Bad boy carve-outs come into play with nonrecourse commercial real estate loans, which are loans secured by collateral and paid back only from the profits gained from the project being funded, not from any other assets the borrower has, meaning there’s no personal liability. Let’s look into this and the concept of bad boy carve-outs further.
A mortgaged property would be an example of a nonrecourse loan in that the house is the collateral. For example, in a commercial loan for a real estate transaction to build an apartment building, the land serves as collateral. The loan gets paid back as soon as the project is complete and starts bringing in money. If the project never makes any money, the borrower becomes a “bad boy” and walks away without paying back the debt.
(Note to women in commercial real estate: This field has traditionally been a boys’ club, and this term is a blatant reminder.)
In a pure nonrecourse loan, if a borrower or guarantor can’t pay back the loan, the commercial lender simply takes the collateral. What can happen with real estate loans, however, is the value of the collateral might be less than the debt owed. The lender would then be out of luck.
Making matters even worse for lenders of nonrecourse loans is that some borrowers, knowing they won’t be able to pay back the loan and also understanding they aren’t personally liable for the loan unless they show a profit, might try to siphon money from the project just before defaulting. Lenders need to protect themselves from events that could lead to loan default.
Carve-outs refer to exceptions
In bad boy carve-outs, carve-outs mean exceptions. These carve-outs, or exceptions, benefit lenders as they help keep borrowers honest, or good boys, and serve to limit their economic risk. Bad boy carve-outs help prevent the borrower from diluting the value of the collateral or to perform acts that would make it difficult for the lender to enforce its right to the collateral.
Let’s say a bad boy carve-out doesn’t allow the borrower to misappropriate funds, such as using the proceeds of the loan to fund a personal vacation, or to file a voluntary bankruptcy, which would make it difficult for the lender to foreclose. If there are carve-outs, and if the borrower does indeed misappropriate funds or file bankruptcy, that borrower would now be liable to the lender for any losses the lender might suffer.
Borrowers need to understand the bad boy carve-outs
Bad boy carve-outs are common in commercial real estate loans, but they vary among creditors. Sometimes the carve-outs are straightforward and obvious, like the two examples above. But other times, they’re numerous and complex. Commercial real estate investors need to understand what the bad boy carve-outs are whenever they seek funding.
Because the carve-outs can be difficult to understand, before committing to the loan and signing any paperwork, a borrower should have an attorney review the loan documents before consenting to these terms. The attorney should consider each bad boy clause and adequately explain them to the borrower so that the borrower understands their liability potential in case they inadvertently are “bad” per the contract. Note that carve-outs can apply to a borrower’s actions or inactions.
For example, rather than protect the lender from obvious bad boy behavior, a loan contract can have so many carve-outs that the loan essentially becomes a recourse loan. Some lenders might require the same letterhead be used in all transactions or that financial reports be sent by a certain date or the carve-outs’ trigger.
The Xpress Loans 911 bottom line
All nonrecourse loans can become recourse loans if the borrower has become a bad boy, as defined by the loan’s bad boy carve-outs. If that happens, the borrower becomes responsible for any losses the lender incurs. Borrowers can try to negotiate some carve-outs, and if need be, seek funding elsewhere.