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What is a Sham Guaranty and How Can Banks Avoid This Defense in Loan Defaults? – Glass & Goldberg | Financing, Property & Bankruptcy Law
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What is a Sham Guaranty and How Can Banks Avoid This Defense in Loan Defaults?

Banks commonly require a guarantor’s signature when making loans to individuals or businesses.  Whether the guarantor’s agreement to pay will be valid in the event of the borrower’s default depends on a number of factors, including the identity of the borrower and the purpose of the guaranty in the first place.  In this article, we will help shed some light on how California courts tend to distinguish between a sham guaranty and a valid guaranty.

The purpose of a guaranty is plain – to ensure payment of the loan in the event the borrower defaults.  The addition of a guarantor gives the lender added assurance that the loan will be repaid.  In simple terms, as long as the guarantor’s identity is not co-mingled with the borrower’s identity, and the guaranty was not calculated to avoid California’s anti-deficiency statutes, then the guaranty will generally be valid and enforceable by a lender against the guarantor.

Problems arise when the borrower and the guarantor are essentially one in the same.  For example, if Bob and Tom are general partners in Fran’s Flowers, then neither Bob nor Tom could sign a valid guaranty on a loan to Fran’s Flowers.  The reason is that general partners are already jointly and severally liable for debts of the business.  A purported guaranty signed by Bob or Tom on a loan to Fran’s Flowers would have no additional force or affect than what already existed under the law. 

California Civil Code § 2787 defines a guarantee as “the promise to answer for the debt…of another person.”  By definition, one cannot guarantee his own debt, so the purported ‘guaranty’ in the example above would be considered a sham.  California’s anti-deficiency statutes would preclude any attempt to collect a deficiency from Bob or Tom after the lender’s nonjudicial foreclosure of Fran’s Flowers’ loan.

Another situation where a guaranty will be deemed a sham is when the guaranty was extracted by the lender as a means to circumvent California’s anti-deficiency statutes.

California Code of Civil Procedure Section 580d precludes a judgment for “any loan balance left unpaid after the lender’s nonjudicial foreclosure under a power of sale in a deed of trust … on real property.” 

The classic example of this type of sham guaranty is River Bank America v. Diller, 38 Cal. App. 4th 1400 (1995).  In River Bank, the Dillers signed as guarantors on a loan by River Bank to Hacienda Gardens Venture, a limited partnership.  When Hacienda Gardens defaulted on the loan, River Bank sought to enforce the Dillers’ guarantee.  The Dillers successfully presented evidence that they created Hacienda Gardens Venture at the bank’s direction as a condition of getting the loan.  It appeared to the court that the purpose of the bank’s requirement was to enable it to circumnavigate California’s anti-deficiency statutes and hold the Dillers liable as guarantors in the event of loan default.

Thus, the pertinent two-part question for lenders to consider when deciding to rely on or enforce a guaranty is (1) whether the purported debtor is anything other than an instrumentality used by the individuals who guaranteed the debtor’s obligation, and (2) whether the purpose and effect of the loan and guaranty may be construed by the courts as preemptive attempts to recover deficiencies in violation of California’s anti-deficiency statutes.

If you are a lender seeking payment of a defaulted loan from a guarantor, consult with an attorney experienced in commercial lending and litigation.  The attorneys at Glass & Goldberg provide high quality, cost-effective legal services and advice for clients in all aspects of business litigation and transactional law.  Call us at (818) 888-2220, email us at info@glassgoldberg.com, or visit us on the web at www.glassgoldberg.com to learn more about the firm and to sign up for future newsletters.

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