"Bad Boy" Carve-Outs Definition and Explanation
Non-recourse loans allow a commercial real estate borrower to take out a loan without being personally liable if the loan goes into default. Most Fannie Mae, Freddie Mac, HUD, and CMBS loans are non-recourse. However, there is a catch to non-recourse loans called “bad boy” carve-outs. Essentially, the recourse has been “carved out” of the agreement if the borrower conducts themselves badly and has thus been a “bad-boy.”
Common “Bad Boy” Activities By Investors
Some of the most common “bad boy” activities by investors include:
Preparing fraudulent tax or income statements to make themselves appear more financially strong than they really are during the loan application process
Conspiring with property appraisers, inspectors, or others to falsify third-party reports
Fraudulently changing a property’s profit and loss (P&L) statement to make the property’s income appear higher or the expenses lower than they really are
Intentionally committing bankruptcy
Embezzling money from the investment property
Taking out a subordinate loan without the express permission of the lender
What Happens When a Borrower Acts Like a “Bad Boy”?
If a borrower engages in bad boy activities, the lender may attempt to foreclose on the property. If the foreclosure amount does not fully pay back their outstanding loan amount plus interest, expenses, legal fees, and any additional default fees, the lender is free to pursue the borrower’s personal property (i.e. homes, cars, bank and brokerage accounts) in order to make themselves whole.
Bad Boy Carve-Outs and CMBS Loans
Bad boy carve-outs are especially strict for CMBS loans, and this means that borrowers need to be additionally careful when signing a CMBS loan agreement.
Common additional bad boy carve-outs for CMBS or conduit loans include:
Failing to send in quarterly P&L reports on time
Being late on property taxes
Being late on insurance payments
CMBS loan carve-outs can be especially tricky, as CMBS loans are not serviced by the lender, and are instead serviced by an independent servicer. If the loan goes into default, a special servicer will be used. Special servicers are notorious for refusing loan workouts and may even wish (however unethically) to repossess the property to add it to their own portfolio.
For this reason, commercial and multifamily real estate borrowers should always have an experienced real estate attorney review their borrowing agreement, and should always remind them to focus on all aspects of the recourse/non-recourse section of the agreement. Otherwise, what a borrower thought was a non-recourse loan could easily turn into full-recourse financing.