California Appeals Court Shuts Down Sham Guaranty DefenseA California appeals court has found that the sham guaranty defense is not available to guarantors who formed a borrowing entity without being required to do so by the lender.

In CADC/RAD Venture 2011-1 LLC v. Bradley, a loan was made to a limited liability company and guaranties were obtained by the lender from the managers of the LLC, who were the sole owners of the LLC. Per the guaranty agreements, the guarantors waived all rights and defenses under antideficiency statutes. The structure of the loan was requested by the guarantors on advice of their tax advisor and the lender agreed.

The borrower then defaulted on the FDIC loan, and the plaintiff began foreclosure proceedings. Following the foreclosure sale, the plaintiff sued the guarantors to recover the amount due under the guaranties, which totaled approximately $1.3 million. The guarantors argued that the guaranties were not enforceable because the borrower and the guarantors were essentially one and the same. A lower court jury agreed and found for the guarantors.

On appeal, the California Court of Appeal reversed, finding that the borrower and the guarantors were sufficiently separate. In reaching its decision, the court explained that a guaranty is an unenforceable sham if the guarantor is the principal obligor on a debt. A guarantor becomes a principal obligor when the guarantor (1) personally executes the loan agreements or a deed of trust, or (2) is the principal obligor under another name.

The court also noted that if a loan is structured by the lender to avoid antideficiency rules by requiring a guarantor to borrow under another entity, the guaranty may be an unenforceable sham. However, in this case, the lender did not require the formation of a separate entity as a prerequisite for the loan. The guarantors had dictated the structure of the loan to gain a tax break. Since the corporate formalities were followed by the LLC, it was a separate entity from the guarantors.

To avoid a sham guaranty defense, lenders should avoid advising borrowers to become guarantors under a separate borrowing entity and should also ensure that borrowing entities are following the proper corporate formalities to keep their separate entity status intact.

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