As I mentioned in a prior post, guarantors are usually in a tough position defending litigation by the lender because most guarantor defenses are lawfully waived in the guaranty documents. As stated in that post:
The widely believed fiction is that guarantors are just “backstops” to be held accountable only if the borrower doesn’t pay. The reality is that under California law, guarantors are clearly on the liability front lines.
Borrowers enjoy many statutory protections, including the anti-deficiency statutes and the one action rule, that cannot be waived at the inception of the loan.
Guarantors, on the other hand, also have many statutory protections (e.g., to force the lender to go after the borrower first, to force the lender to go after the borrower’s security first, to force the lender to join co-guarantors), but almost all can be freely waived.
But a recent decision from the California Court of Appeal (Fourth District in Riverside), California Bank & Trust v. Del Ponti, highlights that there are limits to the defenses that a guarantor can lawfully waive.
The loan and guaranty
In 2006, a bank made a $22.5 million construction loan for a 70-unit townhome project in Rialto, California. The developer LLC’s managing members signed guarantees, which contained standard waivers of statutory defenses.
By early 2008, serious problems emerged. Does this sound familiar?
When the first phase of the project was nearly completed, the bank withheld payments on several timely draw requests. The bank had apparently received an appraisal of the property revealing that the loan-to-value ratio exceeded an acceptable level (due to the real estate downturn in the Inland Empire). The bank told the guarantors that with the declining values in the market, the bank would not make additional advances and that a capital call might be required by the developer LLC.
The bank did NOT declare the loan in default or issue a notice to cure, but continued to withhold funds.
The failed workout: bank breaks promises
Due to the bank’s failure to fund advances, subcontractors were not getting paid. The project stalled. During an attempted workout, the bank took an active role in the development, making adjustments to the scope of work established by the construction contract.
The bank and the developer agreed on a “global strategy” — the developers would finish the remaining construction for the first phase (for which the bank would pay advances), market and sell the units quickly, negotiate discounts with the unpaid subcontractors (who would be paid by the bank), and continue working on the project, all in exchange for a modification of the loan or a release from the guarantees.
The developer and the general contractor accomplished their tasks, but the bank continued to withhold payments, and never extended a modification of the loan or release from the guarantees. Instead, the bank declared the loan in default, filed an action against the developer and guarantors, and foreclosed on the property via trustee’s sale.
Bank’s trial court case against the guarantors
The trial court rejected the bank’s claims against the guarantors, finding that the bank materially breached the loan agreement with the developer and doomed the project by improperly withholding funds. The bank also found the bank led the guarantors to believe they would be released from the guarantees if they performed the workout items required by the bank. The trial court also awarded costs and attorney fees to the guarantors.
The bank appealed.
The Court of Appeal confirms that guarantors can’t waive bank misconduct
In its appeal against the guarantors, the bank did not challenge the trial court’s findings that the bank breached the loan agreement and induced guarantors to perform certain workout tasks. Instead, the bank argued that the guarantors waived all of their defenses under the guarantee agreements.
The court of appeal rejected the bank’s position.
The court noted that under Civil Code section 2856, guarantors may generally waive a vast array of specified rights, including subrogation, reimbursement, indemnification, contribution, rights arising from the creditor’s election of remedies, and rights arising from the principal obligation being secured by real estate.
But, the court observed, “waivable” defenses begin and end with the list above. The court held: “A waiver of statutory defenses is not deemed to waive all defenses, especially equitable defenses, such as unclean hands, where to enforce the guaranty would allow a lender to profit by its own fraudulent conduct.”
In support of its “strict construction” of contractual pre-default waivers by guarantors, the court cited a related line of case law holding that a guarantor cannot be held liable where a contract is unlawful or contravenes public policy, and also highlighted the “duty of continuous good faith and fair dealing” owed by the bank to the guarantors.
Pre-default waivers in the guaranty agreement can only go so far.
Guarantors often effectively waive many substantial statutory rights that would otherwise be available to them, and such waivers often render the guarantor essentially defenseless and ready to settle (or file for bankruptcy protection).
But under this decision by the Court of Appeal, guarantors can’t waive their equitable defenses upfront, including those arising from potential bad behavior by the lender. Sometimes these equitable defenses can make the difference between courtroom victory and defeat.