AHK Law Office

The Rise of the Sham Guaranty Defense to Actions against Guarantors: Suggestions for Protection

"Sham Guaranty" Defense to Actions against Guarantors

There has been a huge increase in the number of "sham guaranty" defense claims asserted in actions by lenders against their guarantors. In these real estate secured loan situations, a true borrower is protected by the anti-deficiency laws under the Code. A true guarantor would not be so protected. This concept has resulted in efforts by "guarantors" to have the guarantor re-classified as the true borrower, giving the "sham guarantor" the protections of the anti-deficiency laws. The frequency of the sham guaranty defense has increased significantly in the last few years when property values declined significantly and lenders pursued guarantors more aggressively.

What is a "sham guaranty"?

A guaranty is defined in the Civil Code. A guaranty is a promise to answer for the obligation of another. The Code itself says a guarantor is a party who "promises to answer for the debt, default, or miscarriage of another, or hypothecates property as security." (Civil Code §§ 2787 et seq.).1

It is hornbook law that one cannot guaranty one's own debt. The definition of a guarantor itself requires the debt guaranteed to be the debt of "another", as stated above. Therefore, for example, a partner of a general partnership is already liable for the debts of the partnership. If such a partner guaranteed a debt of the partnership, the guaranty would be meaningless and therefore unenforceable because the partner is already liable for the debt. Thus, the term "sham" (or, sometimes "purported") guaranty arose.

The anti-deficiency protections of the Code of Civil Procedure apply.

Once a guaranty of a note secured by a deed of trust has been determined a sham, the anti-deficiency protections of the Code of Civil Procedure apply. Thus, sections 580a, 580b and 580d and 726, for instance, all apply preventing a creditor from suing the now determined "true" borrower for a deficiency. A "deficiency judgment" is defined as "a personal judgment against a debtor for a recovery of the secured debt measured by the difference between the debt and the net proceeds received from the foreclosure sale." (Dreyfuss v Union Bank of Cal., 24 Cal.4th 400, 407, (2000)).

The anti-deficiency provisions of the Code, depending on which one, either do not apply to guarantors or can be waived. The Legislature has made it clear that guarantors can waive all of the anti-deficiency protections of the Code. (Civ. Code § 2856). Most all properly drafted guaranties used in a real estate context contain waivers of the anti-deficiency protections provided by the Code, as well as other waivers.

The attack by attorneys on the guaranty signed by the person involved in the real estate venture goes like this:

  1. I am really the person who borrowed the money. My alter ego, (my LLC or corporation or other entity) is just me in disguise. Therefore, I owe the money directly, not just as a guarantor.
  2. As a direct borrower, or "true borrower", I cannot guaranty my own debt. Such a guaranty is a "sham" or a "purported" guaranty.
  3. Because the guaranty is invalid, and because I am the "true borrower", I have all of the protections of the anti-deficiency provisions of the Code. Therefore, you, secured lender, cannot sue me for the deficiency owed to you after you non-judicially foreclose.

    a. (Note: it may be possible (through use of a judicial foreclosure proceeding) to obtain a deficiency judgment limited by the fair value rule of CCP section 580a even if a sham guaranty defense is raised. Thus, a decision must be made before going to non-judicial foreclosure whether to pursue judicial foreclosure instead to keep this option viable.)

Under what circumstances can a "sham" guaranty arise?

There have only been a few cases on this issue, but the underlying principals are long established. The law is "judge-made" law, that is, other than the statutes already cited, there is no specific statute that defines "sham guaranties". Both judges and attorneys are confused by this issue as it is a bit complicated. It is not at all clear what guidelines determine precisely what constitutes a sham guaranty. Here are a few of the cases that discuss the issue:

  1. NFG Parcel A LLC v Matrix (2009 WL 5215373, C.D. Cal.) (A very good case, unpublished, that gives a nice overall view of the area. Recommended reading.)
  2. Cadle Co. II v. Harvey (2000) 83 Cal. App.4th 927.
  3. In re Prestige Ltd. Partnership (Bankr. N.D. Cal. 1997) 205 B.R. 427.
  4. River Bank America v. Diller (1995) 38 Cal.App.4th 1400.
  5. Paradise Land & Cattle Co. v. McWilliams Enters., Inc. (9th Cir. 1992) 959 F.2d 1463.
  6. Torrey Pines Bank v. Hoffman (1991) 231 Cal.App.3d 308.
  7. Roberts v. Graves (1969) 269 Cal.App.2d 410.
  8. Union Bank v. Brummell (1969) 269 Cal.App.2d 836.
  9. Union Bank v. Dorn (1967) 254 Cal.App.2d 157.
  10. Valinda Builders, Inc., v. Bissner (1964) 230 Cal.App.2d 106.
  11. Riddle v. Rushing (1962) 203 Cal.App.2d 831.

What results from a court finding that the guaranty is a sham?

The result of a court finding a guaranty a sham is that the guaranty becomes unenforceable. Assuming the guaranty agreement has an attorneys' fees clause, attorney's fees can be awarded against the creditor to the successful defending guarantor.

What can a lender do to protect itself against the defense that a guaranty is a "sham"?

Given the nebulous nature of the case law, nothing can be done to "guaranty" (to use a phrase) a guaranty will not be successfully attacked as a "sham". However, there are some suggested steps to take that may assist in defeating such a defense, even before a trial.

1. Recommendation One: Create an "estoppel certificate".

The courts have been accepting of "estoppel certificates" in such areas as landlord-tenant relationships and deeds in lieu of foreclosure to conclusively establish certain matters as fact. Estoppel certificates are often generated in lending arrangements to have a lender rely upon certain statements from a tenant. For example, in Plaza Freeway Ltd. Partnership v. First Mountain Bank 81 Cal. App.4th 616 (4th Dist. 2000) the court of appeal held that an "estoppel by contract" under Evidence Code section 622 determined the date of termination of a lease, even though the date was disputed by the parties. Similarly, estoppel affidavits are almost always required by title companies before agreeing to insure a deed in lieu of foreclosure.

Evidence Code § 622 provides:
"The facts recited in a written instrument are conclusively presumed to be true as between the parties thereto, or their successors in interest; but this rule does not apply to the recital of a consideration."

Evidence Code § 622 is not limited to landlord-tenant or deed-in-lieu situations. The Plaza Freeway case discusses exactly what constitutes a "written instrument", not always a perfectly clear term. However, it seems highly likely that a court would consider recitations (i.e., actual "recitals") in a guaranty or loan agreement, or a deed of trust, or other similar "written agreement" to constitute facts in a written instrument conclusively presumed to be true. It would seem that even a separate "estoppel certificate" attesting to the facts surrounding the creation of an LLC, the loan and the guaranty would be enforceable.

The court in Plaza Freeway stated:
"The conclusive presumption of section 622, … codifies the common law doctrine of "estoppel by contract." (Estate of Wilson (1976) 64 Cal.App.3d 786, 801, 134 Cal.Rptr. 749.) Under section 622, "[t]he facts recited in a written instrument are conclusively presumed to be true as between the parties thereto, or their successors in interest...." Although the word "instrument" as used in this section usually refers to a contract, we find the term also applies to estoppel certificates." (Id., page 625 – 626.)

2. Recommendation Two: Have the estoppel certificate "notarized" with a jurat, not just a notarization.

A "jurat" is an "oath", i.e., a declaration by the person signing the document that the facts stated in the affidavit (declaration) are true. A "notarization" is a statement by the person signing the document they, indeed, signed the document, not that the statements contained in the document are true. If too inconvenient, a declaration under the penalty of perjury can be used in place of a jurat. But, the impact of a person raising one's hand and swearing to the truth of the document could be significant, especially in front of a jury when the notary testifies to the oath.
So, what to put in such an estoppel certificate?

There are no cases on this issue and the case law is ambiguous, to say the least. It is speculation as to what elements should or should not be included. However, it is suggested that certain representations from the guarantor and borrower should be considered. This is not an exhaustive list. And, of course, there is no assurance that even an estoppel certificate would be sufficient to put a stake in the heart of the sham guaranty defense. Certainly, the representations must be true and should not be used if they are not. The representations, among others that could be used, are suggested as follows:

  1. The lender was not involved in the suggestion to use, the preparation of or the formation of the LLC and did not direct the guarantor to use an LLC.
  2. The LLC was in existence prior to the proposed transaction and was fully formed and operating before the LLC applied for a loan from the lender. [*Again, only if this is the fact.]
  3. The lender has not required the LLC be created as a condition of any loan, and has not required that a guaranty be executed as a condition of granting the loan [*unless, of course, this is not true in which case the sham guaranty issues may or may not arise, perhaps depending on the presence of other circumstances].
  4. The guarantors/borrowers have created the LLC solely for their own purposes, including, but not limited to, limiting the liability of the individuals who are members or managers of the LLC (or officers or directors or shareholders of a corporation). The individuals understand and accept the trade-off between possible total liability for the guaranteed loan under the guaranty on the one hand, and protection of the individuals from liability arising from the operation of the venture on the other hand.
  5. The individuals behind the LLC understand they, as guarantors, will be fully liable for the entire debt being guaranteed and that the lender can waive the security and proceed against the guarantor alone.
  6. The guarantor is a sophisticated real estate investor and has previously signed guaranties for borrowers [*if that is the case] and has full knowledge and understanding of the terms and consequences of a guarantee.
  7. The LLC has been, or will be, fully funded, properly formed, sufficiently capitalized for the venture undertaken, operated as a separate entity, and is a valid, viable and operating separate entity. The LLC is not the alter ego of the guarantor.
  8. The financial information of the borrower was thoroughly reviewed in the loan underwriting process. The guarantor's financial information was not reviewed in the loan underwriting process and played no part in the decision to make the loan to the borrower. The assets of the borrower are sufficient to justify the loan [*if that is the case].
  9. The guarantor is answering for the debt of another, i.e., the borrower, and the guarantor's obligation is wholly independent and apart from the debt of the borrower under the note and deed of trust.
  10. The guarantor has been advised to seek independent legal representation to guide the guarantor through this transaction. Guarantor has been advised to seek independent legal representation as to the impact of and liability under a loan guaranty regarding the guarantor. The guarantor has sought such advice and has been fully advised as to the legal impact of a guaranty regarding the guarantor's liability, and, after contemplating and understanding such advice, has decided to become fully liable under the guaranty as part of the loan transaction.

Again, the foregoing suggestions are for educational purposes only, and there is no assurance that an estoppel certificate containing such representations will defeat a sham guaranty defense.

Conclusion: Pursuing guarantors for recovery after coming up short with secured property for the note and deed of trust can be rewarding. Many guarantors have been successfully pursued. Those guarantors with assets may be forced to pay. And, just the pressure of having personal liability for the guarantor may be significant enough to cause the borrower to make the deal work.

However, the risks of pursuing sham guarantors include the expenditure of attorney's fees, sometimes significant sums, in defending such a claim. Should the defense succeed, the specter of (1) not collecting; (2) paying one's own counsel; and, (3) paying the guarantors' counsel, among other things, arises.

Clearly, it is a risk reward scenario that should be analyzed before proceeding against a guarantor.
A good set of business purpose and security purpose documents including a separate one for any guarantor is a good start in protecting the lender from subsequent claims of a sham guaranty.


1 While there were many machinations in litigation regarding the difference between a surety and a guarantor, those distinctions were abolished by the Legislature in 1939. So, when talking about sureties or guarantors, the meaning is essentially the same now.