There has been much recent California case law regarding the sham guaranty defense and for good reason – success for a guarantor on this defense can eliminate a lender’s recovery of a deficiency against a guarantor of a secured real property loan following the non-judicial foreclosure.  This can be quite troubling for a lender especially if the deficiency is substantial.  Just last month,  I spoke at the annual conference for the American College of Mortgage Attorneys (ACMA) on a panel discussing issues concerning guaranty agreements, including the possible harmful effects of the sham guaranty defense.   Luckily for secured lenders, earlier this month, a California appellate court further limited the application of the sham guaranty defense in the case of LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP.

Recall that although the anti-deficiency protections found under California law may shield a borrower of a loan secured by a deed of trust on real property from liability following a non-judicial foreclosure sale, the anti-deficiency statutes generally do not apply to a guaranty of the real property secured loan.  The sham guaranty defense is typically raised to bar enforcement of a guaranty of the real property secured loan following non-judicial foreclosure on the ground that the guarantor is not a distinct entity from the borrower.  Accordingly, the sham guaranty defense exists to prevent a lender from structuring the loan so that the primary source of repayment is the guarantor and not the borrower  to avoid the effects of the anti-deficiency statutes.

The Festival Retail Fund case is important because it holds that the fact that the guarantor may be an alter ego of the borrower, in and of itself, may not be sufficient for the sham guaranty defense to apply.  In the Festival Retail Fund case, Festival Retail Fund 1, LP (Festival Fund), a limited partnership, entered into a purchase agreement for the purchase of commercial real property.  Festival Fund’s partnership agreement prohibited Festival Fund from purchasing real property except through a single purpose entity (SPE), unless it first obtained the consent of the lead investor and the general partner.  Accordingly, Festival Fund assigned its right to take title to the property under the purchase agreement to Festival Retail Fund 1 357 N. Beverly Drive, LP (Borrower), a single purpose entity formed after Festival Fund entered into the purchase agreement, in which Festival Fund was the limited partner.  The general partner of the Borrower, FRF1 357 N. Beverly Drive, LP, was also formed after Festival Fund entered into the purchase agreement.

The purchase was financed by a loan made to Borrower in the original principal amount of $25 million.  The lender further required as a condition of the loan that Federal Fund guaranty $1.5 million of the loan.  After Borrower defaulted under the loan, the lender filed suit against the guarantor.  Thereafter, following the completion of the lender’s non-judicial foreclosure of its deed of trust, the lender sought to enforce the guaranty against the guarantor, Festival Fund .  After a court trial, the trial court ruled that the guaranty agreement was not enforceable under the sham guaranty defense. The Festival Retail Fund court reversed the trial court decision.

A few interesting points from the Festival Retail Fund decision:

• Similar to the reasoning found in CADC/RAD Venture 22011-1 LLC v. Bradley case discussed in a previous post on this blog, the mere fact that the transaction was structured in such a way that the borrower was a SPE and that the guarantor had significantly more assets than the borrower is not, in and of itself, sufficient to establish a sham guaranty especially when the borrower, and not the lender, structures the loan transaction.
• Also, the lender’s request for financial information from the guarantor but not the borrower did not, in and of itself, compel a conclusion that the guaranty was a sham, especially where the lender examined the value of the property and its cash flow;
• The Festival Retail Fund court also dismissed Federal Fund’s “business enterprise” defense that the guaranty was a sham. The guarantor’s business enterprise defense was based on its claim that the guaranty was not enforceable because Federal Fund, the guarantor and limited partner of the Borrower, was the alter ego of the general partner of the Borrower, making Federal Fund, the de facto general partner of the Borrower, responsible for the Borrower’s liabilities.  However, Federal Fund provided no evidence that the lender was aware of any facts supporting this alter ego claim at the time that the lender extended the loan to the Borrower.  Thus, the Festival Retail Fund court ruled that a guarantor could not avoid liability owed under a guaranty by simply instructing its partners to disregard corporate formalities.
• Further, the fact that the Federal Fund’s liability under the guarantor was far less than the original principal balance of the loan was relevant to the Court’s conclusion that the lender did not view the guarantor as the primary obligor of the loan.

Perhaps more troubling was language in the loan documents creating ambiguities as to whether the lender looked to Festival Fund as the primary obligor of the loan, despite the fact that it executed a guaranty of the loan.  For example, language in the guaranty referred to Festival Fund as “a primary party and not merely a surety.”  The loan agreement also stated that the obligations of the Borrower and Festival Fund were “joint and several”, despite the fact that Federal Funding was obligated to the lender under the guaranty agreement, and not under the loan agreement.  Although the Festival Retail Fund court found that this language was not sufficient to find that Festival Fund a disguised borrower of the loan, it would seem advisable that lenders be extra vigilant against such sloppy language, especially as it appears that the sham guaranty defense is being raised much more frequently by guarantors and the result of a guarantor‘s successfully raising of this defense can be devastating to the lender.