The deterioration of real property equity in today’s credit crisis environment has greatly increased the attention given to the legal enforceability of personal guarantees. Guarantors are becoming much more creative and aggressive in their defenses, and so both prudent lenders and prudent guarantors will want to keep themselves up to date on the arguments being made.
Most sophisticated parties are quite familiar with California’s anti-deficiency rules, which are usually the starting point in any analysis. Under Union Bank v Gradsky (1968) 265 Cal.App.2d 40, unless there is an effective waiver, a guarantor can claim that a non-judicial foreclosure eliminates the lender’s rights to proceed for the difference between the successful foreclosure bid and the loan balance because a foreclosure impairs the guarantor’s subrogation rights against the borrower. While most lenders have attempted to address this issue with waivers in the loan documents, it is surprising how often the language is so general and vague that serious enforceability questions arise. For example, in the case of Indusco Management Corp. v. Robertson (1974) 40 Cal. App. 3d 456, the Court invalidated a purported waiver of “all suretyship defenses and defenses in the nature thereof.” At the other end of the spectrum, the extensive recitals set forth in Civ. Code § 2856(a) are considered to be a safe harbor, though to the extent that language is less comprehensive, guarantors may have leverage.
Importantly, proceeding directly against a guarantor, either before or after a foreclosure, often involves a separate lawsuit which could take as much as a year for court resolution while the parties battle over defenses posed in the form of lender liability claims to be presented to a jury that may well include many borrowers. Accordingly, a full understanding of these kinds of claims seems to be essential to any successful work-out negotiation strategy.
Lender liability claims in this arena chiefly fall into two major categories. First, breaches of the loan agreement can be alleged, centering upon whether the lender has met its express and/or implied contractual obligations. These defenses usually have more potential in development loan settings, since those involve many more detailed obligations on the part of the lender and hence more risks that loan administration may compromise the security. For example, we have recently seen a significant number of cases where an allegedly disloyal managing member of a borrower applied for construction draws without adequate backup documentation and then misapplied the funds (e.g., by not paying subcontractors), significantly increasing the guarantors’ bargaining power in the ensuing negotiations. Similarly, we have seen situations where a lender’s knowledge of irregularities and/or of commingling of funds by a borrower on one project it has financed became imputed to the lender for purposes of determining whether that lender indirectly abetted fraud by the same borrower on another project financed by the lender, handing the guarantor several potent defenses. We have even seen cases where lenders have been successfully accused of closing with a greater loan-to-value percentage than had been contemplated in the loan agreement, arguably exposing investor capital to dishonest manipulation by the borrower’s managers.
A second category of lender liability contentions relates to allegations that the terms of the underlying debt have been changed without the guarantor’s agreement. While certain changes that benefit the guarantor might by their nature imply consent, a material increase in the amount of the obligation can exonerate the guarantor. Fruit Grower’s Supply Co. v. Goss (1935 4 Cal.App.2d 651; Shuey v. Bunney (1935) 4 Cal.App.2d 408; Johnson v. Quinby (1923) 62 Cal.App. 137; and Braun v. Crew (1920) 183 Cal. 728. We have recently noticed an increased tendency to claim that such exonerating increases in the debt have occurred where cost overruns were improperly funded, or where loan draws were improperly used by a borrower (such as on other projects, or for excessive internal compensation, or relating to other self-dealing that can occur when a borrower’s managers are affiliated with one or more of the project’s vendors or contractors).
Rights of exoneration can be waived, but the language needs to be both express and specific. Pearl v. General Motors Acceptance Corp. (1993) 13 Cal.App.4th 1023.
In the end, the key for the guarantor is usually to show the lender’s complicity in one or more acts by others which impair security, or which form a reasonable basis for suspicion that mischief is afoot. Loan instrument clauses stating that the lender is not obligated to police the borrower’s own project management are helpful to the lender, as can be specific release and indemnity language, but all of these are potentially vulnerable in the face of a lender’s actual or imputed knowledge of third party improprieties.
Bankruptcy issues also have become important because if the borrower files a Chapter 11 bankruptcy case, the guarantors may argue that all proceedings against them must also be stayed (11 USC Section 362) since their defenses, as well as their claims for indemnity against the debtor, are all interwoven and need to be coordinated in the bankruptcy process. However, with limited exceptions, the automatic stay rule will likely protect only the debtor-borrower and will usually not prohibit the borrower’s creditors from pursuing a collection against a guarantor. In order to extend the automatic stay to non-debtor guarantor, the borrower will probably have to commence an adversary proceeding in the bankruptcy case and then argue that the traditional test for a preliminary injunction (irreparable harm, likelihood of success, and minimal harm to the other party) entitles the guarantor to equitable relief. See, In re Family Health Services, Inc. 105 B.R. 937, 943-946 (Bkrtcy. C.D. Cal. 1989).
Guarantors have also fashioned arguments based upon the legal principle that one cannot guarantee one’s own debt, a rule usually applied in general partnership settings but one that is at least arguably available also in some LLC settings. Assuming the lender seeks to proceed against the guarantor prior to a non-judicial foreclosure sale, the question then becomes whether a guarantor-principal of the borrower is a “true guarantor” or is really just the principal obligor because a person cannot guaranty his own debt. Everts v. Matteson (1942) 21 Cal. 2d 437; Valinda Builders, Inc. v. Bissner (1964) 230 Cal. App. 2d 106. Thus, it has been held that when the debt of a partnership is secured by California real property, a general partner’s guaranty of the partnership debt is not enforceable, and the general partner who is personally liable for the partnership debts has the same right to enforce the anti-deficiency limitations as the principal debtor-partnership. Union Bank v. Dorn (1967) 254 Cal. App. 2d 157; Riddle v. Lushing, (1962) 203 Cal. App. 2d 831
This protection does not exist when the lender makes a loan to a closely held corporation and requires a guaranty of the loan by the shareholders. When the corporation is a valid, viable, independent entity, the guarantor of the corporate debt is a “true” guarantor, and, upon enforcement of the guaranty, the guarantor does not have the anti-deficiency protection which is available to the corporate debtor. Krueger v. Bank of America (1983) 145 Cal. App. 3d 204; United California Bank v. Maltzman (1974) 44 Cal. App. 3d 41.
Interestingly, however, there are to date no actual reported California decisions considering the liability of a limited liability company member under a guarantee where anti-deficiency or one-form-of-action principles are at issue. So parties will continue to argue over whether the proper analogy in such situations is a general partnership or a closely-held corporation.
Forbearance agreements can also contain prospective waivers. However, as a general rule, to be enforceable a waiver is required to evidence an intentional relinquishment of a known right such that the person has a true understanding of what is being waived and intends to waive the right. Lenders typically propose to include such waiver clauses while borrowers will predictably resist, and there are strong arguments that guarantors may not be bound by such waivers.
Contribution rights among co-guarantors can also affect the legal landscape.
In sum, the stakes are obviously high, and the defenses being fashioned by guarantors in today’s challenging environment have become increasingly sophisticated. More than ever before, they require more patience and greater risk tolerance for lenders and guarantors alike.
For more information, please contact Bill Norman.