Anti-Deficiency and the Sham Guaranty Defense

March 9, 2020 by Bibin Mannattuparampil, Esq.

California’s anti-deficiency laws are codified in Code of Civil Procedure sections 580a through 580e and 726. These statutes prohibit a lender from obtaining a deficiency judgment from a borrower following a nonjudicial foreclosure of real property.

The anti-deficiency statutes’ protections generally do not extend to guarantors, however, and a lender may recover a deficiency judgment from a guarantor who waives his or her anti-deficiency protections, even though the anti-deficiency statutes would bar the lender from recovering that same deficiency from the primary borrower (CADC/RADC Venture 2011-1 LLC v. Bradley (2015) 235 Cal.App.4th 775, 784 (Bradley).).  In addition, Civil Code section 2856, subdivisions (a)(3) and (c) expressly allow a guarantor to waive anti-deficiency defenses.

Even when a guarantor waives anti-deficiency protections, however, the protections may still apply if the named guarantor is in actuality a principal borrower (Cadle Co. II v. Harvey (2000) 83 Cal.App.4th 927, 932.)  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.

Applying the Sham Guaranty Defense

Application of the sham guaranty defense requires proving that the guarantor is actually the principal obligor and thus entitled to the same non-waivable protection of the anti-deficiency statutes.  Civil Code section 2787 defines a true guarantor as, “one who promises to answer for the debt, default, or miscarriage of another.”  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. (Bradley, supra (2015) 235 Cal.App.4th 775, 787.)  A court’s overall focus when examining whether guarantees are shams is to “look to the purpose and effect of the parties’ agreement to determine whether the guaranty constitutes an attempt to circumvent the anti-deficiency law and recover deficiency judgments when those judgments otherwise would be prohibited.” (California Bank & Trust v. Lawlor (2013) 222 Cal.App.4th 625, 638 (Lawlor).)

The most frequently cited case in this area is Torrey Pines Bank v. Hoffman (1991) 231 Cal.App.3d 308 (Hoffman).  In Hoffman, a husband and wife, who were the trustors, trustees and the primary beneficiaries of their revocable living trust, signed personal guarantees in connection with a construction loan to their revocable trust. The court applied the “instrumentality” test, defined as whether the trust was “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.” ( Id. at p. 320.) Ultimately, the court made the determination that the structure of the trust made no significant distinction between the guarantors and the borrower. Thus, the husband and wife were deemed primary obligors that could not guaranty their own debt, and the guarantees the husband and wife provided were deemed unenforceable.

Not all trusts are protected, and in Hoffman, the court recognized that the greater the degree of separation between trustors, trustees and beneficiaries that exists, the more difficult it will be to establish the sham guaranty defense.  Such was the case in the matter of Talbott v. Hustwit (2008) 164 Cal.App.4th 148 (Hustwit).  In Hustwit the court made several distinctions by noting that the husband and wife guarantors were secondary, not primary, beneficiaries of their trust and that they were not the named trustees, but rather, used a limited liability company as trustee, thus limiting their personal liability for their trust’s obligations.  In Hustwit , the court deemed the husband and wife as true guarantors because the trust arrangement actually removed them from their status and obligations as debtors.

This analysis also often applies to partners that guaranty the debt of a partnership. In Riddle v. Lushing (1962) 203 Cal.App.2d 831, property was purchased by a partnership and a promissory note and deed of trust evidencing a loan were signed by each partner.  The partners also individually guaranteed the note. When the partnership later defaulted, the court focused on whether the transaction created different liabilities for the partners as guarantors. Since, by law, the partners were already jointly and severally liable for debts of the partnership, the court permitted the “guarantors” to raise the sham guaranty defense and invoke the protections of anti-deficiency law.

Compared to these earlier cases, however, the court in Lawlor seemingly raised the bar for establishing a sham guaranty defense, stating that the guarantor must additionally prove that the lender conducted the transaction at issue in such a way that was meant to mask a primary obligor as a guarantor.

The principals in Lawlor had formed entities to shield themselves from being personally liable, with the guarantees being the only form of liability that affected them concerning the loans. The entities were created long before the loans were executed, implying that they were not established because of the lender’s requirements. There was also no sign that the lender had asked for financial statements solely from the guarantors—a factor which in a similar case could have established proof of a lender’s designation of the guarantors as the primary obligors.  Lawlor is significant in that it points to a judicial trend in which it is being markedly more challenging for guarantors to successfully claim the sham guaranty defense.

If the preceding overview makes one thing abundantly clear, it’s that the sham guaranty defense is an extremely fact-dependent analysis that is still being refined by the courts. It is thus advisable to seek experienced legal counsel to be adequately prepared to deal with litigation that may involve the sham guaranty defense.

If you have any other questions about anti-deficiency and the sham guaranty defense, reach out to Geraci Law Firm for a consultation today.

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