The “sham guaranty” defense may absolve a guarantor of liability when no deficiency is available against the borrower, and the guarantor is really the borrower with a different name. In California Bank and Trust v. Lawler (2013) 222 Cal.App.4th 625, the Court revisited application of the “sham guaranty defense” to enforcement of a guaranty given for a note secured by a deed of trust and held the guaranty was not in fact a “sham.” For context, California’s “antideficiency” legislation, enacted after the Great Depression, limits the ability of lenders to obtain a judgment for the amount the debt exceeds the value of the security. No deficiency may be obtained following nonjudicial foreclosure of real property (§ 580d) or judicial or nonjudicial foreclosure under a purchase money deed of trust (§ 580b). Because these protections are grounded in the strong public policy to avoid exacerbating real estate downturns, the protection cannot be waived by private agreement. Section 580b(c) was amended in 2013 to expressly provide that the antideficiency limitations do not affect the liability of a guarantor for that deficiency.
In some cases, guarantors have argued that they are entitled to the same antideficiency protection as the debtors because the guaranty is a “sham,” under the theory that the guarantor is in reality the primary obligor. The Courts have held that in order to be subject to a deficiency judgment, a guarantor “must be a true guarantor, not merely the principal obligor under a different name.” (See, for example, Riverbank America v. Diller (1995) 38 Cal.App.4th 1400, 1420.)
In this case, the borrower was a limited liability company whose members were David Lawler, Jerry Smith, and Joanne Smith, who either in their own names, or through one of their other entities, were the sole members of, and wholly owned, the borrower entity. The bank required that the Smiths and Lawler, as well as one of their other entities, execute a guaranty for the loan. The lender also required the Smiths and Lawler to “submit extensive information about their individual financial resources before it authorized the loan.” The loan was also secured by a deed of trust.
The loan went into default and the lender acquired the property securing the loan by credit bid at a trustee’s sale, and sought a judgment against the Smiths, Lawler and the other guarantors, for the difference between the amount credit bid at the sale and the unpaid debt. The Smiths and Lawler did not dispute that they signed the guaranty, but argued it was a “sham guaranty,” and therefore unenforceable.
The Court of Appeal disagreed. After reviewing prior case law regarding sham guarantees, the Court determined that in this case, the borrower entities were legally separate and distinct from the guarantors, and there was no evidence to suggest otherwise. For example, there was no evidence that corporate formalities had not been respected with respect to the borrower entities. The Court noted that while there may be ultimate common ownership between the borrower and the guarantors, there was no evidence that the borrower was a mere “instrumentality” of the guarantors, nor that the lender had required formation of the borrower entity to evade antideficiency protections. Rather, the limited liability company borrower was a legally distinct entity from the individual guarantors, even though these same individuals – either directly or through other entities – owned the borrower entity. As the Court noted: “Individuals may structure their own business dealings to limit their personal liability, but they must accept the risks that accompany the benefits of incorporation.” In other words, simply because the guarantors chose to borrow money through a separate entity borrower which they ultimately owned, did not absolve them of their separate, individual obligations under the guaranty.
The Smiths and Lawler also argued that the Bank’s demand for “extensive documentation” from them in connection with the loans demonstrated that they in fact were the primary borrowers. Again, the Court disagreed, stating that “[t]here is nothing unusual about a bank asking for financial information from a person or entity that is guaranteeing a loan.”
The moral of this case is that a court will not allow individuals who have chosen to structure their borrowing through separate entities to assert a “sham guaranty” defense to absolve them of liability when those loans are unpaid, particularly when there is no evidence that the borrower is a “mere instrumentality” of the guarantor or that the borrower entity was created to evade antideficiency protections.