The Guarantor’s Defense — Part 1: The Lender’s Own Hands Are Not Clean

Part 1 of a 5-part series on defending against carve-out guaranty claims in commercial real estate.

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, but the concept is available and 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 rent proceeds and reserve accounts. The lender then denies draw requests from the capital expenditure reserve. 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.

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. 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 or assert recourse at that time; the guarantor or borrower reasonably relied on the lender’s inaction; and the lender later attempts to use the same conduct as a basis for recourse liability.

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. Second, it creates leverage in settlement. Lenders prefer clean enforcement actions. A defense requiring 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.

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.

Next in the series: Causation Is Not Automatic — Make Them Prove It.

Matthew M. Clarke is a shareholder at Kelley Clarke, PC and Chair of Litigation. He represents guarantors, borrowers, and investors in commercial real estate disputes. This article is for informational purposes only and does not constitute legal advice.