The law governing California real estate investment, development, and secured lending evolves in real time | Lessons from the courtroom battlefront….

Sham Guaranties Are Hard To Come By

In prior posts here and here, I highlighted the difficult position occupied by guarantors of real estate secured loans.  In short, while California law extends very strong anti-deficiency protections to borrowers, those same protections can be (and almost always are) waived by guarantors.

As a result, guarantors might view themselves as only a “backstop” for the borrower’s obligation, but the reality is they are often the main target of the lender’s collection efforts.

One of the rare successful defenses available to guarantors is that the guaranty is an unenforceable “sham” — i.e., that the guarantor is “merely the principal debtor by another name.”  But a recent decision by the California Court of Appeal (First District in San Francisco) — CADC/RAD Venture 2011-1 LLC v. Bradley — shows that the standards for proving the “sham guaranty” defense are tough to satisfy.

The loan and guaranties

Guarantors Richard Bradley and G. Reynolds Yates decided to purchase a 7.38 parcel of undeveloped land in Napa as part of an Internal Revenue Code section 1031 exchange.  They intended to use proceeds from the sale of an office building in Seattle owned by their corporation, No Boundaries, Ltd.

No Boundaries submitted a loan application for the transaction, and submitted financial statements reflecting corporate assets exceeding $6.5 million, as well as personal financial data of the guarantors.  The lender approved the loan, which was secured by the Napa property.  The loan approval documents reflected that the lender expected an “exchange accommodation titleholder” to initially assume the loan and then transfer its obligations to No Boundaries to effectuate the 1031 exchange, and that No Boundaries would be the primary source of repayment.

Just before the loan agreement was signed, the guarantors decided (on the advice of their tax consultant) to switch the borrowing entity from No Boundaries to Nohea, a new single-asset (the Napa property) entity to be created to facilitate the 1031 exchange, for the purpose of avoiding California withholding tax consequences.  The lender approved this change without requesting financial information from Nohea.  Agreements between the guarantors’ entities clarified that No Boundaries was responsible for the loan.

No Boundaries sold the Seattle office building in 2006, realizing a $6.6 million gain, and was able to defer taxes on that gain through the 1031 exchange.  As planned, No Boundaries made payments on the loan on behalf of Nohea.

The default, foreclosure, and deficiency action against the guarantors

The loan matured in June 2011.  Nohea defaulted.

After loan modification discussions failed, the lender foreclosed non-judicially.  The property was sold at a trustee’s sale for $1.2 million; the unpaid loan balance after the sale was $1.3 million.

The lender sued the guarantors for the balance.  At trial, the guarantors argued that their guaranties were unenforceable shams.  The jury sided with the guarantors, and a judgment was entered in their favor.  The lender appealed.

The Court of Appeal’s Opinion

The Court of Appeal reversed, and directed the trial court to enter a new judgment in favor of the lender.

The court rejected the “sham guaranty” defense.  The court noted the defining characteristics of a true sham guaranty as revealed by prior case law, noting for example that sham guaranties have been found where:

— the borrower was a partnership and the loan was guarantied by two of its partners (who were already liable for the partnership’s debts)

— a shell corporation was formed as an instrumentality of its owners (the guarantors) for the sole purpose of taking on the loan

— a family trust took the loan, which was guarantied by individuals who were also the settlors, trustees, and beneficiaries of the trust

— the lender structured the transaction to circumvent the protections of the anti-deficiency laws.

From these examples, the court announced the following guiding principles:

A guaranty is an unenforceable sham where the guarantor is the principal obligor on the debt.  This is the case where either (1) the guarantor personally executes underlying loan agreements or a deed of trust, or (2) the guarantor is, in reality, the principal obligor under a different name by operation of trust or corporate law or some other applicable legal principle. … Thus, courts may find a sham guaranty where a lender structures a transaction to avoid antideficiency protections, even though the borrowing entity is a properly formed corporation that observes the necessary formalities.  However, a sham guaranty defense generally will not lie where there is adequate legal separation between the borrower and guarantor, e.g., through the appropriate use of the corporate form.

The court held that here, none of the typical “sham” characteristics were present.

The guarantors argued that Nohea was “merely a shell and they are its alter ego.”  (As an aside, it is noteworthy that asserting a “sham guaranty” defense often places a guarantor in the uncomfortable position of arguing in favor of alter ego liability — something most business owners want to avoid like the plague.)

But the court held there was no evidence supporting the alter ego argument.  The guarantors could not be Nohea’s “alter ego,” the court held, because they were not even the technical owners of Nohea.  (Instead, Nohea was owned by No Boundaries, which in turn, was owned by the guarantors.)  Without a direct ownership interest, the guarantors could not be the entity’s alter ego.

Further, the court held, while Nohea might have been created solely to facilitate the 1031 exchange, No Boundaries (Nohea’s owner) was a fully functioning entity, which “observed the necessary formalities, including passing corporate resolutions, holding corporate meetings, and maintaining separate bank accounts and assets.”  Thus, even if piercing Nohea’s corporate veil to reach No Boundaries was justified, piercing No Boundaries’ corporate veil to reach the guarantors was not.

Last, and perhaps most importantly, the court observed there was no evidence that the transaction structure was dictated by the lender.  To the contrary, the guarantors made all of those decisions, based largely on their own personal tax considerations.  The guarantors — not the lender — decided to switch the borrowing entity from No Boundaries to Nohea, and the lender played no role in Nohea’s selection or creation.

The court held that the guarantors could not disclaim their guaranty obligations (including their anti-deficiency waivers) by deciding to “borrow through a shell entity for their own purposes” where there was “adequate legal separation between the guarantors and the borrower.”  The court summarized: “Where individuals purposefully take advantage of the benefits of borrowing through a corporate entity, they must also assume the risks that come with it.”

Lesson

The “sham guaranty” defense is one of the few tools available to guarantors, but it usually fails.  To succeed, a guarantor needs to prove that he is merely the borrower by a different name.  Usually, this requires proof that the guarantor is the “alter ego” of the entity borrower (an argument that carries many unwanted risks), and that the lender’s “fingerprints” were all over the transaction structure.  Wise lenders will stay far removed from the borrower/guarantor entity structure decisions.

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