Loan Guarantors Fail To Establish Sham Guaranty Defense to Avoid Commercial Loan Obligations

A California appellate court recently found that despite the unity of ownership between a defendant's entities used for purposes of borrowing money in a commercial loan transaction, the debtor could not rely on the "sham guaranty" defense to avoid its contractual guarantee obligations.  Rather, the entities pursuant to which the defendant undertook the transaction at issue provided legal separation such that the guarantees could not be considered "an attempt to circumvent the antideficiency law and recover deficiency judgments when those judgments otherwise would be prohibited."  (California Bank & Trust v. Lawlor (November 25, 2013, G047899, G047910) — Cal.Rptr.3d —-, [2013 Daily Journal D.A.R. 16,706].

Jerry Smith and David Lawlor ("Debtors") were real estate developers who, along with Smith’s wife, formed several different entities for the purpose of undertaking various development projects.  In 2008, Alliance Bank made a commercial loan to Heritage Orcas Partners and Heritage Orcas VL Partners (“Heritage Orcas”), two of the entities that had been formed by Debtors.  As part of the loan transaction, Alliance required Smith, Lawlor, and two of Debtors' other entities to execute a continuing guaranty of the commercial loan. 

In 2009, California Bank &Trust (“California B&T”) acquired Alliance’s assets and, shortly thereafter, Heritage Orcas defaulted on its loan.  In 2011, California B&T conducted a nonjudicial foreclosure sale under the trust deed that secured the loan to Heritage Orcas.  Because the foreclosure sales resulted in proceeds that were insufficient to cover the amount of debt, California B&T sought to enforce the continuing guaranty executed by the Debtors and Debtors' entities.  On California B&T's summary judgment motion, the Debtors sought to avoid their guaranty obligations by seeking protection under California's "sham guaranty" doctrine, by which the Debtors argued that they were entitled to the protection of California’s antideficiency statutes and California B&T could not obtain a judgment against them for the difference between the value of the security and the outstanding loan balances.

California’s antideficiency laws limit or prohibit lenders from obtaining personal judgments against borrowers where the lender’s nonjudicial foreclosure and subsequent sale of the underlying security produces proceeds insufficient to cover the amount of debt.  However, guarantors may expressly waive the protections of antideficiency laws, such that a lender may recover the deficiency judgment against the guarantor even though the lender could not collect the same deficiency from the primary obligor.  To be subject to a deficiency judgment, however, a guarantor must be a true guarantor and not the principal obligor under a different name.  If the guarantor and principal obligor have a strong unity of interest, the guaranty may be considered a "sham" designed solely for purpose of avoiding the antideficiency laws.

To determine whether a guaranty is an unenforceable "sham," a court will look "to the purpose and effect of the parties' agreement to determine whether the guarantees constitute an attempt to circumvent the antideficiency law and recover deficiency judgments when those judgments otherwise would be prohibited."  More particularly, a court will "examine whether the legal relationship between the guarantor and the purported primary obligor truly separated the guarantor from the principal underlying obligation, and whether the lender required or structured the transaction in a manner designed to cast a primary obligor in the appearance of a guarantor."

In California Bank & Trust v. Lawlor, the court of appeal determined that the Debtors failed to offer any evidence that showed a unity of interest between them and the primary obligors on the loan to Heritage Orcas.  The entities’ legal status as a limited liability company and limited partnership provided legal separation between those entities, as the primary obligors, and Debtors, as guarantors.  The Debtors presented no evidence to show these entities were not properly formed or failed to observe the necessary formalities that usually protect their owners from corporate liabilities.  Additionally, the Debtors failed to offer any evidence showing that Alliance, as California B&T's predecessor in interest, requested or required any involvement in the selection or formation of the entities that were the borrowers and primary obligors.  The court found that the evidence suggested the Debtors formed the entities for their own purposes, independent of the loans.  As a result, the court held that the Debtors failed to present sufficient evidence to create a triable issue on their sham guaranty defense and affirmed the trial court’s summary judgment in favor of California B&T.

California Bank & Trust v. Lawlor is a good reminder to debtors that a debtor cannot create a complex system of distinct legal entities for purposes of insulating against personal liability while also claiming that the entities are not distinct to avoid their commercial guarantees.  While the sham guaranty doctrine was designed to protect debtors, debtors cannot use the doctrine to circumvent their properly assumed commercial obligations.


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Mark E. Ellinghouse | 916.321.4500