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Why Should A Nevada Borrower be Aware of California’s Sham Guaranty Defense?

Posted by: on Tue, Jan 29, 2013

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Ocassionally, Nevada banks will demand, as a condition precedent to extending a loan (even though secured by Nevada real estate) to California borrowers or guarantors, that the real estate first be conveyed from the borrower’s individual names into an LLC or corporate entity, so that the individual borrowers can then act as the personal guarantors of the corporate loan obligation. In these situations, the personal guaranty agreements are sometimes then carefully revised to contain specific waivers of California’s anti-deficiency statutes and to contain California choice-of-law provisions. This factual scenario seems to fit precisely into the fact pattern where California courts apply the Sham Guaranty defense to prevent lenders from relying on the sham guaranty that was created merely to side step anti-deficiency legislation. The public purpose behind the sham guaranty defense is to prevent lenders from circumventing the anti-deficiency protections by pursuing a true principal as if it had the status of a guarantor. This occurs when a lender requires an individual borrower to first convey the subject real property to a corporate or LLC entity so that the lender can then require that the individuals become the personal guarantors. Typically the lender has included strong anti-deficiency waivers in the personal guarantees, all typically done without any explanation to the borrowers (who usually have no counsel to represent them). To further assist the lender, California choice of law provisions are included in the guarantees. This of course explains why California choice-of law clauses are often used for California borrowers as personal guarantors, while the other documents governing a loan will be governed by Nevada law, including even the corporate guarantees, when the corporate or LLC entities are incorporated in Nevada.

Application of Sham Guaranty Defense to Corporate/LLC Borrowers

If the actual purchaser of a property uses a third party to take title and enter into the loan obligation, a guaranty executed by the actual purchaser may be a sham guaranty. In Wilton-Maxfield Management Co. v. Coast Federal Savings & Loan Ass’n , 117 F.2d 913 (9th Cir. 1941), a corporation purchased real property in California and directed the seller to convey the property to a third party, which then executed a promissory note in favor of the seller. The seller was aware that the corporation, as guarantor of the note, was the real purchaser and that the third party merely took title as a “dummy.” The corporation guaranteed the promissory note. Upon default, the seller foreclosed on the property and sought a deficiency judgment against the guarantor, but the court concluded that because the corporation was the “actual purchaser” of the property, section 580b precluded the seller’s claim.

If a corporation is the principal borrower, guaranties signed by its officers and shareholders may be sham guaranties. In a case involving a real estate development, two individuals entered into a contract to purchase land and develop a housing tract. Pursuant to the contract, the individuals formed a corporation which they owned and controlled to take title to the property and execute a note and trust deed to the seller. The contract of sale, signed by the individuals, contained both a promise to perform and a guaranty of the note. When the corporation defaulted, the seller sought to enforce the guaranties against the two individuals, but the court ruled that because the individuals were the purchasers of the land, the corporate entity was a “mere shell” and the guaranty was not a debt “of another.” Valinda Builders, Inc. v. Bissner, 230 Cal. App. 2d 106 (1964).

Other California cases support this analysis. For example, in Younker v. Manor , 255 Cal. App. 2d 431 (1967), the guarantor intended to borrow funds individually. However, the lender solicited him to form a corporation instead and then told him that his signature as guarantor was merely for use as collateral. This raised the issue of whether he was “truly a guarantor,” precluding summary judgment in favor of the lender.

Similarly, in Union Bank v. Brummell , 269 Cal. App. 2d 836 (1969), the guarantors intended to borrow funds individually but the bank advised or required them to form a corporation instead to be the borrower. The guarantors argued that the bank intended this device specifically to avoid the anti-deficiency statutes, and the court held that they sufficiently raised the sham guaranty issue as a defense at trial.

More recently, in River Bank America, 38 Cal.App.4th 1400 (1995), a developer proposed a joint venture arrangement with the bank to buy out an apartment complex. Instead, the bank insisted that the developer create a new entity to borrow the needed money and that the developer, his wife, and their development company had to guarantee the loan. After completing the project, the borrower defaulted. A foreclosure sale left a $13 million deficiency, which the bank sought from the guarantors. The guarantors argued that the guaranties were unenforceable sham guaranties because the bank actually looked to the guarantors as the primary obligors, and had structured the loan to avoid the protections of the anti-deficiency legislation. In denying the bank’s summary judgment motion, the court concluded that there were triable issues of material fact regarding the sham guaranty defense, since 1) the bank changed the structure of the transaction to a participating loan with accompanying guaranties, 2) the bank insisted that the developer create a new limited partnership to be the actual “borrower,” and agreed to it being a shell corporation controlled by the developer, and 3) the bank never inquired about the financial condition of the borrower entity, and instead relied on the extensive financial statements of the guarantors.

About the Authors: The law firm of Albright, Stoddard, Warnick & Albright is an A-V Rated Nevada-based full-service law firm having attorneys licensed in Nevada, California and Utah.

Note: This article, and any other information you obtain at this website, is not offered as legal advice, nor should it be relied upon as such, nor is it a solicitation for legal services. Only a licensed attorney can advise you with respect to your specific legal needs. We welcome your contacting our firm to discuss such representation. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.

About the Authors: The law firm of Albright, Stoddard, Warnick & Albright is an A-V Rated Nevada-based full-service law firm having attorneys licensed in Nevada, California and Utah. Our firm’s practice includes a strong emphasis on personal injury accidents. Call us at 702-384-7111.

Note: This article, and any other information you obtain at this website, is not offered as legal advice, nor should it be relied upon as such, nor is it a solicitation for legal services. Only a licensed attorney can advise you with respect to your specific legal needs. We welcome your contacting our firm to discuss such representation. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.