Originally published in the April 2004 issue of Indian Gaming.
Casino financings are often described as “recourse” or “non-recourse,” or, more accurately, “full recourse” or “limited recourse.” What do those terms mean, what difference do they make, and what are the consequences for a tribe in choosing one type over another?
“Recourse” describes the extent to which a lender can require a borrower to use its funds, assets or revenues to pay a debt. If a loan is “full recourse,” the borrower is obligated to use any money, assets or revenues that it has to pay the debt when due. If a full recourse loan goes into default the lender can, after obtaining a judgment against the borrower, exercise that judgment against any of the borrower’s assets (subject to any applicable legal limitations). If a loan is “limited recourse,” the borrower is only obligated to use certain money, assets or revenues that are identified in the loan documents to pay the debt. If a limited recourse loan goes into default the lender can, after obtaining a judgment, exercise that judgment only against those specified assets of the borrower.
Say I decide to take out a loan to buy a new car. I have $20,000 in the bank that was left me by my grandmother, but I don’t want to use that money to pay the loan; instead, I plan to make the loan payments out of my wages from my job. Everything goes fine for the first year, but then I get laid off and have a hard time finding a new job. When the monthly payment on my loan comes due, if I were to tell the finance company, “I’m sorry, but I can’t pay you back. I intended to pay this loan off out of my salary, but I lost my job. I do have $20,000 in the bank but I don’t want to use that money to pay you.” The finance company wouldn’t say “That’s ok-we understand.” They’d say “Get that money out of the bank and use it to pay this loan!” If I didn’t do so, they could take me to court, get a judgment against me for default, foreclose on my car and sell it, and get the money out of my bank account and apply it to anything left on my loan. That’s an example of “full recourse” and it’s the way that most of us borrow money all of the time - we are legally obligated to use any funds that we have to repay our debts, even if we had expected to pay them off out of particular sources or revenues and even if the loan is secured by specific collateral. If our planned sources aren’t sufficient, we have to use whatever other funds or assets we do have to satisfy the debt.
Governments often don’t borrow that way. Instead, governments frequently borrow on a “limited recourse” basis. In that type of borrowing, the government and the lender agree in advance that the government is only obligated to use certain, identified revenues or assets to satisfy its loan obligations. If those revenues or assets are insufficient, the government isn’t obligated to use any other revenues or assets, even if those other revenues or assets are available and would be more than enough to satisfy the debt. For example, a city might finance improvements to its municipal water and sewer system on a limited recourse basis by agreeing to repay the loan solely out of the revenues generated by water and sewer charges. The city would be obligated to use its water and sewer revenues to pay the loan, but if those revenues were insufficient the city would not be obligated to use any of its other funds - for example: tax revenues, investment earnings, general treasury funds - to pay the loan. And if the city defaulted on the loan and the lender sued and obtained a judgment, the lender could only exercise that judgment against future water and sewer revenues, not any other city funds.
How do these concepts apply to tribal casino financings? In this manner: A tribe could borrow to finance a new casino, or improvements to an existing casino, on either a full recourse or a limited recourse basis. If a tribe took out a full recourse borrowing, then the tribe would be promising to repay the loan out of any of funds, assets or revenues that it could legally use to make that payment. (Some tribal funds, such as federal program funds, can legally only be used for specific purposes and could not legally be used to make payments on a casino financing.) Even though the tribe may have expected to repay the loan out of casino earnings, if those earnings were insufficient then the tribe would have to turn to its general treasury, or tribal investments, to make payment of the loan when due.
On the other hand, the tribe could finance the casino on a limited recourse basis, agreeing to repay the loan only out of casino earnings. If the lender agreed to make the loan on that basis, and if the loan documents were properly drafted, then the tribe’s legal obligation to repay the loan would be limited to the earnings of its casino, and the tribe would not be obligated to use any other tribal funds to repay the loan, regardless of how much it had on hand in the general fund or in investments. The lender would be depending up on the casino to generate sufficient cash to make the loan payments; if the casino earnings proved to be insufficient, the lender could not require the tribe to use any non-casino funds to pay the loan.
Nothing prohibits a tribe from using other funds to pay a limited recourse loan if the designated revenue source proves insufficient. For example, if recourse on a loan is limited to casino earnings and if those earnings prove insufficient, the tribe might decide to make loan payments out of other funds in order to prevent the loan from going into default - particularly if, upon default, the lender would have the right to take control of the casino’s accounts or to foreclose upon the casino’s equipment. Either of those steps might adversely affect the operations of the casino and, ultimately, the tribe’s financial health, and the tribe might decide that it was in the tribe’s best interests to avoid that result. The tribe might also decide to make payment out of other sources in order to stay on good terms with the lender and to have the opportunity to do financings in the future, or it might simply not want to have its name connected with a loan that’s in default. Those choices, however, are within the tribe’s power to make in a limited recourse situation - the tribe is not legally obligated to do anything but what it promised to do.
At this point, one might be tempted to say “Well, this is a no-brainer. If I can choose between a full recourse and a limited recourse financing, limited recourse is clearly the way to go.” Not so fast! There is no such thing as a free lunch, and the use of limited recourse financing has consequences that need to be identified, thought through and applied to each tribe’s specific situation. These include the following:
The willingness of lenders to make a loan in the first place. Limiting a lender’s recourse tends to increase the risk that the loan might not be repaid when due. If the general credit of the tribe is not behind the loan there is automatically less in the way of assets or revenues supporting repayment and the credit strength of the loan is weaker than it otherwise would be. Is the casino strong enough that lenders will be comfortable relying upon it as the sole source of repayment of the loan? Or will they want the full credit of the tribe to stand behind it? Limited recourse will be more likely where the casino is already up and operating successfully, or where the tribe has no other significant assets or revenue sources that would add to the security in any event.’ Even then, a lender may require full recourse should the tribe breach some fundamental covenant or representation made in the loan transaction.
The effect on the interest rate that the tribe pays on the loan. The two principal factors affecting interest rates are credit risk (which the tribe can affect) and market risk (which it can address through choices such as floating vs. fixed rate, length of loan term, and similar methods). Because limiting the lender’s recourse tends to increase credit risk, the lender may require a higher interest rate in order to compensate for that risk.
The nature and scope of any financial covenants. If the lender’s sole source of repayment is casino earnings and assets, the lender will be very interested in how the casino performs and how - and on what terms - the casino can distribute revenues upstream to the tribe. When funds move from the casino accounts over to the tribe’s general accounts, they generally become tribal - not casino - funds. If the lender does not have recourse against the tribe and its general accounts, then that money, once it does move over, is outside of the lender’s reach. The lender will want to ensure that that happens only after the casino’s financial needs are fully addressed, any appropriate reserves are funded, and a financial cushion is established for unexpected events. This may be reflected in a covenant that includes transfers from the casino to the tribe as an element of the fixed charge, or debt service, coverage ratio; the effect of that covenant would be to limit such transfers to the amount that the casino can support and still maintain the required coverage ratio (thus maintaining a financial cushion at the casino). Alternatively, the casino might run its daily receipts through a waterfall of accounts with the lender or a separate depository, under which casino revenues would be applied to operating expenses, debt service and reserves and then released to the tribe once those obligations are fully funded. These, and similar, structures are intended to ensure that money gets transferred to the tribe only after it is likely no longer needed as part of the security for repayment of the loan. If the loan is full recourse, and if the lender can require the tribe to use any available funds to make loan payments, the need for provisions like these is reduced.
The special case of a tribal-entity borrower. Some tribes have established separate legal entities - such as a tribal corporation or instrumentality or a Section 17 corporation - to own and operate their gaming enterprises. If such an entity, rather than the tribe itself, is the borrower there is another level of recourse issues. Tribes, as the governments who create and regulate tribal entities, have the power to act in ways that can affect the entity’s ability to repay its obligations. These could run from imposing a tax on the entity’s revenues, to establishing a second entity to conduct a competing casino, to revoking the entity’s authority to conduct gaming, to abolishing the entity outright. These, or similar, actions would impair the security and repayment of the loan. A lender does not generally seek to prevent the tribe from taking any of these actions - to do so would be a restriction on governmental authority. However, lenders do generally require that if the tribe takes one of these steps the loan obligation becomes an obligation of the tribe itself, either with recourse to all gaming-related revenues or on a full recourse basis. This tribal liability cannot happen unless the tribe affirmatively takes one of the specific identified actions. As a result, the tribe remains in control over whether, and to what extent, the limited recourse nature of the loan is modified.
The nature and extent of a lender’s recourse is one of the fundamental elements of any casino financing. The principles summarized here should serve as starting points for a tribe’s consideration of what works best for its specific needs.