Indiana Court of Appeals Confirms Validity of Carve Out Guarantees and Enforcement of Prepayment Premiums

Jul 5, 2013

Author: Jim Carlberg
On July 16, 2013, the Indiana Court of Appeals issued an opinion affirming the decision of the Marion County Superior Court granting Fannie Mae a judgment of over $1.8 Million against a guarantor pursuant to a “carve out” or “bad boy” guaranty. The affirmed judgment included a prepayment premium of $1.4 Million.
The “carve out” or “bad boy” guaranty has become common in otherwise non-recourse commercial real estate loans, enabling the creditor to look beyond the mortgaged property for repayment of the loan when certain “bad act” default events occur. When these “bad act” events occur, the guarantor is made liable for specific damages relating to certain types of defaults (e.g., failure to remit rental income after default; failure to pay real estate taxes; etc.) or liable for the entire indebtedness in the event of certain other defaults (e.g., the borrower files a bankruptcy proceeding; the borrower violates the due on sale clause; the borrower fails to discharge mechanics’ liens or permits an unauthorized transfer of the property, etc.)
In this case, the default event that triggered liability for the entire indebtedness owed on the loan was the failure of the borrower and guarantor to discharge mechanics’ liens totaling approximately $70,000 which had been recorded against the property.
In affirming the judgment, the Court of Appeals made the following holdings, which are of great significance to lenders and financial institutions in Indiana:
Loan Documents Are Not Ambiguous Merely Because They Are Complex
  • The Court of Appeals rejected the guarantor’s assertion that the loan documents were so complicated that they were unenforceable due to “latent ambiguity”.
  • The guarantor claimed no party would anticipate that it would be liable for millions of dollars when the total amount of unpaid mechanics’ liens totaled only around $70,000. He also claimed he did not read the documents because he was told that he would not be personally liable.
  • The Court, noting that the guarantor admitted he did not read the loan documents, held that the loan documents, although complex, were not ambiguous, and rejected the guarantor’s extrinsic evidence regarding what he understood at the time of contracting, which was offered in support of his claims.
  • The Court also held that parties are obligated to know the terms of the agreements they are signing, and a failure to read the documents does not make them ambiguous.
A “Carve Out” Guaranty Is Not Unenforceable As Constituting A Penalty
  • The Court of Appeals rejected the guarantor’s argument that the guaranty imposed an unenforceable penalty because it provided for full liability for a $1.8 Million deficiency judgment based on the occurrence of a “carve out” default associated with approximately $70,000 in unreleased mechanics’ liens.
  • The Court held that the “carve out” provisions are not liquidated damages provisions because they merely define when personal liability is triggered and are not relevant to determining the extent of the damages resulting from the “carve out” defaults.
  • Prepayment Premiums Are Not Necessarily Unenforceable Penalties
  • The Court of Appeals rejected the guarantor’s argument that the prepayment premium was an unenforceable penalty.
  • The Court held that the prepayment premium was an enforceable liquidated damages provision which insured the lender against the loss of its bargain if interest rates declined.
  • The Court noted that the prepayment premium provision in the loan documents recited that prepayment subjected the lender to reinvestment losses and losses due to its third party commitments to pay bondholders, that those damages were very difficult to ascertain, and that the prepayment premium was a forecast of the lender’s loss.
  • The Court noted that it was not significant that the prepayment premium amounted to almost 25% of the original loan amount of $6 Million, as it bore a reasonable relationship to the amount of the loss upon prepayment, as projected at the time the loan was made, indicating that, to be enforceable, the prepayment premium only must be reasonable and bear a relation to the lender’s loss on prepayment.
  • The Court affirmed the enforceability of the prepayment premium despite the fact that the prepayment in the case was an involuntary prepayment resulting from the acceleration of the loan balance.
Loan Documents Are Not Unconscionable Absent A Disparity In Bargaining Power Which Results In Unwilling Or Uninformed Execution
  • The Court of Appeals rejected the guarantor’s claim that the loan documents were unenforceable based on the doctrine of unconscionability.
  • The Court indicated that, generally, a contract is unconscionable when a great disparity in bargaining power exists which leads the weaker party to sign a contract unwillingly or without being aware of its terms, and that the contract must be such that no sensible person not under delusion, duress or in distress would make and such as no honest fair individual would accept.
  • The Court held that even though there is a disparity in bargaining power between a lender and a guarantor, loan documents are not unconscionable unless the disparity caused the guarantor to sign the guaranty unwillingly or caused the guarantor to be made unaware of its terms.
  • The Court found that the guarantor in this case was an experienced business person and not in a position of weakness or unequal bargaining power.
 If you have further questions about these issues and their application to your business, please contact Jim Carlberg or your Bose McKinney & Evans attorney.