Recently, and shortly after my visit to several lender clients to make presentations regarding, among other topics, the enforceability of commercial guaranty agreements and the sham guaranty defense, the California Court of Appeal decided the CADC/RAD Venture 22011-1 LLC v. Bradley case. Coincidentally, this case clarifies the sham guaranty doctrine and may, in certain circumstances, provide greater protections for lenders against the sham guaranty defense. Understanding this case is imperative for commercial lenders.
In the CADC/RAD case, the defendants included two individuals who wished to buy real property in Napa, California as part of an exchange to invest the proceeds from the sale of real property located in Seattle, Washington under Internal Revenue Code Section 1031. The defendants approached their lender, plaintiff’s predecessor in interest, about obtaining a loan for the purchase of the Napa property with the intent that the seller of the Seattle property, No Boundaries, serve as the borrower for the loan. No Boundaries was a Washington corporation in which the defendants were the principals. The defendants agreed to guaranty the loan.
A day before the closing of the loan, the defendants decided to change the borrower to a limited liability company that was not formed until after the loan closed. At no time did the original lender obtain any financial information about the borrower, although it did obtain financial information about the defendant guarantors.
The borrower defaulted under the loan and the lender proceeded with non-judicial foreclosure. After the non-judicial foreclosure was completed, the lender sought to recover the deficiency against the defendant guarantors. The defendant guarantors claimed, among other things, that their guaranty agreements were not enforceable and were shams.
The jury at the trial court level ruled in favor of the guarantors and the appellate court reversed. As noted by the CADC/RAD court, California anti-deficiency statutes prohibit in most instances a lender from seeking a deficiency against a borrower whose obligation is secured by a deed of trust on real property following a non-judicial foreclosure sale. However, in general, the anti-deficiency statutes do not prohibit the lender recovering against a guarantor of the borrower, provided that the guaranty is not secured by a deed of trust and the guaranty agreement contains the requisite waivers. The sham guaranty defense is an exception to this rule and prevents the secured lender from enforcing the guaranty if it is determined that (a) there is no separation between the borrower or the guarantor, or (b) equity requires that the guaranty not be enforced such as in situations in which lender structures the secured financing transaction to avoid the protections of the anti-deficiency statutes.
The CADC/RAD court had little trouble finding that the defendants were unable to satisfy the first requirement for establishing a sham guaranty. The CADC/RAD court ruled that the borrower was separate and distinct from the defendant guarantors, and was not the alter ego of either of the guarantors. In particular, the CADC/RAD court noted that the seller of the Seattle property, No Boundaries, was the sole member of the borrower. The defendant guarantors held no direct membership interest in the borrower. Furthermore, although the borrower was not formed at the time the loan was closed, the CADC/RAD court found that the borrower was formed soon thereafter.
The CADC/RAD court also ruled that the defendants did not satisfy the second requirement for establishing a sham guaranty defense. In finding that enforcement of the guaranty was not inequitable, the CADC/RAD court paid particular attention to the fact that the defendants, and not the lender, devised the structure and composition of the borrower. Thus, the CADC/RAD court found that it would be unfair to allow the defendant guarantors to disclaim their liability owed to the lender if the guarantors, and not the lender, decided to borrow through a shell entity for their own purposes so long as there exists adequate legal separation between the borrower and the guarantors.
The CADC/RAD case is important not merely for the fact that it clarifies the sham guaranty defense. The CADC/RAD case prevents a guarantor from successfully challenging the enforceability of a guaranty merely because the lender relied on the financial condition of the guarantors as opposed to the borrower, provided that (a) the lender does not structure the loan transaction to deprive the guarantor of the protections of the California anti-deficiency statutes and (b) there is legal separation between the guarantor and the borrower. Therefore, the CADC/RAD case is an important decision to keep in mind both in connection with initial negotiations regarding the structuring of the loan and the enforcement of the loan.
