The Guarantor’s Defense — Part 1 of 5
When a commercial real estate project fails, the narrative tends to run one direction. The lender asserts that the borrower mismanaged the collateral, diverted funds, committed waste, or violated covenants. The guarantor is then asked to pay.
What often goes unexamined is the lender’s own conduct during the period at issue.
Lenders are not passive observers in distressed projects. They control reserve accounts. They approve or deny draw requests. They sweep rents through lockboxes. They issue notices, impose cash management, restrict distributions, and exercise blocking rights over operational decisions. In many deals, by the time the lender files suit, it has been an active participant in the project’s financial management for months or years.
That participation matters. It is often the most underused defense available to a guarantor.
The Duty of Good Faith
Every contract in most jurisdictions carries an implied covenant of good faith and fair dealing. Commercial loan agreements are no exception.
That covenant does not rewrite the contract. It does not create obligations the parties did not agree to. What it does is prohibit conduct that destroys or injures the right of the other party to receive the fruits of the agreement.
When a lender exercises contractual discretion in a manner that damages the borrower’s ability to perform — and then seeks to collect on a guaranty triggered by that inability — the lender’s conduct is legally relevant.
Courts have recognized this principle in varying degrees depending on jurisdiction. In some states, lender liability claims based on good faith violations are well-developed. In others, they require more precise pleading. But the concept is available, and it is frequently underdeveloped in guaranty defense litigation.
The Reserve Freeze Paradox
Consider the most common version of this pattern.
A project encounters occupancy pressure. Cash flow declines. DSCR falls below the covenant threshold. The lender activates cash management and gains control over the rent proceeds and reserve accounts.
The lender then denies draw requests from the capital expenditure reserve. The borrower submits repair requests. The lender approves some, delays others, denies others outright. The property deteriorates. Deferred maintenance accumulates.
Later, the lender sues on the guaranty and alleges waste.
The waste allegation is not unfounded in isolation. The property did deteriorate. But the lender’s control over the funds that would have prevented that deterioration is a material fact.
If the lender held the money and refused to release it for property maintenance, the legal question is whether the borrower’s inability to maintain the property was caused by the borrower’s misconduct — or by the lender’s decision to withhold the resources necessary to prevent the damage.
That is a causation argument, and it has real force.
Documenting Lender Refusals
The practical challenge is documentation.
A guarantor who argues that the lender withheld reserves must be able to show the requests were made and denied. That requires a paper trail:
– Written draw requests submitted through proper channels.
– Lender responses denying or delaying approval.
– Communications identifying specific repair or maintenance needs.
– Evidence that the borrower had no alternative source of funds.
– Property condition reports from both before and after the denial period.
Lenders will often argue that draw requests were procedurally deficient, that documentation was incomplete, or that requests were denied for legitimate underwriting reasons. Those arguments must be anticipated and countered.
But where the record shows that maintenance funds existed, were requested, and were refused — the waste allegation loses its foundation.
Estoppel: When the Lender Knew and Did Nothing
Another powerful defense arises when the lender had knowledge of the alleged misconduct, took no action, and continued to accept loan payments, retain fees, or otherwise benefit from the relationship.
This is an estoppel argument. The core elements are:
– The lender knew or had reason to know of the alleged carve-out violation.
– The lender failed to declare a default, accelerate the loan, or assert recourse at that time.
– The guarantor or borrower reasonably relied on the lender’s inaction.
– The lender later attempts to use the same conduct as a basis for recourse liability.
Courts are not uniform in applying estoppel to commercial loan defaults. Many loan agreements contain anti-waiver language specifically designed to prevent this defense. But where the lender’s conduct was active and sustained — where it participated in the workout, continued accepting payments, and communicated approval or acquiescence — estoppel and waiver arguments can be substantial.
The key is establishing the lender’s actual knowledge and the period of inaction.
The Dual-Role Problem
A distinct issue arises when the same individual at the lending institution serves both as an operational decision-maker during the loan period and as a declarant or witness in subsequent litigation.
This occurs more often than it should.
The person who denied the draw request, approved the cash management trigger, or refused to release insurance proceeds may be the same person who later submits an affidavit asserting that the borrower committed waste or diverted funds.
That dual role creates evidentiary and credibility issues. Discovery should be targeted at:
– All internal communications involving that individual during the distress period.
– Approval and denial records for reserve and draw requests.
– Internal credit memos, workout files, and special assets team communications.
– Any communications between the lender and third parties regarding the property’s condition.
The goal is to establish what the lender knew, when it knew it, what decisions it made, and how those decisions contributed to the conditions it now characterizes as the borrower’s fault.
The Litigation Posture
A guarantor who leads with a lender conduct defense does several things at once.
First, it shifts the narrative. Instead of defending against a list of alleged violations, the guarantor puts the lender’s own conduct at issue. The lender must now account for its decisions.
Second, it creates leverage in settlement. Lenders prefer clean enforcement actions. A defense that requires them to produce internal workout communications, credit committee records, and decision logs for reserve denials complicates the litigation significantly.
Third, it may provide independent claims. Depending on the facts and jurisdiction, lender misconduct may support affirmative counterclaims — not just defensive arguments.
This approach requires early and aggressive discovery. It requires a lawyer who understands both the loan documents and the lender’s operational role during the distress period. And it requires a client who has kept records of every interaction with the lender.
But where the facts support it, it is often the strongest ground available.
Bottom Line
The lender’s role in a distressed commercial real estate project is not passive. Lenders make decisions that affect the borrower’s ability to perform. Those decisions are part of the factual record.
A guaranty defense that ignores lender conduct addresses only half the story.
The next article in this series examines causation — the requirement that a carve-out breach actually caused the alleged loss, and why that element is frequently conceded when it should be contested.
