What Is a Carve-Out Guaranty in Commercial Real Estate?

A guaranty in real estate is a legal agreement where a third party, known as the guarantor, agrees to be responsible for fulfilling the obligations of another party, the debtor, if they default. This arrangement adds security for lenders and investors by providing an additional source of repayment if the primary borrower fails to meet commitments. The presence of a guarantor can also increase a borrower’s chances of loan approval, particularly if their credit history is not strong or if they have insufficient collateral. This confidence can sometimes lead to more favorable loan terms for the borrower.

What a Carve-Out Guaranty Is

A carve-out guaranty is a specific provision within commercial mortgage agreements that holds a guarantor personally liable for certain actions, even when the loan is generally non-recourse. Commercial mortgages are often structured as non-recourse loans, meaning the borrower’s liability is limited to the property securing the loan. If a borrower defaults, the lender’s recovery is typically restricted to foreclosing on the collateral property.

Carve-out guaranties create exceptions to this non-recourse nature. These exceptions, sometimes referred to as “bad boy” or “springing” guaranties, mean that while the borrower’s personal assets are generally protected, they become exposed under specific circumstances. The guaranty protects the lender from particular “bad acts” or misconduct by the borrower that could harm the loan or collateral, targeting specific situations where personal liability is triggered.

Specific Actions That Trigger Liability

Carve-out guaranties are triggered by specific actions or failures of the borrower that are detrimental to the lender’s interest. These “bad acts” can impair the collateral’s value or divert funds meant for the property or loan repayment. Common triggers include:

• Fraud or misrepresentation: Intentionally providing false or misleading information, such as fabricated appraisals or financial statements, which undermines the lender’s risk assessment.
• Misappropriation or misapplication of funds: Diverting money meant for the property or loan, including rents, insurance proceeds, or condemnation awards, which jeopardizes the lender’s security.
• Waste: Physical damage or neglect of the property, which decreases the collateral’s value and harms the lender’s ability to recover their investment.
• Unauthorized transfers or encumbrances: Selling, transferring, or placing new liens on the property without lender consent, which can dilute the lender’s claim.
• Bad faith bankruptcy: Filing for bankruptcy in bad faith or colluding with creditors to initiate involuntary bankruptcy, which lenders discourage to prevent avoidance of obligations or delays.
• Failure to pay taxes or insurance: Neglecting real estate taxes or insurance premiums, which are essential for protecting the property’s value and the lender’s interest.
• Environmental contamination: Causing environmental damage that leads to cleanup costs and reduces the property’s market value.

The specific nature and scope of these triggering events are usually detailed within the carve-out guaranty agreement.

The Extent of Personal Liability

The extent of personal liability under a carve-out guaranty varies depending on the specific “bad act” committed. These guaranties delineate two main categories of liability: loss recourse and full recourse.

Loss recourse, also known as “bad boy” acts, means the guarantor is only liable for the actual monetary damages or losses incurred by the lender directly resulting from the specific triggering event. For example, if the borrower misapplies $50,000 in rent, the guarantor would be liable only for that amount, plus any associated legal costs.

In contrast, full recourse, often termed “springing recourse,” transforms the entire non-recourse loan into a full personal recourse obligation for the guarantor. This means that upon certain severe “bad acts,” the guarantor becomes personally liable for the entire outstanding loan balance, not just the loss caused by the specific action. Common actions triggering full recourse include voluntary bankruptcy filings, unauthorized property transfers that undermine collateral, or a breach of single-purpose entity covenants. The distinction between these two types of liability is important, as full recourse can put the guarantor’s entire personal wealth at risk, while loss recourse limits exposure to specific damages.

Who Signs a Carve-Out Guaranty

A carve-out guaranty is typically signed by the individual principals of the borrowing entity, rather than the entity itself. This often includes the owner of a limited liability company (LLC) or the general partner of a partnership. The purpose of requiring these individuals to sign is to provide a direct incentive to act responsibly and avoid engaging in the “bad acts” detailed in the guaranty.

By placing personal assets at risk, the guaranty encourages those who control the commercial property and the borrowing entity to manage the asset prudently and uphold their obligations to the lender. This structure ensures that even if the borrowing entity, such as an LLC, offers limited liability protection, the individuals behind it face personal consequences for certain misconduct. It is the personal wealth of these individual guarantors that is exposed, not merely the assets held by the borrowing entity.