Sham Guaranty Defense Narrowed in California

Practical Law Legal Update w-004-9266 (Approx. 5 pages)

Sham Guaranty Defense Narrowed in California

by Practical Law Real Estate

Sham Guaranty Defense

California anti-deficiency laws do not apply to guaranties of loans secured by real property (Cal. Civ. Proc. Code §§ 580a to 580e and 726). Anti-deficiency protections may be not be waived by a borrower, but may be waived by a guarantor. The sham guaranty defense claims that the guarantor is not a distinct entity from the borrower, so that the primary source of repayment on the loan is actually the guarantor and not the borrower. Accordingly, that guarantor cannot waive the protections of the anti-deficiency statutes as the primary obligor, and the guaranty is effectively a sham because the guaranty adds no additional support for the primary obligation.

The sham guaranty defense can be raised by a guarantor to prevent lenders from obtaining a deficiency judgment against the guarantor when the guarantor is really the principal borrower and the guaranty was an attempt to circumvent the anti-deficiency laws. A successful sham guaranty defense can limit or eliminate a lender's recovery of a deficiency against a guarantor after a non-judicial foreclosure.

Background

In Clover Property, the guarantor was a limited partner and majority owner (99.99%) of the borrower, a limited partnership and special purpose entity (SPE) formed by the guarantor to take title to a retail property. The guarantor also formed a limited liability company (LLC) to be the general partner and minority owner (0.01%) of the borrower. The guarantor also made a $9 million equity contribution to the SPE.

The borrower then sought a $25 million acquisition loan from the lender. The lender reviewed:

The value of the property and its cash flow.
The borrower's, general partner's, and guarantor's organizational documents.
The guarantor's financial information.

To make the loan, the lender required:

An assignment of leases and rents.
A guaranty of $1.5 million.

During the term of the loan, the general partner and minority owner (0.01%) of the borrower failed to follow corporate formalities, in that it:

Never had a separate bank account.
Never owned assets or made investments other than its interest in the SPE.
Never had income.
Never had employees or paid for services.
Never held regular meetings.
Did not conduct day-to-day business operations.
Was undercapitalized.

Later, the borrower defaulted on the $25 million loan and the lender instituted a non-judicial foreclosure, which resulted in a deficiency. The lender then sought to enforce the $1.5 million guaranty agreement for the deficiency against the guarantor, who then asserted the sham guaranty defense. The guarantor claimed that the guaranty was a sham because:

A general partner is liable jointly and severally for all obligations of the limited partnership and, accordingly, a de facto primary obligor of the loan (Cal. Corp. Code § 15904.04).
The guarantor was the alter ego of the general partner because:
- the guarantor wholly owned the general partner; and
- the general partner failed to observe corporate formalities.
The lender primarily looked to the guarantor for repayment of the loan because it required a guaranty from the guarantor.

The trial court found that the guaranty was unenforceable under the anti-deficiency statutes because the guarantor was the de facto primary obligor and the guaranty was a sham.

Outcome

The court of appeals overturned the trial court's ruling and held that there was not substantial evidence sufficient to prove that the guarantor was the true principal obligor. In support of its holding, the court found:

The lender did not dictate the borrower's ownership structure. The borrower formed the SPE and ownership structure before the loan was sought from the lender. There was no evidence that the entities were designed by the lender to avoid the anti-deficiency laws.
The fact that the guarantor was an affiliate was not sufficient alone to support the sham guaranty defense. The court noted that guarantors almost always are affiliated with borrowers.
It is absurd to use the alter ego argument as a defense that would allow guarantors and their affiliates to choose to avoid corporate formalities to avoid liability.
The guaranteed amount was small relative to the loan amount.
The lender examined the property's value and income potential.

Practical Implications

To minimize the successful use of the sham guaranty defense, lenders should refrain from:

Relying primarily on the guarantor's assets and income as a source of repayment of the loan. The lender should instead rely primarily on the property's value and cash flow by performing the following at a minimum:
- obtaining a current appraisal of the property;
- examining the property's proforma cash flows and income potential; and
- taking an assignment of leases and rents.
Referring to the guarantor as a primary party to the loan obligations as opposed to just the guaranty obligations.
Making the borrower and the guarantor jointly and severally liable under the loan agreement.
Dictating the organizational structure of the borrower, guarantor, or their affiliates.

For more information on anti-deficiency laws in California, see Practice Note, Navigating the One-Action Rule in California (CA).

Sham Guaranty Defense Narrowed in California | Practical Law