Non-Recourse Loans

A “non-recourse loan” is a loan where the bank’s right of recovery is generally limited to recovery against a particular piece of collateral, usually a mortgaged piece of real estate. 

A standard loan includes documents such as a Note, a Mortgage, and a Guaranty.  The general idea is that if the borrower does not pay under the Note, the bank can bring a lawsuit against the Borrower under the Note, bring a lawsuit against the guarantor under the Guaranty and foreclose on the real estate.  Normally the foreclosure would occur first, and the bank would ultimately pursue the Borrower and the Guarantor for the “deficiency,” which can be either the difference between the outstanding amount of the loan and what the property brings at a Sheriff’s sale, or, if the bank buys the property at the sale, the difference between, the outstanding amount of the loan and what a court determines the property is worth. 

In a non-recourse loan, the bank generally cannot pursue the deficiency.  The Bank may pursue a monetary judgment against the Borrower and sell the mortgaged real estate or it may foreclose under the mortgage and sell the real estate (two similar procedures), but once the property goes to Sheriff’s sale, the Bank is limited to (i) taking what the property brings at the Sheriff’s sale or (ii) buying the property at the Sheriff’s sale with the hope of selling it for a greater amount later.   

As can easily be imagined, before any bank will make a non-recourse loan it will become comfortable with certain aspects of the deal.  For example it will determine that the mortgaged property provides a healthy “equity cushion” so that the property pays off the debt.  The typical way that banks gauge whether there is a sufficient enough cushion is by calculating a loan to value ratio for the loan—basically the maximum outstanding principal value of the loan divided by the value of the property.  For example, a bank that might normally require an 80% loan to value ratio for a full-recourse loan might require a 65-75% loan to value ratio in order to make a non-recourse loan.

Non-recourse status is not absolute.  A non-recourse loan generally limits a bank to the collateral and prevents personal liability of the borrower.  However, typically a non-recourse loan will contain what are known as “bad-boy provisions.”  Among other things, these provisions will often provide that the loan goes “full-recourse” if a borrower commits certain egregious acts or if certain conditions fundamental to the mortgaged property arise.  Typically those acts and events include missing a first debt service payment, misrepresenting to the bank about itself or the mortgaged property, the bank finding out that the mortgaged property has environmental problems, or the borrower filing for bankruptcy.  The list of “bad boy” events is usually significantly longer than this.  If any of the enumerated events occurs, the buyer is back on the hook just as it would be in a normal full-recourse loan.

Finally, what about guaranties in the non-recourse loan transaction?  Often, a bank will ask for a guarantor even on a non-recourse loan.  Based on the general idea of what the remedies are when a non-recourse loan is in default, there would appear to be no reason to have a guarantor.  If the bank intends to look to the property why would it need a third party guarantor involved?  The short answer is that the bad boy provisions also cause the guaranties to go “full-recourse.”  This can be a powerful threat in the bank’s arsenal of weapons.  Among other things it can provide a strong incentive for a borrower (particularly a borrower owned or controlled by the guarantor) to not file for bankruptcy.

What is the upshot of all this for a potential real estate borrower?  If you can get non-recourse financing at a rate and on terms that are in some sense comparable to a full-recourse loan you should seriously consider it.  However,  not all borrowers qualify and often times the real estate is required to be titled in the name of a “single purpose entity.”  Any non-recourse borrower or guarantor should be (along with his, her or its lawyer) very attuned to the number and type of bad-boy provisions in negotiating the loan.  If the borrowing parties are not careful, these exceptions can seriously erode the non-recourse protection the borrower expects.

— Rod Fluck

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