Is The Guaranty Enforceable? Items to Consider in a Loan Modification or Default

For many years, borrowers have been required by lenders to execute personal guarantees in conjunction with many types of commercial real estate loans. At the time, no one gave them much consideration because it was a standard requirement of those types of loans, loan-to-value ratios were generally within conservative limits, and no one imagined that commercial real estate and land values would drop by 40% or more.

In this economic climate, with almost no liquidity in commercial real estate, and with loans coming due at an increasing rate, both borrowers and lenders are reviewing the personal guaranty as backup to the real estate security, and finding mixed results.

When the loans were made, in a climate of increasing values and abundant liquidity, California borrowers and lenders alike probably didn’t focus on the fact that ours is one of the few states with an established set of laws intended to protect guarantors from being pursued by a lender under certain circumstances. When modifying a loan, a lender can make a previously unenforceable guaranty enforceable, and many lenders and their counsel are attempting to do so as a condition of a loan modification.

Therefore, during these times, it is important for borrowers and lenders to review the original guaranty before entering into a loan extension or modification agreement in order to understand the outcomes that might result from any extension or modification. In this Advisory, I will briefly discuss California law on guaranties, three loan structures that borrowers and lenders should be aware of when entering into a loan modification or extension, and what is the impact of such structures on a lender’s ability to enforce a particular guaranty.

California Law

In California, a guaranty is enforceable against the guarantor if the guaranty is a separate obligation of such party (separate and apart from the loan obligation itself), and such party is not otherwise already obligated on the loan, which is what the courts call a “true guarantor.” For example, a guarantor who is the general partner of a borrowing partnership already has liability for the partnership’s debt as the general partner. Therefore, even though the general partner may have signed the personal guaranty, the guaranty is not valid because that general partner is not a “true guarantor.”

Three California cases which analyze the legal theory of a “true guarantor” are the most cited in legal literature:

In 1962, in the case of Riddle v. Lushing, the appellate court held that the general partners were not liable on a guaranty of a note signed by their partnership (as in the foregoing example). Three decades later, in the case of Torrey Pines Bank v. Hoffman, another appellate court held that individual guarantors were not liable on a guaranty of a note where the individual guarantors were the settlors, trustees, and primary beneficiaries of the trust which was the borrower. The reasoning used by the courts in these two cases was that, in situations where there is “insufficient separation of identity” between the borrower and the guarantor, such guaranty will not be enforced because the courts view the guarantor as, in essence, the same obligor as the borrower. Hence, the guarantee is unenforceable in this case where the individual trustees of the general partner revocable trust signed the guaranty.

In 2008, another appellate court in the case of Talbott v. Hustwit followed the reasoning of the prior cases but reached a different conclusion on different facts. In that case, two individual guarantors attempted to avoid their obligation to pay a loan deficiency (which is the difference between the amount owed and the amount bid at foreclosure sale) following a foreclosure sale. They argued that they were not “true guarantors” and, thus, did not have to pay the deficiency under their guarantees. In rejecting this contention and holding the guarantors liable for the obligations under the guaranty, the court focused on the following factors to distinguish their case from the prior cases. First, the individual guarantors were not the trustees of the borrowing trust, instead, a limited liability company owned by the individual guarantors was the trustee of the trust. Second, the individual guarantors were only the secondary, not the primary, beneficiaries of the trust. Third, the individual guarantors were not otherwise personally liable for the obligations of the trust because of their use of the limited liability company as the trustee for the borrower trust. As a result of these factual distinctions, the court specifically found that there was sufficient “separation” between the borrower trust and the individual guarantors to make the guaranty enforceable against the individual guarantors as “true guarantors.” There is an added complexity in the context of guaranties executed by trustees due to a distinction in the law between revocable and irrevocable trusts, which is beyond the scope of this advisory. If you are placed in this situation, please consult an attorney.

It is important to note that California is one of the few states with such established protections for guarantors. The laws of other states do not have such protections, and therefore, if the loan documents are governed by the laws of a state other than California, lenders do not face the same restrictions on enforcing a guaranty.

Three Common Loan Structures

There are three commonly used loan structures that can result in the guaranty not being enforceable against a guarantor.

First, as indicated in the Riddle case, if the borrower is a general partnership and the guaranty for such loan was signed by one of the general partners of such partnership, then such guaranty is likely not enforceable under the “true guarantor” test.

Second, as indicated in the Torrey Pines case, if the borrower is a revocable trust and the guaranty for such loan was signed by a trustee or a beneficiary who is also the settlor of such trust, chances are good that such guaranty is not enforceable. Finally, if the borrower is a limited partnership and the guaranty was signed by one or more of the general partners, such guaranty would likely not be enforceable.

There are other loan structures where the guaranty would be unenforceable, but those loans require a detailed analysis of the parties, their obligations, and the loan structure. Furthermore, it is important to note that although a guaranty may not be enforceable against a guarantor, in the case of a recourse loan the lender may still pursue its claims for a deficiency judgment directly against the borrower following a judicial foreclosure action.

Conclusion

In the current economic climate, borrowers and lenders may be tempted to process a loan modification or extension quickly without understanding the long term impacts of such actions. It is not uncommon for a lender to discover that they have a problem with a California guaranty after the loan has been made and may later attempt to correct such problem by requiring the loan parties to sign new provisions in loan modification documents that can increase the liability of such borrowing parties. The complexity of the protections afforded to California guarantors necessitates that prior to even entering into negotiations to modify or extend a loan, prudent parties should first analyze whether the guaranty is valid. Such analysis requires that the parties understand the following: (i) the loan structure, (ii) the relationship among the various loan parties and whether there have been any changes since the time of the loan, and (iii) the applicable governing law. If the guaranty is not valid, then the borrower needs to further analyze the contemplated loan modification or extension in order to understand whether the changes provided therein would cause such invalid guaranty to now become enforceable. If the foregoing is true, then the borrower should then determine whether it even makes business sense to continue with a modification or extension with such disadvantageous terms or conditions. Ultimately, if a lender succeeds in converting an otherwise unenforceable guaranty into an enforceable guaranty, such lender would have the right to pursue an action against such guarantor simultaneously with its action against the collateral for the loan.