Guarantor Liability - A Litigation Perspective
By Carl D. Ciochon
[Originally published in The Wendel Report, Fall 2008 issue.]
As the real estate market continues its downward turn and lenders find themselves increasingly undersecured, the issue of guarantor liability grows ever more relevant. This article summarizes basic principles of California law governing guaranties in the context of real estate secured transactions and answers three common questions concerning guarantor liability.
According to the California Civil Code, “a surety or guarantor is one who promises to answer for the debt, default, or miscarriage of another.” In the usual scenario, the lender, as a condition of extending credit to the borrower, requires that the guarantor sign a written guaranty promising to assure payment of the debt. In the real estate context, where the debt is typically secured by a mortgage or deed of trust, any analysis of guarantor liability must be made with the following three points in mind:
When a loan is secured by a mortgage or deed of trust, California law extends powerful “antideficiency” protections to the borrower. These historic protections were originally enacted by the California Legislature to protect borrowers from perceived overreaching by mortgage lenders. They include, among other things: (a) the requirement that the lender proceed first against the property securing the loan and bring only “one action” against the borrower; (b) that in the event of judicial foreclosure, the borrower receive “fair value” protection against low-ball bidding, as well as up to a one-year right to redeem the property; and (c) an absolute bar on deficiency judgments if the lender elects to proceed by way of trustee’s sale instead of employing the more cumbersome and expensive process of judicial foreclosure.
Significantly, the California courts have deemed these antideficiency protections nonwaivable in most circumstances as a matter of public policy.
California law nominally provides strong protections for guarantors as well. Known as “suretyship defenses,” these protections severely restrict the lender’s ability to recover from the guarantor (who is sometimes described as a “surety”). Significantly, these suretyship defenses may be waived by the guarantor. Accordingly, most common forms of guaranty, particularly those used by institutional lenders, contain broad waivers of all potentially applicable suretyship defenses.
The obligation created by the guaranty is legally separate and distinct from the guaranteed obligation itself. Taken together, these points have significant implications for guarantors. In particular, because the lender may procure a valid waiver of the guarantor’s suretyship defenses, but not of the borrower’s antideficiency protections, the guarantor’s exposure may be both more immediate and substantial than that of the borrower. Against this background, this article next addresses three common questions relating to guarantor liability.
Must the Lender Proceed First Against the Borrower and/or the Property?
Technically, the answer is “yes” – the suretyship provisions of the California Civil Code effectively require that the lender first seek to recover against the borrower and/or the property before pursuing the guarantor. The typical form of guaranty will contain an express waiver of these provisions, however, and the repercussions of a valid waiver can be profound. Because the guaranty is deemed to be an obligation separate and distinct from the underlying debt, a lender who has obtained a valid waiver of the relevant suretyship defenses may proceed directly against the guarantor, without first exhausting its remedies against the borrower.
Thus, while guarantors often believe their liability to be secondary in the real estate context, where the loan is typically secured by a deed of trust, this common expectation is frequently misplaced. Indeed, because California’s nonwaivable antideficiency protections impose significant limitations on the lender’s remedies against the borrower, the lender may well prefer to pursue the guarantor, and retain its rights against the property as a backstop. This is particularly true in a declining real estate market. Faced with a choice between (a) foreclosing on property that is underwater and attempting to obtain a deficiency judgment against an insolvent borrower or (b) bringing suit directly against a deeppocket guarantor, a lender may elect to pursue the guarantor primarily on what was originally viewed (at least by the guarantor) as a secondary obligation.
What Defenses May the Guarantor Assert?
Assuming that the guaranty contains “state of the art” waivers of the standard suretyship defenses, the guarantor may nonetheless be able to assert viable defenses in an action to enforce the guaranty. These defenses include the following:
The “Sham Guaranty” Rule.
As discussed earlier, California’s powerful antideficiency protections are deemed nonwaivable as a matter of public policy. The sham guaranty rule effectuates this policy by voiding guaranties that attempt to circumvent these protections. The classic applicationof the sham guaranty rule arises in the context of a general partnership. Because the partners of a general partnership are jointly and severally liable for the partnership’s obligations, the law views the partners and the partnership as essentially one and the same. Accordingly, a partner’s guaranty of the partnership’s real estate secured obligations will be deemed an invalid sham guaranty. Whether the sham guaranty defense is applicable in other situations, such as a guaranty of a limited partnership’s obligations by a limited partner, an LLC’s obligations by a member, or a corporation’s obligations by an officer or shareholder, will depend on the facts presented. Although courts frequently uphold guaranties in these circumstances, if the guarantor can present evidence that the “purpose and effect” of the guaranty was to “subvert” California’s antideficiency protections, the sham guaranty defense may apply.
Guarantor’s Obligations Secured By Real Property.
If the guarantor’s obligations are secured by real property, antideficiency protections will apply even if suretyship defenses have been waived. While a complete analysis of this issue is beyond the scope of this article, the guaranty (and related documentation) should be carefully scrutinized to determine whether antideficiency protections may be available to the guarantor.
Traditional Contract Defenses.
A guaranty is subject to the full panoply of traditional contract defenses, such as incapacity, unconscionability, illegality, duress, fraud, and mistake, as well as equitable defenses such as waiver and estoppel. The applicability of these defenses will depend upon the facts presented. In general, the closer the transaction appears to the ideal of an arms length transaction negotiated by sophisticated parties represented by counsel, the less likely these defenses are to succeed. By the same token, the farther the facts stray from this ideal, the greater the possibility a court may find one or more of these defenses applicable, particularly if there is evidence of lender misconduct.
What Rights Does the Guarantor Have Against the Borrower?
What happens when the guarantor makes good on the guaranteed obligation? Specifically, what rights does the guarantor have against the borrower? Stated broadly, the answer is that the guarantor may have two types of legal rights – a right of subrogation and a right to indemnity. Subrogation refers to the right to enforce the original obligation against the borrower: A subrogated guarantor is said to “stand in the shoes” of the lender and therefore may assert the lender’s rights pursuant to the loan documents. For reasons that are beyond the scope of this article, a state of the art guaranty will contain a so-called “Gradsky waiver,” pursuant to which the guarantor waives any and all subrogation rights. By legislative mandate, such waivers are expressly enforceable and broadly construed.
Indemnity, by contrast, refers to an obligation to save the indemnified party from the consequences of the conduct of the indemnitor or another party. Indemnity rights can arise either from contract or by operation of law. Depending upon the circumstances, even where subrogation rights have been expressly waived, a guarantor may still possess indemnity rights against the borrower (or others for whose benefit the guaranty was made).
While guarantors often view themselves as defendants of last resort, the reality in California is often exactly to the contrary. Where the guaranty contains waivers of suretyship defenses, the lender may well find the guarantor a far more attractive target than the real property, particularly if it is underwater. This sometimes harsh reality gives rise to two corollary cautions. First, potential guarantors should carefully consider the risks before signing any guaranty of a real estate secured obligation. Second, if a guaranty has been signed, given current market conditions, the guarantor may wish to consult with counsel to assess potential exposure and explore various means of limiting that exposure.