Appellate Court Narrows the Scope of the Sham Guaranty Defense

California's anti-deficiency statutes limit a lender's right to recover a deficiency judgment against the borrower after a non-judicial foreclosure sale, but such protections generally do not extend to guarantors. A number of guarantors have successfully asserted a defense to guaranty enforcement called the "sham guaranty" defense, arguing that they should be treated as borrowers (and therefore protected from a deficiency judgment), either because they were the "true" principal obligor on the loan by reason of a legal doctrine such as alter ego or trust law, or because the lender had improperly relegated them to the guarantor role in order to circumvent anti-deficiency laws.

In LSREF2 Clover Property 4 LLC v. Festival Retail Fund 1, L.P., California's Second District Court of Appeal continued a recent trend of limiting application of the sham guaranty defense. The court, in rejecting application of the defense, focused on the fact that there was no evidence the lender was attempting to circumvent anti-deficiency laws at the time of the loan. The lender did not structure the loan transaction or mandate the form or identity of the borrower – the borrowing parties already had a proposed structure and borrower in place when they sought the loan. Also, while the court acknowledged the existence of certain facts that might support an alter ego finding, it noted that at the time of the loan, the lender was unaware of most of those facts. In prior sham guaranty decisions, courts allowed a guarantor to establish the sham guaranty defense either by proving an alter ego relationship (i.e. there is such unity between a corporate entity and its owner(s) that it would be inequitable to recognize the separateness of the entity) or proving lender's intent to circumvent anti-deficiency law. In LSREF2, the court stated that a potential alter ego relationship "is just one factor" and that if the lender was unaware of those facts, the defense would be inapplicable. Thus, guarantors attempting to establish the defense will likely have to show that the lender either mandated and controlled the loan/guaranty structure or was aware the borrowing parties failed to follow corporate formalities.

Potential Impact

Before bringing an action against a guarantor, a lender should investigate what role it, or its predecessor, played in choosing the loan structure and the corporate form of the borrower, and should also investigate what facts were available to it at the time of the loan that might point to an alter ego relationship between the borrower and guarantor.