The Real Estate Market, California’s Anti-Deficiency Laws and Sham Guaranty

 

The California real estate market has dropped sharply since 2007. With that sharp drop, commercial real estate lenders have turned their focus, with good reason, to those individuals who guaranteed these commercial loans. Not only may the projects be under water, and therefore unable to re-pay these debts, but the lender cannot ordinarily recover any deficiency from the borrower due to California’s anti-deficiency legislation. That is not so as to guarantors and, as a result, lenders purposely made guarantees an important tool in many real estate transactions, specifically, so that the guarantor may be held liable to cover any deficiency. Guaranty agreements are lengthy, they are detailed and they waive practically every defense imaginable.

The “sham guaranty” doctrine, however, offers guarantors one of the few legal theories available to avoid liability under a written guaranty. Typically, when an individual or entity guaranties a real estate-secured loan, the guarantor enjoys few, if any, legal defenses, including anti-deficiency protection. The successful application of the sham guaranty defense can exonerate a guarantor leaving the principal debtor as the sole source of repayment to the lender.

In this email we will define the sham guaranty and show its application in a deficiency situation. In two subsequent emails we will 1) detail how courts have viewed the assertion of sham guaranty by various guarantors, and 2) discuss the implications of the sham guaranty as litigation strategy.

Anti-Deficiency Protection. In California, a creditor's right to collect on a loan secured by a deed of trust on real property is limited by various anti-deficiency statutes, including Code of Civil Procedure sections 580a (requiring credit for fair market value), 580b (limiting deficiency judgments on purchase money mortgages), 580d (limiting deficiency judgments on foreclosures under power of sale), and 726 (one form of action rule). 1

These statutes were enacted during the depression era to prevent creditors in private foreclosure sales from buying in at deflated prices and realizing double recoveries by holding debtors for large deficiencies. 2 The legislation provided an incentive to lenders not to overvalue their security. 3 The legislation also protected debtors from personal liability for large deficiency judgments after their property was taken by the creditor through foreclosure proceedings. 4

The California Supreme Court observed that these statutory provisions “indicate a considered course on the part of the Legislature to limit strictly the right to recover deficiency judgments, that is, to recover on the debt more than the value of the security.” 5 Because anti-deficiency legislation was established for a public reason, a principal debtor cannot be compelled to waive its protection by private agreement. 6

Lack of Protection for Guarantors. Despite the avowed policy objectives of California’s anti-deficiency statutes , the legislature did not extend anti-deficiency protection to guarantors and the courts have so held. 7 The concept of a guaranty is simple – a promise to pay the debt of another. But typically the guarantors never really expect to have to pay, while lenders use waivers, warranties, exceptions and other protective clauses in the loan agreement to ensure that guarantors do pay.

Moreover, California broadly provides that guarantors may waive any and all anti-deficiency defenses they might be entitled to, whether statutory or otherwise. 8 Consequently, most lenders routinely include extensive anti-deficiency waivers in their standard form guaranties. Not only do lenders regularly pursue guarantors for deficiency judgments - which they cannot do against the principal - they often reap a windfall by purchasing the security at a deeply discounted price as the only bidder at a non-judicial foreclosure sale.

A Sham Guaranty May Exonerate a Guarantor. A “sham” guaranty arises when the principal debtor and guarantor share a “substantial identity.” 9 Under Civil Code section 2787, a guarantor is one who promises to answer for the debt, default or miscarriage “of another.” Thus, when a principal obligor purports to take on additional liability as a guarantor, the principal does not guaranty the debt “of another” and nothing is added to the primary obligation. 10 The signatories do not need to be identical to establish the “sham.” The fact that the names “on the dotted line” are different on the promissory note and trust deed, on the one hand, and on the guaranty agreement, on the other hand, does not remove the matter from section 2787, since “the supposed guarantors against whom suit has been brought [could be] nothing more than principal obligors under another name.” 11

The sham guaranty defense prevents lenders from circumventing the anti-deficiency prohibitions by relegating true principals to the position of guarantors. Thus, if the guarantor is actually the principal obligor, the guarantor is accorded the same unwaivable protection of the anti-deficiency statutes as the principal.

Courts recognize sham guaranties in various loan-guaranty contexts. We will review decisions that apply to different types of guarantors in the next email.

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1Except as provided, statutory references are to the California Code of Civil Procedure.

2Commonwealth Mortgage Assurance Co. v. Superior Court, 211 Cal.App.3d 508, 514 (1989). Although the California Supreme Court questioned the precedential value of Commonwealth generally (see Western Security Bank v. Superior Court, 15 Cal.4th 232, 250 and fn. 7 (1997), this stated purpose of the anti-deficiency statutes is otherwise well-established. See Guild Mortgage Co. v. Heller, 193 Cal.App.3d 1505, 1511 (1987); Cornelison v. Kornbluth (1975) 15 Cal.3d 590, 600-602 (“[D]uring the great depression with its dearth of money and declining property values, a mortgagee was able to purchase the subject real property at the foreclosure sale at a depressed price far below its normal fair market value and thereafter obtain a double recovery by holding the debtor for a large deficiency”).

3Torrey Pines Bank v. Hoffman, 231 Cal.App.3d 308, 318 (1991).

4Id.

5Brown v. Jensen, 41 Cal.2d 193, 197 (1953) (emphasis added).

6Torrey Pines 231 Cal.App.3d at 318 (section 580d cannot be waived by debtor); Riddle v. Lushing, 203 Cal.App.2d 831, 835 (1962) (section 580b cannot be waived by debtor).

7Talbott v. Hustwit, 164 Cal.App.4th 148, 151 (2008), citing Mariners Sav. & Loan Assn. v. Neil, 22 Cal.App.3d 232, 234 (1971) ( “Since section 580a has to do solely with actions for recovery of deficiency judgments on the principal obligation [it] has no application to an action against a guarantor”); Heckes v. Sapp, 229 Cal.App.2d 549 (1964) (section 580b did not bar action against guarantors); Everts v. Matteson, 21 Cal.2d 437, 444-445 (one-action rule under section 726 inapplicable to suit against guarantor). Even the so-called “Gradsky” defense, which indirectly extends the protection of section 580d to guarantors, arises through principles of estoppel. See Union Bank v. Gradsky, 265 Cal .App.2d 40 (1968).

8See Civil Code section 2856 (permitting waivers by guarantors of all rights or defenses where principal obligation is secured by real property, including Sections 580a, 580b, 580d, or 726 and the “Gradsky” defense).

9Torrey Pines, 231 Cal.App.3d at 320; Trust One Mortg. Corp. v. Invest America Mortg. Corp., 134 Cal.App.4th 1302, 1312 (2005).

10Torrey Pines, 231 Cal.App.3d at 319-20.

11River Bank America v. Diller, 38 Cal.App.4th 1400, 1420 (1995).