Unintended Risks from Nonrecourse Loans

Like many borrowers, you may be drawn to nonrecourse loans because the arrangements can shield you from personal liability. But they don’t provide protection in all cases. “Carveouts” in the loan documents can saddle you with full liability if violated. However, you may be able to minimize personal liability for violations through savvy negotiating.

Exceptions to liability protection

Under a nonrecourse loan, the lender agrees that the borrower won’t be held personally liable on the loan. Theoretically, that means the lender’s only “recourse” in the case of default lies in the collateral (generally real estate).

However, the lender may include specific carveouts — or exceptions — that will nullify that restriction. Common carveouts include the borrower’s fraud, misapplication of insurance proceeds, waste, or intentional destruction of property. Few court cases have directly tackled the enforceability of carveouts in nonrecourse loans or the lender’s ability to accelerate foreclosure and recover the full amount of the loan if a carveout is violated. So proceed with caution.

Advice for borrowers

Before entering a nonrecourse loan, evaluate and negotiate any carveouts in the loan documents. Watch out for overly broad language and make sure that the potential causes of default are clearly defined.

Also look out for “springing guarantees” that trigger a guarantor’s obligations to pay the full amount of debt, as opposed to only the damages proximately caused by a breach of a carveout. Ideally, you want to limit such guarantees to intentional acts, excluding mere negligence or mistake.

You may be able to limit liability under both springing guarantees and carveouts to only damages caused by the prohibited act, instead of the entire debt deficiency. And require the inclusion of notice and cure periods to secure the opportunity to take corrective action before acceleration and foreclosure.

Once the loan has closed, avoid taking actions that could violate carveouts, especially those that might affect the value of the collateral securing the loan. If you sell the property and the buyer assumes the loan, negotiate a release from liability so you aren’t exposed to potential liability for the buyer’s acts. (Note that nonrecourse agreements frequently include a carveout requiring written consent from the lender before transferring mortgaged property.)

Don’t get carved up

To protect yourself from personal liability, carefully review every carveout with your attorney before entering into a nonrecourse loan. A financial expert can help you determine proximate damages from a hypothetical (or real) breach of a loan carveout provision.