YOU'RE EXONERATED: Exploring the "Sham Guaranty" Defense to Eliminate Liability Under a Guaranty

YOU’RE EXONERATED:
Exploring the “Sham Guaranty” Defense to Eliminate Liability Under a Guaranty

by Robert M. Heller

Lenders commonly require principals of a company to personally guarantee a real estate loan. While the business may be protected by California’s anti-deficiency statute, guarantors are not. Lenders also carefully draft guaranties to expressly waive or otherwise exclude anti-deficiency defenses. In many cases, the only defense a guarantor may have to secure the protections of the California anti-deficiency statute is the “sham guaranty” defense.

I.             California’s Anti-deficiency Statute Does Not Apply to Guarantors.

Code of Civil Procedure Section 580d provides in relevant part: “No judgment shall be rendered for any deficiency upon a note secured by a deed of trust or mortgage upon real property … in any case in which the real property … has been sold by the mortgagee or trustee under power of sale contained in the mortgage or deed of trust.” This protection against deficiency judgments cannot be waived.  (See River Bank America v. Diller (1995) 38 Cal. App.4th 1400, 1420.)

However, § 580d applies only to primary obligors. Guarantors, on the other hand, are not protected against deficiency judgments after non-judicial foreclosures.  (Hodges v. Mark (1996) Cal.App.4th 651, 656-657.)

II.            Absent Anti-deficiency Protections, Lenders Create Windfalls for Themselves.

In one recent case, a lender conducted a non-judicial foreclosure sale of real property and was the sole bidder. The amount of the indebtedness owed on the subject loan was approximately $3,000,000. The fair market value of the property was approximately $2,400,000. The lender purchased the property with an arbitrary and unchallenged bid of $1,500,000, i.e., $900,000 less than the property’s fair market value.

The borrower would be protected in this circumstance by the anti-deficiency statute. However, because a guarantor is not protected by the anti-deficiency statute, the lender may proceed against the guarantor in the amount of the lender’s unilateral foreclosure bid and the indebtedness owed ($1,500,000). If the lender owns real property valued at $2,400,000, and further obtains judgment in the amount of $1,500,000 against the guarantor, the lender will enjoya very significant $900,000 windfall.

The circumstance above presents a classic example of a lender creating a golden opportunity and taking advantage of a guarantor’s non-coverage under California’s anti-deficiency protections to obtain for itself an excessive deficiency judgment after a non-judicial foreclosure sale of the real property securing its loan.  Similar scenarios have recently been reviewed and affirmed by appellate courts.  (See Talbott v. Hustwit (2008) 164 Cal.App.4th 148 (fair value protections of § 580a do not extend to guarantors; lender permitted to deduct lower purchase bid amount instead of fair value of property from balance due on loan).)

Unless and until additional legislation remedies this situation, guarantor defendants will remain exposed to substantial judgments well exceeding the lender’s actual damages.

III.           The “Sham Guaranty” Defense Comes into Play Where a Guarantor Can Show that the Lender Effectively Looked to the Guarantor as a Primary Obligor.

Under Cal. Civ. Code § 2787, “[a] surety or guarantor is one who promises to answer for the debt … of another … (emphasis added).” Conversely, a principal obligor cannot “guaranty” its own debt. A “sham guaranty” occurs where the guarantor is not a true guarantor but rather a principal obligor in guarantor’s guise.  (River Bank, supra, 38 Cal.App.4th at 1422.)

Where a “sham guaranty” exists, the guarantor, in essence, gains the protection of the anti-deficiency statute which is ordinarily accorded to the principal. “[I]f the guarantor is actually the principal obligor, he is entitled to the unwaivable protection of the anti-deficiency statutes, including Code of Civil Procedure section 580d. ”  (River Bank, supra, 38 Cal.App.4th at 1420.)  Another court has gone so far as to say that any such purported guaranty is superfluous and unenforceable; in other words, such “sham guaranties” are of no legal effect.  (Valinda Builders v. Bissner (1964) 230 Cal.App.2d 106, 112; see also, River Bank, supra, 38 Cal.App.4th at 1420.)

Whether a guarantor defendant can prove he or she was the principal obligor depends, of course, upon the facts of the case. Case law broadly holds that “[t]he correct inquiry set out by the authority is whether the purported debtor is anything other than an instrumentality used by the individuals who guaranteed the debtor’s obligation, and whether such instrumentality actually removed the individuals from their status and obligations as debtors.  [Citation.]  Put another way, are the supposed guarantors nothing more than the principal obligors under another name?  [Citation.]  (River Bank, supra, 38 Cal.App.4th at 1422, quoting Torrey Pines Bank v. Hoffman (1991) 231 Cal.App.3d 308, 320.)

More specifically, the River Bank court considered three principal factors:

                1.    Whether the named borrower was a legitimate entity as opposed to a mere shell for the guarantors as individuals;

                2.    Whether the lender inquired about the financial standing of the named borrower or actually relied on the financial statements of the guarantors; and

                3.    Whether the purpose of the loan agreements was to subvert the anti-deficiency statutes.

(River Bank, supra, 38 Cal.App.4th at 1420-1424.)

Such factual inquiry can grow rather broad. Relevant questions in pursuit of the defense include:

  • Is the defaulting entity a shell company created solely for the purposes of obtaining equity financing from various investors to purchase the property, hold title to the property, and obtain the loan?
  • At the time the loan was made, did the entity have substantial assets other than the property itself and/or was it undercapitalized?
  • When it made the loan, was the lender aware of the entity’s assets or lack thereof? Did the lender ask the entity for a financial statement or otherwise inquire about its financial standing, or did the lender merely ask for financial statements from the guarantors?
  • Did the lender demand that additional collateral owned by the guarantors be added to the transaction?
  • Did the lender first seek to secure liens against the personal property of the guarantors?
  • Did the lender look from the outset and throughout its lending relationship exclusively to the purported “guarantors” for collection of any deficiency after foreclosure?
  • Was the lender aware and/or did the lender intend that the structure of the loan would circumvent the anti-deficiency statute in the event a deficiency existed after foreclosure on the property?

These and other related factors will determine the trial court’s willingness to entertain the “sham guaranty” defense and thereby protect the guarantor instead of allowing the lender a windfall.

Robert M. Heller, the principal of Robert M. Heller, a Professional Law Corporation, is a business litigation attorney with more than 30 years experience. He can be reached at (310) 286-1515 or by e-mail at heller@rhellerlaw.com.

This article was originally published in the April/May 2010 edition of The Magazine of the Solo & Small Firm Section of the State Bar of California.  It may be viewed at http://www.rhellerlaw.com/the_real_deal.pdf

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