One very common but often misunderstood issue facing real estate lenders is how each state’s laws regarding the treatment of community property affect the enforceability of guarantees. Many lenders that fail to perform due diligence on their guarantors are blind-sided later by issues that can ultimately lead to a broken deal or a failure to recover the debt.
For example, a lender makes a mortgage loan to a borrower who is subject to a full payment guaranty, and during the loan term, the property value decreases. It is possible in this situation that the borrower may become insolvent and default on the loan, and the lender may believe the best option to recover the debt is to sue the guarantor under the full payment guaranty.
The lender may believe that the guarantor has sufficient net worth and liquidity to satisfy his obligations under the guaranty, but if the guarantor is domiciled in a community property state and the guarantor’s spouse did not sign the guaranty, the lender’s access to such guarantor’s full net worth may be limited. This is because in community property states any assets obtained during the marriage of the guarantor and the guarantor’s spouse are community property and, without the spouse signing the guaranty (or a spousal joinder), may be off-limits to the lender. Consequently, instead of the lender recovering the full amount of the debt, it may be able to enforce its judgment only against the guarantor’s assets that existed before the marriage.
By understanding marital property and how it differs in community property states compared to common law states, lenders can avoid a multitude of issues when dealing with guarantors.
Marital property refers to property that a couple acquires during the marriage and is considered the property of both spouses. Each state uses either common law principles or community property and, usually, where a couple is domiciled determines which state’s law governs what is “marital property.”
As detailed below, whether marital property is determined under common law or designated as community property will result in very different consequences for lenders.
Marital Property in Common Law States
Marital property in a common-law state includes property that both spouses agree to hold jointly. As such, each spouse is considered a separate entity and can own property independently of the other spouse. However, absent documentation to the contrary, each spouse is generally deemed to hold an undivided one-half interest in assets acquired during the marriage. Thus, in common law states, a creditor is generally entitled to the guarantor’s undivided one-half interest in the guarantor’s and spouse’s marital assets, which likely leads to a larger recovery.
Currently, 40 states follow the common law system. These 40 states include every state except Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin, and Alaska.
Marital Property in Community Property States
Marital property in a community property state includes earnings by either spouse, all property bought with those earnings, and all debts accrued during the marriage. By contrast, any property received by one spouse during the marriage by inheritance or gift remains the separate property of that spouse. Separate property also includes any property acquired before the marriage, any property acquired after the couple physically separates with the intention of not continuing the marriage, and property acquired after legal separation. Earnings, debts, or property acquired during this time will remain separate, so long as the couple does not live together.
Because the two spouses are considered one economic unit in a community property state, any property acquired during the marriage cannot be separated, and as a result, depending on state-specific statutes, either (i) all of the assets can be “encumbered” by a single spouse or (ii) none of the assets can be “encumbered” by a single spouse. Lenders need to be particularly wary of states that follow the latter rule.
The nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Alaska is unique in that it is an opt-in community property state that gives both parties to the marriage the option to make their property community property. There are differences, however, among these community property states, and the differences can have major consequences for lenders. For instance, both Arizona and California are community property states, but, in Arizona, a statute bars collection of guaranteed debt from the community property unless both spouses sign the guaranty. In California, on the other hand, the community property is subject to collection even if only one spouse signs the guaranty.
Generally, Idaho, Louisiana, Nevada, New Mexico, Washington, and Wisconsin follow Arizona’s formulation, and signatures of both spouses are required to bind community property. California and Texas, however, are two states in which creditors may be successful (subject to the pertinent facts and certain disclosures) in binding the other spouse, even if the other spouse was not a party to the debt or a judgment for the debt and did not sign the guaranty. Nevertheless, best practices still dictate that both spouses should execute the guaranty in those states.
Choice of Law Issues
As mentioned earlier, often the laws of the state where the guarantor is domiciled govern what constitutes community property; however, if a guarantor’s state of domicile and the state in which a material portion of the guarantor’s assets are located differ, a conflict of law issue may arise.
In the Ninth Circuit’s decision in First Community Bank v. Gaughan (In re Miller), 853 F.3d 508 (9th Cir. 2013), a guarantor, who was domiciled in Arizona with his wife but owned other assets in California, executed a guaranty and acknowledged that the agreement was subject to California law. The guarantor’s spouse did not sign the guaranty.
After conflicting decisions were handed down by an Arizona district court and an Arizona bankruptcy court, the Ninth Circuit ultimately decided based on conflict of law rules that California, not Arizona, law should apply despite the guarantor and his spouse being domiciled in Arizona. Though the specifics of the case are certainly of interest, the takeaway is that because the lender failed to require both the guarantor and his spouse sign the guaranty, the lender (i) risked the ability to collect on the full amount of the debt and (ii) subjected itself to lengthy and needless litigation time and expense that could have otherwise been avoided.
Impact on Lender Best Practices
Community property law can seriously affect creditors if proper steps are not taken to obtain a proper personal guaranty. As stated above, in community property states, if the lender has not obtained the signature of the guarantor’s spouse, the guarantor’s shared assets may be shielded entirely from the reach of the personal guaranty.
Although best practices in community property states dictate that both the guarantor and his spouse execute any guaranty, lenders must proceed with a certain degree of caution to ensure that such practice does not run afoul of any federal regulations. The Equal Credit Opportunity Act (ECOA) prohibits discrimination in lending, including discrimination based on marital status. On multiple occasions, judges have ruled that forcing a spouse to sign a personal guaranty without first evaluating the creditworthiness of solely the guarantor is discrimination based on marital status. In these situations, the guaranties provided by the spouse have been held unenforceable.
Consequently, in community property states, prudent lenders should initially underwrite the creditworthiness of its guarantor based on such guarantor’s non-marital assets. The first step of this process would be to obtain an individual financial statement detailing the guarantor’s non-marital property such that the lender can evaluate the creditworthiness on such a basis. If the lender determines that the guarantor meets the underwriting criteria based on its non-marital assets, such financials should be attached to the guaranty, and the guarantor should represent as to their accuracy. In conjunction with the foregoing, lenders should also tie any ongoing reporting, net worth, and liquidity covenants to the guarantor’s non-community property. If based on such guarantor’s non-marital assets additional credit support is required, lenders should then require that the guarantor’s spouse execute the guaranty, thus subjecting both the non-marital and marital property to any judgment a lender obtains. Often guarantors will resist having their spouse sign the guaranty, in which case the lender’s options are fairly limited. The lender can either refuse to close the real property loan or absorb the credit risk of limiting its recourse to non-marital assets.
Don’t Make the Same Mistake Twice
A real estate lender needs to know in which state a guarantor is domiciled and where a majority of such guarantor’s assets are held. Prudent lenders should determine whether a community property state is involved, evaluate the guarantor’s individual creditworthiness, and, if the proposed guarantor does not meet the lender’s criteria based on its sole assets, require that the guarantor and the guarantor’s spouse both execute the guaranty.