172 Madison (NY) LLC v. NMP-Group, LLC, New York County Supreme Court Index No 650087/2010

Springing non-recourse carve-out guaranties are a standard feature of many commercial mortgage loans.  Under such arrangements, the lender generally agrees to look only to the property and its single purpose entity fee owner to recover its loan in the event of a default.  In other words, the loan is generally non-recourse. But if the the borrower commits certain acts, sometimes referred to as “bad boy acts,” guaranty liability “springs” into existence.  A common bad boy act is the borrower filing for bankruptcy.

Those were the facts in 172 Madison (NY) where the borrower filed for bankruptcy on the day the foreclosure auction was scheduled. Justice Shirley Kornreich held for the lender.  On a motion for summary judgment against the guarantor, Justice Kornreich wrote: “Recourse carve-out guaranties are primarily created to deal with situations such as the one that has arisen here.  In exchange for agreeing to look only to the mortgaged property in the event of default, lenders typically require that the borrower or its guarantor promise to pay the entire debt if the impede foreclosure by filing for bankruptcy.  It can be said without exaggeration that the Guaranty was intended to apply to the exact circumstance currently confronting Lender.”

So far, Justice Kornreich’s opinion is straight-forward, but there was more.  The guarantor argued that it could not be liable because the complaint, which was filed well before the borrower filed for bankruptcy did not contain a cause of action against the guarantor for the debt.  Justice Kornreich made short shrift of that defense.  The court wrote that it  would “not allow the guarantor to put of her day of reckoning by insisting on a pointless supplemental pleading to formally bring the complaint up to date where there is no surprise and the underlying facts are not in dispute.”

The guarantor also argued that any judgment against it was barred by Real Property Actions and Proceedings Law section 1301, the election of remedies statutes.  The election of remedies statute provides that a lender can either (i) proceed on a claim for the debt it is owed and forego the equitable remedy of foreclosure; or (ii) the lender can foreclose and wait until after the property is sold at a foreclosure sale to seek to recover any monetary damages if the amount realized on the foreclosure sale is less than the debt (this is known as a “deficiency judgment”).  The lender cannot do both.  It must “elect” its remedy.  Here, the guarantor contended that the lender having chosen to foreclose, could not switch its sought after remedy by seeking to recover on the guaranty.

Justice Kornreich rejected this position and held the prior commencement of the foreclosure action did not prevent the lender from seeking to recover on the guaranty.  The court noted that when the lender made its election to foreclose, the borrower had not yet filed for bankruptcy.  Accordingly, at the time of the lender’s election of its foreclosure remedy, the lender had no right to proceed against the guarantor on the debt.

Justice Kornreich, however, recognized that once the borrower filed for bankruptcy “a choice between the two remedies must ultimately be made.”  Accordingly, Justice Kornreich required the lender to submit a new order and judgment that would either amend the existing judgment of foreclosure and sale to permit allow for a deficiency judgment against the guarantor or vacate the foreclosure judgment and substitute a money judgment against the guarantor for the entire amount of the debt.

The lessons of 172 Madison (NY) are several.  First, all commercial borrowers must be cautious not to file for bankruptcy and thereby inadvertently “spring” a springing, non-recourse carve-out guaranty.  Second, courts will not hesitate to permit lenders to add claims against guarantors even where such claims arise during the pendency of foreclosure actions.  Third, courts will still require lenders to elect there remedies and proceed either on the debt or in foreclosure.