Last month in CADC/RAD Venture 2011-1 LLC v. Bradley, the California Court of Appeal ruled against the "sham guaranty" defense by guarantors who had formed the borrowing entity without being asked to do so by the lender.  This case follows a recent trend in which courts have been making it increasingly difficult for guarantors to successfully assert the sham guaranty defense.

In this case, the original lender made a loan to a limited liability company and obtained guaranties from the managers of the company, who were the only shareholders of a corporation that owned the borrower.  Under the guaranty agreements, the guarantors waived all rights and defenses under antideficiency laws.  The guarantors requested this loan structure at the advice of their tax consultant, and the lender did not object.

The borrower defaulted, and the plaintiff, who had acquired the loan from the FDIC, commenced foreclosure proceedings.  After the foreclosure sale, the plaintiff sued the guarantors to recover $1.3 million due and owing under the guaranties.  The guarantors asserted that the guaranties were unenforceable shams because the guarantors and borrower were effectively one and the same.  Although the jury in the lower court found in favor of the guarantors, the Court of Appeal reversed, finding in favor of the lender.

The court observed that a guaranty is an unenforceable sham where a guarantor is the principal obligor on the debt, and explained that a guarantor is the principal obligor where (1) the guarantor personally executes loan agreements or a deed of trust, or (2) the guarantor is, in reality, the principal obligor under a different name.  The court also pointed out that if a lender structures a loan transaction to avoid antideficiency rules by requiring a guarantor to form a borrowing entity, the guaranty may be an unenforceable sham even if the borrowing entity is formed in accordance with the legal formalities.

A sham guaranty defense will generally not hold up where the borrower and the guarantor are sufficiently separate.  In this case, the court found that the borrower and the guarantor were sufficiently separate because the legal formalities had been observed and because the guarantors, and not the lender, had dictated the structure of the loan to obtain a tax break.  Thus, they could not later disclaim their antideficiency waivers based on the loan structure.

Lenders looking to protect themselves against the sham guaranty defense should, therefore, avoid telling potential borrowers to become guarantors and form separate borrowing entities, and should also make sure that their customer's borrowing entities have been properly formed and maintained.