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

Sham Guaranties Are (Still) Hard To Come By

In a prior post, Sham Guaranties Are Hard To Come By, we reviewed a decision from the First District Court of Appeal that emphasized how difficult it is for guarantors to win on a “sham guaranty” defense.  That defense generally asserts that the guaranty cannot be enforced because the guarantor signed the loan as the principal debtor, or was “merely the principal debtor by another name.”

A recent decision from the Second District Court of Appeal — LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP — makes the same point.  A “sham guaranty” defense is difficult to prove, and guarantors are usually stuck in the lender’s cross-hairs when a loan is in default.

The loan, the guaranty, and the default

Festival Retail Fund 1, LP (“Festival Fund”), an entity funded primarily by Goldman Sachs, guaranteed a loan made to an affiliate to purchase retail property.

Festival Fund initially entered into a purchase agreement for the property, and then assigned its rights to a single purpose entity, Festival Retail Fund I 357 N. Beverly Drive, LLC (“Festival 357”).  Festival 357 was owned .01% by Festival Fund, and 99.9% by a newly formed entity, FRF1 357 N. Beverly Drive, LLC (“FRF1”).  FRF1, in turn, was wholly owned by Festival Fund.

Term sheets from the lender initially identified the proposed borrower as “TBD,” but later substituted in Festival 357.  The term sheets listed Festival Fund as the guarantor.  In connection with its approval process, the lender requested copies of organizational and financial documents for Festival 357, FRF1, and Festival Fund.

The loan documents for a $25 million loan were executed by Festival 357 as the sole borrower.  Festival Fund signed a guaranty covering repayment of  a portion of the loan.  The guaranty contained standard anti-deficiency waivers.  (Such waivers are normally enforceable against guarantors, but not borrowers.)

After almost four years, Festival 357 defaulted on the loan.  The lender issued a notice of default, but received no payments from either Festival 357 or the guarantor, Festival Fund.

The lender’s lawsuit and the trial court’s acceptance of the “sham guaranty” defense

The lender sued Festival 357 and Festival Fund for judicial foreclosure and breach of guaranty.

During the litigation, the lender non-judically foreclosed on the security property, dismissed Festival 357 from the action, and pursued only its remaining claim against Festival Fund on the guaranty.

In a bifurcated trial, the trial court found that Festival Fund was entitled to judgment in its favor based on its “sham guaranty” defense.

The trial court held that: the lender required Festival Fund to enter into the guaranty; the lender-drafted loan documents suggested Festival Fund was an obligor on the loan, not just a guarantor; and there was a “unity of interest” among the entities that made Festival Fund the primary obligor.

The Court of Appeal’s Opinion

The Court of Appeal reversed, holding that the guaranty was not a sham.

The evidence showed that Festival Fund itself organized the transaction, including the ownership structure of its affiliated entities.  Festival Fund’s custom and practice was to use single purpose entities to complete transactions — i.e., to borrow money and take title to the underlying property.  Festival Fund created most of its entity structuring for this transaction before it even approached the lender for a loan, and without the lender’s involvement.

In short, there was simply no evidence that the lender had a role in the formation of the Festival Fund-affiliated entities, and no evidence that the lender attempted to “conceal the identity of the primary obligor” in order to avoid anti-deficiency protections.

The Court rejected various arguments asserted by Festival Fund, holding:

  • The lender’s insistence on a guaranty from Festival Fund did not demonstrate that the lender viewed Festival Fund as the primary obligor.  The court noted that related-entity guarantees are common: “In basically all instances, a guarantor will have some relationship to the borrower; people do not often agree to answer for the debts of total strangers.”  The court also noted that the guaranty covered only a portion of the loan amount.
  • Submission of organizational documents and financial information to the lender for review and approval did not make the guaranty a sham.  The court observed: “There is a significant difference between requesting information about a borrowing entity and insisting upon the use of one and the form it should take. … There is nothing unusual about a bank asking for financial information from a person or entity that is guaranteeing a loan.”
  • Language in the guaranty referring to Festival Fund as a “primary party” did not make Festival Fund the primary obligor on the loan; instead, it only signified that Festival Fund was the primary party on the guaranty.
  • A statement in the loan agreement that the obligations of the borrower and guarantor would be “joint and several” did not mean Festival Fund was a borrower; Festival Fund was not even a party to the loan agreement, and other parts of the loan agreement clarified that the lender would look to the borrower for repayment on the loan.
  • Festival Fund could not use the “alter ego” doctrine to create a sham guaranty defense because “alter ego is normally a basis for liability, not a defense.”  It would be absurd and inequitable, the court held, to allow Festival Fund to avoid liability on the guaranty by instructing its affiliates to disregard corporate formalities.

Lesson

The sham guaranty defense remains very difficult to prove.  Unless the lender truly tinkered with the organizational structure of the borrower and guarantor to avoid California’s anti-deficiency protections, a guaranty is probably enforceable (and not a sham).

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