California Limits Availability of Sham Guaranty Defense
Lenders can protect their recourse rights under guarantees in nonjudicial foreclosures by avoiding intentionally structuring loan transactions in such a way that the borrower and guarantor are essentially the same entity. Neglecting to exercise such caution can have disastrous consequences for lenders; a lender cannot obtain a deficiency judgment from a guarantor if the borrower and guarantor are essentially the same. Therefore, lenders looking to preserve their rights should ensure there is separation of identity between the borrower and guarantor.
In LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP, No. B259937 (Cal. Ct. App. Oct. 4, 2016) (“LSREF”), the California Court of Appeal declined to extend anti-deficiency protections to a guarantor who had formed the borrowing entity and designed the structure of the loan transaction of its own accord. This decision highlights a recent trend in which California courts have curbed the availability of the sham guaranty defense to guarantors who intentionally design the ownership structure of loan transactions to serve other business considerations.
The borrower in LSREF was a limited partnership formed by the guarantor. Its general partner was a limited liability company (the “LLC”), owned and simultaneously formed by the guarantor (the guarantor was also a limited partner of the borrower). The guarantor intended to limit its liability on the property by using this structure. After the guarantor devised the structure, the borrower entered into a loan agreement with the lender. As a condition of the loan, the lender required that the guarantor guaranty the loan. It further required that the loan be secured by the property and contain an assignment of rents and leases to the lender. Following a default on the loan and a nonjudicial proceeding, plaintiff and appellant sought to enforce the guaranty.
The trial court held that the guarantor was under the sham guaranty defense because by drafting the agreement and requiring an affiliated guarantor, the lender had intentionally structured the loan to avoid anti-deficiency statutes. The trial court further held that as an alter ego of the LLC—which as general partner was liable for the debts of the borrower—the guarantor was in reality the borrower and entitled to protection.
In reversing the decision, the California Court of Appeal held that the sham guaranty defense does not apply “where the lender neither structures the transaction nor knows, at the time of making the loan, of a borrower’s (or affiliate’s) failure to follow corporate formalities.”
The Court emphasized that the sham guaranty defense is intended to punish lenders who intentionally structure loans in such a way that the primary source of repayment is the guarantor rather than the borrower. The defense, however, cannot be used by a guarantor who itself designs the loan, including the ownership structure, to serve other interests and then asserts the defense in an effort to avoid liability for a deficiency judgment. Because the guarantor had devised the structure of the loan to limit its liability on the premises, and did so before borrower requested the loan, there was no basis to conclude that the lender had intentionally structured the loan to conceal the guarantor’s status as the primary borrower.
Moreover, “[t]o allow a guarantor to avoid its obligations simply because the debtor’s general partner—which is entirely owned by the guarantor—avoided complying with corporate necessities would work an absurdity,” said the Court. The alter ego (or single business enterprise) theory is intended to stave injustice not promote inequitable results as would be the case if the guarantor received the benefit of anti-deficiency protections.
For lenders, the LSREF decision is important because it represents a narrowing of the defense to situations where the lender itself intentionally devised a loan structure to subvert anti-deficiency laws or intentionally encouraged a guarantor to ignore corporate formalities. To limit application of the sham defense, lenders should, therefore, avoid selecting the entities, and the form of the entities, that are the borrowers and should ensure that borrowing entities are properly formed and maintained.