The Guarantor’s Defense — Part 3 of 5
Single-purpose entity covenants appear in virtually every institutional commercial real estate loan. They are often presented as routine. They are not.
These provisions impose ongoing behavioral obligations on the borrowing entity throughout the life of the loan. Violations do not require fraud or intent. Many occur under financial pressure, when sponsors are trying to keep a property alive. And in a bad boy guaranty structure, a technical SPE violation can convert a non-recourse loan into full personal recourse.
Most guarantors cannot recite what their SPE covenants require. That is the problem.
What SPE Covenants Typically Require
The precise language varies by loan, but institutional SPE covenants commonly require the borrower entity to:
– Maintain its existence as a separate legal entity.
– Keep separate books, records, and bank accounts.
– Avoid commingling its assets with those of any other person or entity.
– Maintain adequate capital in light of its contemplated business operations.
– Pay its own liabilities out of its own funds.
– Not incur indebtedness other than the permitted loan.
– Not make loans to or invest in other entities.
– Observe all corporate or LLC formalities.
– Not merge, consolidate, or dissolve without lender consent.
– Maintain at least one independent manager and require that manager’s consent for certain actions including bankruptcy.
– Not file for bankruptcy without the required vote of the independent manager.
These are not aspirational guidelines. They are contractual obligations with enforcement teeth.
Where Violations Most Commonly Occur
In practice, SPE violations arise from decisions made under financial pressure, not from deliberate misconduct.
The most common categories include:
Intercompany cash transfers. When a project runs short of cash, sponsors often move money between related entities. Funds may flow from a performing property to a distressed one, or from a personal account into the project. Those transfers — even when made with the intent to preserve the property — may violate the prohibition on intercompany loans, commingling, or unauthorized debt.
Shared services and expenses. Related entities often share staff, office space, vendors, insurance, or management infrastructure. If the allocation of those costs is not properly documented, lenders argue that expenses are being improperly charged to the borrowing entity or that the separateness requirement has been violated.
Unauthorized debt. Vendor obligations that go unpaid for extended periods can be characterized as unauthorized debt in some loan structures. Unsecured credit extended by a related party — even informally — may constitute a prohibited loan.
Failure to maintain accounts. If the borrower uses a general operating account shared with related entities rather than maintaining a dedicated project account, commingling is difficult to defend.
Independent manager failures. Many loan documents require an independent manager whose consent is needed for major decisions. If the required independent manager was never properly appointed, resigned without replacement, or was not consulted on material decisions, that is a structural violation.
Related-Party Transactions and Insider Loans
Related-party transactions are one of the most underappreciated exposure areas in distressed CRE guaranty litigation.
When a project struggles, sponsors frequently provide informal financial support from related entities or individuals — family members, co-investors, affiliated companies. That support may take the form of:
– Cash advances to cover operating shortfalls.
– Deferred management fees from an affiliated property manager.
– Shared vendor relationships where costs are allocated informally.
– Personal guaranty payments made by the sponsor to keep vendors current.
Each of these can be characterized as an unauthorized loan or an SPE covenant violation.
The disclosure obligation adds another layer. Many loan agreements require the borrower to notify the lender of any related-party transaction above a specified threshold. If insiders advanced funds to the project without lender disclosure, the lender may allege that the failure to disclose constituted misrepresentation — which is itself a carve-out trigger.
What looks like a sponsor trying to save a deal can later be framed as a series of undisclosed insider transactions that violated the separateness structure of the loan.
What a Valid Intercompany Structure Looks Like
Not all intercompany support is prohibited. The key is structure and documentation.
A properly structured intercompany transaction typically includes:
– A written loan agreement specifying amount, interest rate, maturity, and repayment terms.
– Lender disclosure and, where required, written consent.
– Separate accounting treatment in the borrowing entity’s books.
– Arm’s-length terms that would be consistent with market rates.
– Repayment documentation if and when funds are returned.
Without those elements, a cash infusion from a related party looks like commingling or unauthorized debt regardless of the intent behind it.
Sponsors who need to support a distressed project should consult counsel before moving funds. The documentation burden is not large. The exposure from skipping it can be the entire loan balance.
The Disclosure Obligation
Disclosure provisions in loan documents are frequently overlooked during a workout.
Many loan agreements require notice to the lender of:
– Any default or event that could become a default.
– Related-party transactions above a specified dollar threshold.
– Changes in ownership or management.
– Material litigation involving the borrower or guarantor.
– Property damage or casualty events.
When insiders advance money to a distressed project without disclosing the transaction to the lender, two problems arise. First, the advance itself may violate the unauthorized debt prohibition. Second, the failure to disclose may constitute a material omission that supports a fraud or misrepresentation claim.
In litigation, lenders often couple their SPE violation allegation with a fraudulent concealment argument. That combination is more difficult to defend than either claim alone.
Practical Checklist: Are You Currently in Violation?
If you are managing a distressed commercial real estate asset with a bad boy guaranty, the following questions identify the most common exposure points:
– Are there any unsecured cash advances from related parties to the project that have not been disclosed to the lender?
– Are project bank accounts separate from accounts used by related entities?
– Is the property manager affiliated with the borrower, and if so, are management fees being deducted from project cash flow in a manner that has been properly disclosed?
– Has the independent manager been properly appointed and maintained?
– Have there been any transfers of ownership interest without lender consent?
– Are financial reporting obligations to the lender current?
– Have any vendor obligations gone unpaid in a manner that creates informal debt?
– Are insurance proceeds being held in a segregated account?
If the answer to any of these questions reveals an undocumented or undisclosed transaction, that exposure should be evaluated before litigation begins.
Bottom Line
SPE covenants are not boilerplate. They impose real, ongoing obligations. Violations arise from decisions made under pressure, and they can convert a limited-liability investment into full personal exposure.
Understanding exactly what those covenants require — and auditing compliance before the lender does — is one of the most valuable things a guarantor can do during a distressed period.
The next article addresses the upstream solution: negotiating the guaranty itself before signing it.
