad Boy Guarantee. There will be far fewer enforcement challenges for a guarantee that is on demand following the borrower's failure to pay – and the sponsor will likely take it more seriously.
Consider limiting the Bad Acts to very specific items that may be a concern in a particular deal – for example on one particular deal we have seen a sponsor guarantee limited to an undertaking that the sponsor will not take steps to COMI shift to France – to give the lender comfort that it will not be involved in a "borrower friendly" French insolvency process. This is much more likely to be acceptable, and where it relates to a specific risk, easier and cheaper to negotiate, and more easily enforceable.
Undertake appropriate background checks on borrowers and sponsors and measure the transaction risk in light of these findings. Where sponsors appear to be "high-risk", the lender should consider including a budget for litigation and legal fees in its downside case modelling. Lenders should be aware that aggressive restrictions in legal documentation only offer so much protection, where a counterparty is simply prepared to ignore its contractual obligations.
Similarly, lenders should take immediate action when they become aware of a deal underperforming and/or a sponsor or borrower failing to comply, cooperate or provide requested information. Taking firm steps at the first sign of problems with a borrower relationship is usually a better approach than "kicking the can down the road". Reminding a sponsor at an early stage of their Bad Boy Guarantee obligations and gauging the sponsor's reaction to this can inform the lender's approach going forward. As indicated above, relying on enforcement of a Bad Boy Guarantee should be a last resort.

We at Stephenson Harwood have significant first-hand experience with Bad Boy Guarantees in the special situations space and would be happy to discuss any of the issues raised in this note in more detail.

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