Appellate Court Rejects Guarantor's "Sham Guaranty" Defense to Guaranty Enforcement

The California Court of Appeal has once again confirmed that a “sham guaranty” defense will not bar a lender from enforcing a commercial guaranty of a real estate secured loan.  The guaranty is enforceable even if the guarantor ignores corporate formalities between it and its affiliate borrower and treats the enterprise as one entity.  But, as a cautionary reminder, guarantees may not be enforced where the lender creates or controls the ownership structure of the borrower and its owner/guarantor.

Festival Retail Fund 1 LP (Festival Fund) entered into an agreement to purchase a retail property in Beverly Hills.  After creating an entity to take title to the property and assigning its rights under the purchase agreement to that entity, Festival Fund applied for a loan in order to close the purchase. The bank requested and approved the organizational documents for the borrower, its general partner, and Festival Fund (which owned 100% of the borrower’s general partner). To further induce the bank to extend credit, Festival Fund agreed to guarantee a small portion of loan.

After the borrower defaulted on the loan, the lender’s successor in interest sold the property in a nonjudicial foreclosure sale and pursued Festival Fund for breach of guaranty.  At trial, Festival Fund argued, among other defenses, that the lender had structured the loan transaction to subvert California’s antideficiency laws. Festival Fund also argued that it was an alter ego of the general partner, as the general partner had failed to recognize corporate formalities such as holding regular meetings, conducting day-to-day business, and maintaining sufficient capitalization. Since the general partner was liable for the borrower’s loan under partnership law, Festival Fund contended that California’s antideficiency laws prevented the lender from obtaining a deficiency judgment against Festival Fund, making the guaranty an unenforceable “sham.”

Reversing the trial court’s ruling, the appellate court emphasized that there was no basis to find that the lender had a role in the formation of the borrower or its affiliated entities, given that it was the guarantor, and not the bank, that designed and created the entities’ ownership structure, including the entity that took title to the property. The court also determined that where the lender neither structures the transaction nor knows, at the time of making the loan, of a borrower’s (or an affiliate’s) failure to follow corporate formalities, there generally will be no basis to apply the sham guaranty defense. In reaching this conclusion, the court noted that if guarantors could undo the effect of their guaranties by simply disregarding corporate formalities, then guaranties would essentially become worthless.

Stay up to date on the latest news, alerts, events and legal insights: