The Court of Appeal of the State of California, First Appellate District, recently reversed a jury’s finding that personal guaranties signed by principals of the corporate borrower were unenforceable “shams,” thereby allowing the loan owner to pursue a deficiency judgment against the guarantors.
A copy of the opinion is available at: http://www.courts.ca.gov/opinions/documents/A140420.PDF
As you may recall, under California law, a lender cannot seek a deficiency judgment where the proceeds of the sale of the property securing the debt by the mortgagee or trustee under power of sale contained in the mortgage or deed of trust are less than the debt. A lender may pursue a deficiency judgment against a “true” guarantor, but where the borrower and guarantor are the same, the guaranty is considered an unenforceable sham.
In 2006, the corporate borrower obtained a $2.1 million loan secured by a deed of trust against a parcel of undeveloped land. Two individuals also signed personal guaranties at the same time.
In early 2011, the State closed the lender bank and the FDIC was appointed as receiver. Shortly thereafter, the loan went into default and then was acquired by the plaintiff in this action, which sued to foreclose in January of 2012. Later that year, the plaintiff purchased the collateral property at a non-judicial foreclosure sale for substantially less than the balance owed on the loan.
The plaintiff then sued to enforce the guaranties. The guarantors defended on the basis that the guaranties were unenforceable shams, and countersued the plaintiff for allegedly violating California’s Unfair Competition Law (“UCL”) by trying to enforce sham guaranties.
The case proceeded to trial, after which the jury returned a verdict for the defendant guarantors. The trial court ruled in favor of the plaintiff on the UCL claim, finding that whether the guaranties were a sham was a close question and, therefore, plaintiff’s attempt to enforce them was not done in bad faith.
On appeal, the Appellate Court noted that California’s anti-deficiency statutes do not prevent a lender from pursuing a deficiency judgment against a guarantor who waives his anti-deficiency protection, even though the lender cannot recover a deficiency against the primary borrower. However, the debtor must be a “true” guarantor and “not merely the primary debtor under a different name. When the principal borrower takes on additional liability as a guarantor, that guaranty is a sham and adds nothing to the primary obligation.”
The Court also noted that, although California law does not define what constitutes a sham guaranty, a threshold issue in such cases is “whether the guarantor of a loan is also obligated as a borrower.” Courts have also considered whether the lender structured the loan to circumvent the protections of the anti-deficiency statutes. However, a sham guaranty defense is not available where there is “adequate legal separation between the borrower and the guarantor. e.g., through the appropriate use of the corporate form.”
The plaintiff argued that the verdict was not supported by substantial evidence and the Appellate Court agreed, reasoning that because there was legal separation between the corporate borrower and the guarantors, the Court could not conclude the borrower was a mere alter ego of the guarantors or that they were directly obligated for the borrower’s debts.
The Appellate Court pointed out that under California law “ownership is a pre-requisite to alter ego liability,” and courts consider factors such as whether there has been “commingling of funds, personal use of corporate assets, inadequate corporate records, lack of employees, offices, or operating funds, and inadequate capitalization.”
The guarantors did not have any direct ownership interest in the corporate borrower, but owned the parent company that, in turn, owned the borrower. Because the evidence showed that the parent company observed the required corporate formalities like “passing corporate resolutions, holding corporate meetings, and maintaining separate bank accounts and assets” the parent company was legally distinct from the defendant guarantors, they were not directly liable for the borrower’s obligation and they thus failed to establish that the parent company’s veil should be pierced.
Having concluded that the defendant guarantors were not directly liable for the borrower’s debts, the Appellate Court turned to the question of whether the lender “structured the loan transaction to subvert the antideficiency laws.”
The Court first pointed out that there was no evidence that the lender “forced defendants to borrow through a shell entity or that it dictated the form that shell entity should take,” and that the ultimate issue it confronted was a question of law: “Can guarantors disclaim their antideficiency waivers if they decide to borrower through a shell entity for their own purposes and there is adequate legal separation between the guarantors and the borrower?”
Noting that antideficiency statutes and case law shed no direct light on this issue, the Appellate Court concluded that “the answer must be no. Where individuals purposefully take advantage of the benefits of borrowing through a corporate entity, they must also assume the risks that come with it.”
The Appellate Court then addressed the defendant guarantors’ argument that the plaintiff’s attempt to enforce the guaranties was an unfair and unlawful business practice under the UCL. The Court found that the attempt to enforce the guaranties was not unlawful because it did not violate any predicate law. It then found that enforcement was also not unfair because the defendant guarantors expressly waived their anti-deficiency protections and, thus, the guaranties were valid and enforceable. It was also not unfair for the plaintiff to exercise its legal right to pursue a non-judicial foreclosure and then sue on the guaranties instead of pursuing a work-out, as the guarantors alleged the loan servicer had promised. Just because the servicer discussed the possibility of a work-out did not obligate the plaintiff or servicer to follow-through.
The Court reversed the judgment in the guarantors’ favor, directed the lower court to enter judgment for the plaintiff on its guaranty claims, and affirmed the trial court’s judgment in plaintiff’s favor on the guarantors’ UCL counterclaim.
Ralph T. Wutscher
McGinnis Wutscher LLP
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Chicago, Illinois 60602
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