Guarantor's "Sham Guaranty" Defense Harder To Prove

A recent case has reaffirmed lenders’ ability to require personal guarantees from principals of borrowing entities.  In California Bank & Trust v. Lawlor, a California appellate court considered the enforceability of guaranties given in connection with two related loans.  In both cases, the lender had made loans to borrowing entities which were guaranteed by the principals of those entities.  In neither case was the guarantor otherwise personally liable for the debts of the entity in question.

After defaults under both loans, the lender foreclosed nonjudicially and then sued to enforce the guaranties.  In defense, the guarantors claimed that these were “sham guarantees."  The trial court disagreed, and the appellate court confirmed the trial court's decision, stating that the guarantors had failed to provide evidence to support this claim.  In order for a guarantee to constitute a “sham guaranty," the court explained that a guarantor must establish that the guaranty represents an attempt by the lender to circumvent the anti-deficiency rules.

Some earlier decisions had found a “sham guaranty” where the guarantor in question was otherwise liable as a borrower (as, for example, when a purported guarantor is also a general partner in the borrowing entity).  In contrast to those decisions, the court in this case stated that the guarantor must also prove that the lender “required or structured the transaction in a manner designed to cast a primary obligor in the appearance of a guarantor.”

In this case, the principals had created entities to insulate themselves from personal liability, and would not have been personally liable under the loans except but for the guaranties.  Moreover, the entities had been formed well before the loans were made, making it clear that they had not been formed at the lender’s request.  There was also no evidence that the lender had requested financial information only from the guarantors – a fact which in another case had provided evidence of a lender’s treatment of guarantors as the primary obligors.

This case signals a development we have noticed in other recent unpublished decisions making it increasingly difficult for guarantors to assert the “sham guaranty” defense.

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