Guarantor Avoids $42 Million Loan Liability

June 2012

In GECCMC 2005-C1 Plummer Street Office v. NRFC NNN Holdings, decided March 29, 2012, the California Court of Appeals held that a guaranty on a non-recourse loan to a borrower, which guaranteed payment in the event of a lease termination, was not triggered when the tenant abandoned the properties.  The court considered two factors in rendering its decision: (1) what constitutes termination of the lease under the California Civil Code and the applicable lease provisions; and (2) the intent of the parties in triggering the guaranty obligations, as set forth in the guaranty and the other loan documents.

This case illustrates the importance of a lender’s careful review of existing lease agreements as part of its due diligence in connection with potential loans, as well as the necessity to draft clear loan document provisions to avoid any potential ambiguities and to give effect to the parties’ intentions regarding events triggering guaranty obligations.

A brief summary of the case is set forth below, together with suggestions to avoid unenforceable guaranties in connection with terminated leases.

Facts.

GECCMC 2005-C1 Plummer Street Office Limited Partnership (“Lender”) made a $44 million loan (“Loan”) to NRFC Sub Investor IV, LLC (“Borrower”) to purchase two commercial properties in Chatsworth, California (collectively, “Properties”).  Borrower leased the Properties under two leases (collectively, “Leases”) to Washington Mutual Savings and Loan as the sole tenant (“Tenant”).  The Loan was non-recourse to the Borrower, secured by the Properties but not by any of the Borrower’s other assets, subject to exceptions for certain forms of Borrower misconduct commonly known as “bad boy acts.”

NRFC NNN Holdings, LLC (“Guarantor”), an affiliate of the Borrower, executed a guaranty that would be triggered by these bad boy acts (“Guaranty”).  The Guaranty provided, in relevant part, that the Loan shall be fully recourse to the Guarantor, and the Guarantor unconditionally and irrevocably guarantees payment of the entire Loan, if after the date of the Guaranty, either of the Leases is terminated or canceled without the prior written consent of the Borrower.

The Tenant went out of business and it and its successors ceased paying rent to the Borrower and abandoned the Properties.  The Borrower thereafter ceased making Loan payments to the Lender, and the Lender took title to the Properties through a non-judicial foreclosure sale in which it bid approximately $11 million.  The Lender then filed suit against the Guarantor for the approximately $42 million balance due on the Loan, plus attorney fees and costs.

The principal issue in the case was whether the Tenant’s ceasing to pay rent and abandoning the Properties terminated the Leases, and triggered the Guarantor’s duty to pay the amount owed on the Loan if the Leases were “terminated” without the prior written consent of the Lender.

Termination of the Leases under the California Civil Code and the Lease Provisions.

The court rejected the Lender’s argument that the Tenant’s breaches terminated the Leases, interpreting the California Civil Code together with the applicable Lease provisions.  Civil Code Section 1951.2(a) provides that “[e]xcept as otherwise provided in Section 1951.4, if a lessee of real property breaches the lease and abandons the property before the end of the term…the lease terminates.” Civil Code Section 1951.4(b) states in relevant part: “Even though a lessee of real property has breached the lease and abandoned the property, the lease continues in effect for so long as the lessor does not terminate the lessee’s right to possession.”

It is undisputed that the Tenant breached the Leases by ceasing to pay rent and abandoning the Properties and that the Borrower never gave notice of termination to the Tenant.  The Leases provide, in relevant part, that the occurrence of any one or more of the following events shall constitute a material default and breach of the Leases by the Tenant: (a) the abandonment or surrender of the Properties by the Tenant; and (b) the failure by the Tenant to make any equal monthly or any other rental payments required under the Leases, as and when due.  However, the Leases also provide that it is the intention of the parties that the Leases shall not be terminable for any reason by the Tenant and that any present or future law to the contrary shall not alter the agreement of the parties.  Furthermore, “[n]o act by Lessor other than giving notice of termination to Lessee shall terminate Lessee’s right to possession.”  The court concluded that under the plain language of the Leases, neither the Tenant’s failure to pay rent nor its abandonment of the Properties terminates the Leases.  The court made special note of the provisions in the Leases that explicitly state that they override any “law to the contrary.”

In addition, in order for Section 1951.4 to apply, the court noted, there must be a provision in the Leases in substantially the following form: “The lessor has the remedy described in California Civil Code Section 1951.4 (lessor may continue lease in effect after lessee’s breach and abandonment and recover rent as it becomes due, if lessee has right to sublet or assign, subject only to reasonable limitations).”  The court found that the Leases satisfied the requirements of Section 1951.4, as the Leases provide that in the event of a material breach by the Tenant, the Borrower may continue the Leases in full force and effect, and the Leases will continue in effect as long as the Borrower does not terminate the Tenant’s right of possession, and the Borrower shall have the right to collect rent when due.

Based on the provisions in the Leases and the undisputed facts, the court concluded that the Leases did not terminate and, therefore, the Guaranty was never triggered.

Thus, if a tenant abandons the property but the landlord does not terminate the tenant’s right to possession, the lease continues in effect, as long as the language required by Civil Code Section 1951.4 is included in the lease.  If a lender wishes to trigger a guarantor’s obligations in the event of a lease termination due to the tenant’s abandonment or other breach of the lease, the lender should make sure to include language to that effect in its loan documents.

By carefully drafting the loan documents to avoid ambiguities and clearly stating the circumstances under which the guarantor’s obligations are triggered, a lender may avoid facing the situation the Lender faced in Plummer Street where it was unable to collect $42 million on the Guaranty, plus attorney fees and costs.  Had the Lender included more detailed language in the Guaranty evidencing the expectation of the Lender in the event of the Tenant’s breach of the Leases, the unenforceability of the Guaranty could have been avoided.  This is particularly important in today’s economy where even the largest and seemingly most successful tenants could go out of business virtually overnight.

Intent of the Parties in Triggering the Guaranty.

The Guarantor pointed out, and the court agreed, that the court’s interpretation of the Guaranty is consistent with the parties’ intent, expressed in the deed of trust and other loan documents, to carve out exceptions to the Loan’s non-recourse provision only in the event that the Borrower commits certain “bad boy acts” that pose particular risks to the Lender’s interests and collateral.  Those same acts trigger the liability of the Guarantor.  In the absence of such misconduct by the Borrower, the sole security for the Loan is the Properties.  In the case, since the Tenant abandoned the Properties and the Borrower did not terminate the Tenant’s right to possession, the Leases were not terminated and therefore, the “bad boy” provisions of the loan documents were not triggered.

What constitutes a “bad boy act” can vary depending on the lender, but some typical examples include the following:

  • The borrower’s fraud, intentional misrepresentation, or material failure to disclose information required to be delivered to the lender, either prior to the closing date or during the term of the loan.
  • Waste to the property caused or permitted by the borrower, and any and all other liabilities, costs, expenses or damages incurred or sustained by the lender to protect the property.
  • The borrower’s or guarantor’s misapplication under the loan documents of any security deposits, rents paid more than thirty days in advance, condemnation awards, insurance proceeds, or other similar funds or payments attributable to the property.
  • Any violation and/or enforcement of the environmental indemnity agreement.
  • The borrower’s failure to pay taxes, assessments, insurance premiums or other sums for which the borrower is liable under the loan documents.
  • The borrower’s failure of its warranty of title in the loan documents.
  • The borrower’s termination of the leases without the prior written consent of the lender.

The court’s ruling provides a valuable lesson for lenders in making guaranteed loans.  In conducting due diligence in connection with a potential commercial loan, lenders or their counsel should carefully review the provisions of the lease agreements in place on the property to determine the tenant’s and landlord’s respective termination rights under the lease agreement and then carefully draft the guaranty and other loan documents to address the circumstances under which the guaranty is enforceable in the event of lease termination, consistent with the expectation and intent of the parties.  Lenders should be aware of the limitations imposed in connection with non-recourse loans for which liability only applies in the event of “bad boy acts.”  The loan documents should specifically address the potential abandonment of the lease and the property by the tenant, rather than an affirmative termination of the lease by the borrower, as a trigger of the guarantor’s obligations under the guaranty.

Tips to Consider when Drafting Loan Document Provisions.

When a lender’s intent is to enforce the guaranty in the event of lease termination by the tenant, subject to the caveat set forth below, the guaranty should clearly state that, notwithstanding any law to the contrary, the guaranty obligations are triggered in the event the lease terminates for any reason whatsoever, including without limitation, a default or breach of the lease by the lessee, or through the actions or inactions of the borrower.

The guaranty should also state that notwithstanding any law to the contrary, if the tenant ceases business operations, whether voluntarily or involuntarily, abandons the property, or otherwise defaults under the lease, whether or not the landlord has terminated the tenant’s right to possession, the lease shall be deemed to be terminated, and the guarantor’s obligations under the guaranty shall be triggered.

It should be noted, however, that, while such clauses are beneficial to a lender, it is unlikely that sophisticated guarantors would agree to such clauses since the suggested language would effectively transform the loan guarantors into guarantors of the tenant’s obligations.  Nonetheless, it is worth including these clauses in the initial guaranty draft in the event that a guarantor will agree to them.