Throughout the not too distant financial crisis and continuing today, real estate project sponsors have sought, and continue to seek, to avoid personal liability on defaulted real estate loans by asserting what has become known as the “sham guaranty defense”.

While the “sham guaranty defense” takes on many forms, its essential characteristic is that the project sponsor alleges that its loan guaranty is unenforceable as the sponsor/guarantor is in effect the borrower and thus entitled to the full panoply of California’s one-action and antideficiency protections generally available to borrowers but not true guarantors.

Fairly Typical Fact Pattern

A recent California Court of Appeal Case, LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP, 3 Cal. App. 5th 1067 (2016), straightforwardly debunks the “sham guaranty defense” asserted on fairly typical facts. Festival Fund, a sophisticated real estate investment fund, located and contracted for the purchase of property in Beverly Hills reserving the right to take title in the name of a single purpose entity to be formed by Festival Fund prior to closing. For purposes of acquiring and owning the property, Festival Fund formed a limited liability company (“Festival 357”). The general partner of Festival 357 was a limited liability company which was owned entirely by Festival Fund (“FRF1”). FRF1 in turn was owned .01 percent by Festival 357 as its general partner and the remaining 99.99 percent interest in Festival 357 was owned by Festival Fund.

Prior to closing, Festival Fund sought financing for the acquisition. Festival Fund obtained two term sheets from the Bank initially showing the borrowing entity as “TBD” and later specifically identifying Festival 357. In both term sheets, Festival Fund was identified as the guarantor. In connection with the loan, the Bank obtained organizational documents for each of Festival 357, FRF1 and Festival Fund, an appraisal of the property, and financial statements from Festival Fund. Other than verifying that Festival 357 received the required equity investment from Festival Fund, the Bank did not concern itself with the financial condition of Festival 357 or FRF1. Ultimately, the loan closed in the amount of $25,025,000 with Festival Fund providing a $1,500,000 partial guaranty of the loan.

Eventually the loan went into default . The Bank demanded, and Festival Fund refused to pay, the guaranteed amount. Following assignment of the loan from Bank to appellant (“Clover”), Clover completed a non-judicial foreclosure sale of the Beverly Hills property securing the loan and sought to recover in the subject action against Festival Fund under the guaranty.

In the Trial Court

Clover’s motion for summary judgment on the guaranty was denied as the trial court found that there were triable issues of fact whether the guaranty was a sham. After a bench trial, the court denied enforcement of the guaranty noting several factors it deemed significant. It noted that the Bank had required that Festival Fund enter into the guaranty, the Bank had drafted the loan documents and that there was a “unity of interest” between FRF1 and Festival Fund and that they formed a “single business enterprise” such that Festival Fund was already obligated on the loan as a principal (FRF1/Festival Fund being the general partner of Festival 357) and entitled to the unwaivable protections of the one-action and antideficiency laws.

Reversed on Appeal

On appeal, the appellate court clearly and concisely framed the issue as follows:

“...in order for the sham guaranty defense to apply, substantial evidence must support a finding that Festival Fund was the true obligor, and that the Bank structured the loan transaction to circumvent the antideficiency law by casting Festival Fund as the guarantor instead of the borrower.”

The court found, as a matter of law, that the evidence could not support the sham guaranty defense as: (i) Festival Fund was not the general partner of Festival 357 or of FRF1 so was not an obligor on the loan by operation of law, (ii) Festival Fund for its own purposes dictated the structure of the borrowing entity and the loan, and (iii) there was no evidence that the Bank designed the ownership structure or otherwise acted to conceal the identity of the true obligor on the loan. The appellate court reversed the judgment in favor of Festival Fund and remanded the case to the trial court.

In doing so, the court rejected Festival Fund’s numerous contentions that many of the Bank’s typical lender requirements were indicative of a sham and the Bank’s primary reliance on Festival Fund as the primary obligor. The court clearly stated that the requirement of a guaranty from an affiliated person or entity does not, in itself, indicate a likelihood that the guaranty is a sham. The court also stated that the Bank’s requirement that Festival Fund and FRF1 submit their organizational documents was not indicative of a sham. In addition, the court noted that the Bank did not ignore Festival 357’s ability to repay the loan as the Bank obtained an appraisal and took an assignment of leases and rents. In that regard, the court found relevant that Festival Fund’s guaranty was only for a relatively small part of the loan rather than for the full amount.

The appellate court also rejected the argument that Festival Fund was in reality the primary obligor on account of a claimed “unity of interest” constituting a “single business enterprise” between Festival Fund and FRF1 which was primarily liable for the loan as the general partner of Festival 357. Noting that the argument was essentially a variant of the alter ego doctrine, the court stated that the argument was only applicable where the guaranty is an attempt to circumvent the antideficiency laws (which it determined was not the case) and found unpersuasive Festival Fund’s failure to strictly abide the corporate formalities between Festival Fund and FRF1, which occurred after the loan was already in place and which were not known to the Bank.

The decision in LSREF2 Clover Property 4, LLC v. Festival Retail Fund is important in that it makes clear that (i) the usual lender requirements and behaviors in a real estate loan (e.g., requirement of a guaranty and the submission of organizational documents and financial statements from all involved) are not alone indicative of a sham structure, and (ii) the sham guaranty defense requires affirmative demonstration of the lender’s intent to circumvent the antideficiency laws through lender dictated entity structuring or otherwise. While LSREF2 Clover Property 4, LLC v. Festival Retail Fund will allow lenders to rely with more confidence on a real estate loan guaranty in connection with existing or independently structured sophisticated borrowing groups, lenders still need to be cautious in dealing with newly formed and/or unsophisticated borrowers and their principals and to carefully document their underwriting of the property value, its cash flow and the other sources of repayment.