October 31, 2016 Practice Points

Traps for the Unwary: Is Your Guaranty Merely an Unenforceable Sham?

Keeping these principles in mind when crafting your guaranty could protect your client from the sham guaranty defense down the road

by Kenneth R. Van Vleck

California’s Court of Appeal recently reversed a trial court’s judgment that a loan guaranty was an unenforceable sham designed to avoid the anti-deficiency protection laws of California in LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP, Los Angeles County Super. Ct. Docket No. SC117145 (2016).

California’s anti-deficiency laws, Sections 580a through 580e and 726 of the Code of Civil Procedure, prohibit a lender from obtaining a deficiency judgment from a borrower following a non-judicial foreclosure of real property.

But when a corporate entity borrows money, a lender often requires a payment guaranty from shareholders, members, or affiliated companies or individuals. And California’s guaranty laws allow guarantors to waive the protections of the anti-deficiency laws. This is not unusual. In fact, guaranties often waive all borrower defenses.

However, even when a guarantor expressly waives anti-deficiency protections, those protections could still apply if the guarantor is, in actuality, a principal borrower. 

For the anti-deficiency waiver to hold up, a guarantor must be a true guarantor and not merely the principal obligor under a different name.  California’s Civil Code defines a guarantor as “one who promises to answer for the debt, default, or miscarriage of another . . . .”   When a principal borrower provides a guaranty on a debt, the guaranty—which adds nothing to the primary obligation—is a sham, and California’s anti-deficiency defenses will apply. This so-called “sham guaranty defense” allows a guarantor to avoid liability under the guaranty.

In determining whether a guaranty is a sham, the court examines whether the guarantor is actually the principal obligor, which occurs when “(1) the guarantor personally executes underlying loan agreements or a deed of trust or (2) the guarantor is, in reality, the principal obligor under a different name by operation of trust or corporate law or some other applicable legal principle.” When there is “adequate legal separation between the borrower and the guarantor, e.g., through the appropriate use of the corporate form,” the sham guaranty defense generally will not shield the guarantor.

The court also determines whether the lender itself structured the loan transaction to avoid the anti-deficiency laws. The object of this analysis is to determine whether the lender designed the transaction so that the primary source for repayment of the loan was placed in the role of guarantor rather than named borrower.

The court’s overall focus when examining whether guaranties are shams is to “look to the purpose and effect of the parties' agreement to determine whether the guaranties constitute an attempt to circumvent the anti-deficiency law and recover deficiency judgments when those judgments otherwise would be prohibited.” Keeping these principles in mind when crafting your guaranty could protect your client from the sham guaranty defense down the road. 

Kenneth R. Van Vleck is a partner with GCA Law Partners LLP in Mountain View, California.


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