Real Estate / 6 min read
It's no secret that the commercial real estate market has faced some serious difficulties in recent years. Prior to such difficulties, and even continuing today, non-recourse lending had become the norm for larger commercial real estate projects. As lenders face difficult decisions about what to do with a growing number of non-performing commercial real estate loans, many lenders are taking a closer look at their loan documents to see what collection options may be available to them other than (or in addition to) foreclosure in what would traditionally be viewed as non-recourse loans.
Even though many commercial real estate loans have been marketed as being "non-recourse," many lenders still insist on the execution of a limited guaranty at closing by one or more of the project investors, commonly referred to in the industry as "bad boy" guaranty agreements. As the name implies, personal liability under these types of agreements is typically triggered through the objectively bad acts of a guarantor, such as theft, embezzlement or fraud. Well-intentioned and honest investors may sometimes give such "bad boy" agreements little thought during the closing process, as they have no intention of taking such nefarious actions. However, virtually every one of these bad boy agreements contains a liability trigger based on the concept of "waste," which is rarely defined (intentionally or accidentally) in the loan documents.
What constitutes "waste" under Texas law in the context of a commercial "bad boy" guaranty? Surprisingly, there is very little case law in Texas answering that question. As lenders consider more aggressive collection strategies, the question of what may give rise to a waste claim sufficient of triggering personal liability is being asked more frequently, both by lenders and guarantors.
One of the few cases in Texas addressing this topic is U.S. Bank, Nat. Ass'n v. Am. Realty Tr., Inc., in which the Dallas Court of Appeals was faced with the question of whether a waste provision was triggered when the borrower decided not to reapply for a Holiday Inn franchise license for the property, and instead elected to rebrand the property as a Clarion hotel. The lender, pointing to lower occupancy levels and reduced revenues, claimed the branding change constituted waste. The guarantor argued that because no physical damage to the property had incurred, there was no "waste."
The Dallas Court of Appeals artfully maneuvered around the analysis of what exactly constitutes waste in Texas, opting instead for a case-specific contract interpretation analysis. Ultimately, the court agreed with the guarantor that the waste carve-out provision did not include any future franchise licenses that may or may not be obtained, and avoided the question of whether waste encompasses only physical damages to property. However, the court alluded to the potential of waste being committed had the circumstances been different:
The distinction is between breaching an existing contract and renewing or reapplying for a new contract. Had Borrower terminated its franchise license with Holiday Inn prior to September 24, 2002 and then changed to a Clarion, this could possibly be waste to the existing property. However, by failing to reapply for a Holiday Inn franchise license and instead re-flag as a Clarion after the Holiday Inn franchise license expired, Borrower did not commit any "waste" on the "property." If appellants wanted the hotel to remain a Holiday Inn, they should have specifically contracted for it. Consequently, a future Holiday Inn franchise that was never acquired never became part of the property in which the waste provision applied.
The Dallas Court of Appeals also briefly touched on the concept of "waste" in Wells Fargo Bank, N.A. v. HB Regal Parc, LLC. There, however, the court upheld the trial court's belief that actual waste had occurred, as a civil engineer testified he had inspected the apartment complex immediately after foreclosure and that he was reasonably certain several problems requiring immediate repair had arisen during the appellees' ownership. The Dallas Court of Appeals found that there was sufficient evidence based on expert testimony that actual waste had been committed.
The questionable holding in the Wells Fargo case presents a potential opportunity to lenders, as well as a potential risk to guarantors, in situations where a property simply fails to generate sufficient net cash flow to pay expenses, as opposed to any affirmative actions taken by the borrower or guarantor to damage the property or its operations. However, as one commentator has astutely stated (in the context of borrower recourse):
Courts should be wary of holding the borrower liable in cases in which the borrower's unfortunate but nonmalevolent actions devalue the real estate. There is little justification for further penalizing the borrower who proves to be nothing worse than foolhardy, incompetent, or unlucky, particularly when that borrower possessed the initial foresight to insist upon a nonrecourse loan and its lender failed to take the precaution of limiting the borrower's flexibility. The nonrecourse lender should suffer the consequences of its original poor decision to place its financial fate so extensively in the hands of a borrower for which things went badly.
In light of the lack of a substantial body of case law in Texas on the topic, courts may look to other jurisdictions for guidance. For example, the Court of Special Appeals of Maryland explored the history behind the cause of action for waste in Boucher Inv., L.P. v. Annapolis-W. Ltd. P'ship. There, the court ultimately held that a mortgagor's failure to negotiate a lease for parking space did not constitute waste. But, in doing so, the court made a number of observations that might be considered helpful to a Texas court looking for guidance on the topic. In making its decision, the Maryland court relied on the Restatement (Third) of Property, which states:
- Waste occurs when, without the mortgagee's consent, the mortgagor:
- physically changes the real estate, whether negligently or intentionally, in a manner that reduces its value;
- fails to maintain and repair the real estate in a reasonable manner, except for repair of casualty damage or acts of third parties not the fault of the mortgagor;
- fails to pay before delinquency property taxes or governmental assessments secured by a lien having priority over the mortgage;
- materially fails to comply with covenants in the mortgage respecting the physical care, maintenance, construction, demolition, or insurance against casualty of the real estate or improvements on it; or
- retains possession of rents to which the mortgagee has the right of possession under § 4.2.
In the course of its analysis, the court mentioned not only cases where physical harm to the building was considered waste, but also recognized those narrow cases which did not involve physical damage to real property, such as the failure to pay taxes and insurance premiums. In short, the court held that the failure to negotiate a lease for parking space was distinguishable from the failure to pay taxes or the non-payment of insurance premiums because it did not result in either an increase of the debt or an impairment of the security by subjecting its liens superior to that of the mortgage. The court also re-emphasized the parties' ability to contractually expand or narrow the definition of waste.
What legally constitutes "waste" is far from being perfectly defined under Texas law and is largely an issue of fact. The line appears to be somewhere between intentional physical harm to the property and a mere inability of a property to generate sufficient cash flow to pay for normal operating expenses. Understanding these risks and uncertainties in our current commercial real estate environment is critically important to both lenders and guarantors. Regardless of which side you find yourself on, the commercial litigation and real estate teams at Andrews Myers can help you maneuver these topics.