What is a "carve-out"?

Minneapolis real estate attorney John Koneck defines a “carve-out.”

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Phone: (612) 492-7038

Transcript:

To understand what a carve-out is, you have to understand what a nonrecourse loan is. And we’ve discussed that. A nonrecourse loan is a situation where the lender can’t go after the borrower for personal liability. The lender instead has to go after the collateral, the security for the real estate. And that’s all the lender can go after. Sometimes a lender will say, “Okay, I’ll agree to that. I’ll agree to the nonrecourse nature of this loan, but I want some exceptions. I want some reasons when I can go after that.” And examples of some of those reasons are if the borrower commits fraud. Let’s say the borrower says, “Here’s my financial statement” and it shows millions of dollars of net worth and it turns out it’s all a lie, the borrower doesn’t have anything. That’s fraud. And if the lender then went to collect a note that was in default and the lender found out that the borrower had defrauded the lender, if that carve-out were in the nonrecourse loan documents, the lender would be able to sue the borrower for the loan because of the fraud.

Other examples are failing to keep money collected in the project inside the project to be used to pay bills like a mortgage loan payment. So let’s say you have the Mall of America and the landlord at the Mall of America is collecting lots of rent. If a common exception or a common carve-out in a nonrecourse loan is where the lender says, “Okay, all the rent you collect, as long as you use it inside the property, the loan is a nonrecourse loan. So if the property doesn’t produce enough money to pay back the loan, that’s okay. I’ll go after the property. I’ll foreclose on the property.” But if you’re taking money out of the project, in other words, the rent is producing enough to pay all the bills, but the borrower, the owner of the property is taking some money and putting it in its pocket or spending it somewhere else, that’s a carve-out. And then the lender can go after the borrower.

A big issue in the carve-out world is whether – if a carve-out applies, the whole loan becomes collectable against the borrower or only what the borrower, what the lender lost because of the borrower’s commission of some event that was a carve-out like, for example, the fraud. It would only be the damages that the lender suffered because of the fraud, not the whole debt. Or in a situation where the borrower was taking rent or insurance proceeds or condemnation proceeds that should have been left inside the project and putting them somewhere else, the borrower’s only liable for what it took out or for the whole loan.