How Does the Sham Guarantor Defense Work?

Under California law, a lender may not pursue a deficiency judgment against a borrower where the sale of property securing a debt produces proceeds insufficient to cover the amount of the debt. Lenders may pursue deficiency judgments against guarantors, but only true guarantors. Where the borrower and the guarantor are the same, however, the guaranty is considered an unenforceable sham.

The first set of antideficiency laws were enacted during the Great Depression. They prohibited lenders from obtaining personal judgments against borrowers where the lender’s sale of real property security produces proceeds insufficient to cover the amount of the debt. These laws were expanded beginning on January 1, 2013 in response to the bursting of the housing market bubble.

Of course, the antideficiency statutes do not affect the liability a guarantor might otherwise have with respect to a deficiency. (§ 580d, subd. (b).) A lender may recover a deficiency judgment from a guarantor who waives his or her antideficiency protections, even though the antideficiency statutes would bar the lender from recovering that same deficiency from the primary borrower. However, to collect a deficiency from a guarantor, he must be a true guarantor and not merely the principal debtor under a different name also known as “sham guarantors.” The following is a summary of the legal framework for sham guarantor analysis. Detailed case law is available in the decision found here.

From the cases cited in the decision above, the following principles may be derived:

A guaranty is an unenforceable sham where the guarantor is the principal obligor on the debt. This is the case where either (1) the guarantor personally executes underlying loan agreements or a deed of trust, or (2) the guarantor is, in reality, the principal obligor under a different name by operation of trust or corporate law or some other applicable legal principle.

The legislative purpose against deficiency judgments may not be subverted by use of a borrowing entity with the true principal obligor relegated to the position of guarantor. Thus, courts may find a sham guaranty where a lender structures a transaction to avoid antideficiency protections, even though the borrowing entity is a properly formed corporation that observes the necessary formalities. However, a sham guaranty defense generally will not lie where there is adequate legal separation between the borrower and the guarantor, e.g., through the appropriate use of the corporate form.

This last tidbit, that “a sham guaranty defense generally will not lie where there is adequate legal separation between the borrower and the guarantor” means the guarantor has to try and pierce the corporate veil for a company he has setup to protect himself from corporate liability! Thus invoking alter ego liability onto himself.