Sham Guaranty? More Stuff I Didn’t Know

LSREF2 CLOVER PROPERTY 4, LLC v. FESTIVAL RETAIL FUND 1, LP, (2016) 3 Cal.App.5th 1067

Issue:  Is the guaranty of a loan by the parent entity here a “sham” guaranty?

Holding:  No, “[T]he overriding concern when deciding whether the sham guaranty defense applies is whether the guaranty is an attempt to circumvent the antideficiency laws.”

Festival Retail Fund 1, LP (the “Fund”) was formed to find real property to invest in.  From the outset, the Fund purchased properties only through newly formed “special purpose entities” (“SPE”).  Here the Fund entered into an agreement to buy a property.  The agreement provided that the property would be purchased by a SPE.  The SPE was also a limited partnership and was wholly owned by the Fund.  Bank then made a loan to the SPE to buy the property.  The Fund guaranteed $1.5 million of the $25 million loan.  The Bank later filed a non-judicial foreclosure complaint and included the Fund alleging breach of the guaranty.  The Fund argued that it was the alter ego of the SPE under the “single business enterprise” theory and therefore it was “protected by antideficiency laws because it was, in reality, the primary obligor on the loan and the loan guaranty was effectively a sham.”  The court agreed and entered judgment for the Fund.

The California court of appeals reversed.

“Even when a guarantor waives antideficiency protections, however, the protections may still apply if the named guarantor is in actuality a principal borrower.  ‘To be subject to a deficiency judgment, … a guarantor must be a true guarantor, not merely the principal obligor under a different name.  Indeed, Civil Code section 2787 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 effectively adds nothing to the primary obligation — is a sham, and therefore antideficiency defenses apply.”

“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 apply.  The court also determines whether the lender itself structured the loan transaction to avoid the antideficiency 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 antideficiency law and recover deficiency judgments when those judgments otherwise would be prohibited.’”

The court of appeals said that the Fund “itself structured the transaction, including the ownership structure under which it obtained the loan.”  It formed the SPE before approaching the Bank.  The Fund, “not the bank, created the ownership structure, including the entity that took title to the property.”  “[T]here was no basis to find that the Bank had a role in the formation of Festival Fund or its affiliated entities, and no evidence to support a conclusion that the entities were designed by the lender to conceal the identity of the primary obligor.” “[T]he overriding concern when deciding whether the sham guaranty defense applies is whether the guaranty is an attempt to circumvent the antideficiency laws.”

As to the single enterprise theory, “the presence of a potential alter ego relationship is just one factor to consider when analyzing a sham guaranty defense.  In a situation like the one here, where the lender neither structures the transaction nor knows, at the time of making the loan, of a borrower’s (or an affiliate’s) failure to follow corporate formalities, there generally will be no basis to apply the sham guaranty defense.”

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