MCLE Article: Fool with a Pen

The use of single purpose entities in real estate loans has raised new issues for lenders and guarantors alike

By Roy S. Geiger And Michael A. Allen

Roy S. Geiger is a partner, and Michael A. Allen is an associate, in the Newport Beach office of Irell & Manella LLP. Geiger specializes in creditors' rights and insolvency, and real estate and finance. Allen specializes in real estate and finance.

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A guarantor, it can be said, is a fool with a pen. With the abolition in California of the distinction between surety and guarantor, this remark is applicable to anyone "who promises to answer for the debt, default, or miscarriage of another, or hypothecates property as security therefor."1 The fool armed with a pen is not just someone who has signed a document called a guaranty but also someone who has pledged or mortgaged an asset for another's debt, as well as someone whose obligation has been assumed by a third party but who remains "on the hook" for that obligation. The suretyship relationship often exists unnoticed except by the experienced observer.

The courts of equity in England and the United States showed a great deal of concern for the plight of guarantors and sureties, exonerating them from their obligations whenever the principal obligor and obligee saw fit to change the contract the guarantor had guaranteed without the guarantor's consent. It is likely that this solicitude grew not so much out of the guarantor's status as a fool, for not all guarantors are genuine fools, but out of the courts' efforts to divine what exactly the guarantor agreed to "answer for." If the guarantor guarantied a note payable on May 1, did the guarantor also agree to guaranty that same note if the payor and payee extended the maturity date to June 1? The negative answer given by the courts of equity2 was codified in the California Civil Code along with a litany of other protections accorded sureties and guarantors by the courts of equity--protections that for the most part remain part of the uncodified legacy of the courts of equity in other states.3

Although solicitous of the plight of guarantors, the courts permitted guarantors to be as foolish as they wished so long as they acted with at least a semblance of understanding about the consequences of what they were doing. Guarantors could therefore waive most, if not all, of their judicially created protections. As with the rights themselves, California has codified the surety's ability to waive its rights.4 A guaranty has thus become a document consisting not only of a promise to answer for another's debt, default, or miscarriage but also page after page of waivers, authorizations, and acknowledgements.

A guaranty involves at least three parties, even though it is signed by only one of them. A guaranty involves the principal obligor, the obligee, and the guarantor. An obligee has rights against both the principal obligor and the guarantor. Assuming the presence of appropriate waivers on the part of the guarantor, the obligee may collect from either the principal obligor or the guarantor. If the obligee collects from the principal obligor, the guarantor has no further liability under the guaranty and the guarantor has no rights against the principal obligor. If, on the other hand, the obligee collects from the guarantor, the guarantor has rights against the principal obligor.

There are two kinds of guarantor's rights against the principal obligor. One is direct and the other is derivative. The guarantor has a direct right of reimbursement against the principal obligor for the amounts paid by the guarantor to the obligee on behalf of the principal obligor. The guarantor's derivative right is known as subrogation, in which the guarantor stands in the shoes of the obligee, as if the guarantor were the purchaser of the obligee's rights against the principal obligor.

The courts have been wary of any actions that the obligee and principal obligor might take that would adversely affect the guarantor's reimbursement and subrogation rights without the consent of the guarantor. The classic example of this judicial concern is the well-known landmark case of Union Bank v. Gradsky,5 which involved a guarantor of an obligation secured by California real property. The lender foreclosed on the real property nonjudicially, using its power of sale. Under Code of Civil Procedure Section 580d, following a nonjudicial foreclosure, a creditor may not seek a deficiency judgment against the debtor on the obligation secured by real estate.6 The Gradsky court held that Section 580d barred the guarantor from pursuing the debtor not only as a subrogee of the secured creditor's claim but also on the guarantor's reimbursement claim. The court further held that because the creditor had deprived the guarantor of its subrogation and reimbursement rights without the guarantor's consent, the guarantor should be exonerated from any liability on its guaranty. Gradsky gave birth to the famous Gradsky waiver, which is codified in the Civil Code and designed to alert the guarantor of the risks involved in guarantying a real-estate-secured loan.7

In Western Security Bank v. The Superior Court of Los Angeles County,8 the California Supreme Court addressed whether an issuer of a letter of credit should be barred by Code of Civil Procedure Section 580d from pursuing a foreclosed-out debtor on a reimbursement agreement. In doing so, the court suggested that the Gradsky court might have gone too far in holding that a guarantor may not recover against a principal obligor either on its reimbursement claim or as a subrogee.9 The guarantor necessarily has no claim against the debtor under its right of subrogation following a nonjudicial foreclosure, as the guarantor's claim against the debtor as a subrogee is no greater than the obligee's rights--and under Section 580d the obligee's rights are wiped out. For the Western Security court, the guarantor's loss of the right of subrogation was sufficient to support the holding in Gradsky. The Gradsky court, therefore, did not have to go the extra step by denying the guarantor any right of reimbursement against the principal obligor following a nonjudicial foreclosure. Whether a guarantor retains or loses its right of reimbursement after a nonjudicial foreclosure may yet be adjudicated, but not in a case in which a guarantor seeks to be exonerated under Gradsky, because the Gradsky waiver is boilerplate in virtually every guaranty in circulation today.

The often misunderstood and sometimes maligned "one action" rule and antideficiency limitations have threatened the efficacy of guaranties on more than one occasion. Indeed, each court ruling in this area has led to a seemingly inevitable legislative response. Gradsky is one example. Another was the unpublished Bank of Southern California v. Dombrow,10 in which the court held that a guarantor could limit its liability by taking advantage of the fair value limitation of Code of Civil Procedure Section 580a rather than pay the amount by which the guarantied debt exceeded the price bid at the foreclosure sale.11 The order not to publish Dombrow did not spell the death of the issue, however.

In the wake of Dombrow came the most expansive legislative statement on the issue of waivers in the history of suretyship law. Civil Code Section 2856 permits the guarantor to waive every right and protection set out in the Civil Code, as well as all rights a guarantor may have under California's antideficiency and one-action rules under Code of Civil Procedure Sections 580a, 580b, 580d, and 726. Moreover, Section 2856 contains user-friendly safe-harbor language that the courts can construe only one way--in favor of a waiver. Yet despite Section 2856, lawyers remain cautious in rendering third-party legal opinions on the enforceability of waivers in guaranties.12 There is a sense that in an egregious case, the courts will decide to wield their equitable powers to limit even the most expansive waiver--notwithstanding the fact that the waiver is engraved in the statute books.

SPEs and Nonrecourse Carve-Outs

If the legislature had not rendered moot some of the issues involved in the protection of guarantors with the passage of Section 2856, commercial practice would nevertheless have made those issues less meaningful, at least in the arena of commercial real estate loans. A large proportion of real estate loans today are made to single purpose entities (SPEs), whose sole asset is the real estate encumbered by the lender's first deed of trust. With only a single real estate asset, and therefore limited business activities and a limited number of unsecured creditors, the borrower who is an SPE is less likely to go bankrupt--and even if it does go bankrupt, the lender is more likely to obtain relief from the automatic stay and to be able to foreclose. A guarantor of an SPE's real estate secured debt is taking on the risk that the guarantor in Gradsky perhaps never understood. The guarantor of an SPE's debt knows that after the lender forecloses on its security, there is going to be nothing left in the SPE from which the lender could obtain reimbursement--and there is nothing that the lender could have obtained beyond the foreclosed upon property even if the lender had foreclosed judicially. As a practical matter, the use of an SPE makes Gradsky meaningless.

The advent of the SPE has also seen the increased use of the nonrecourse loan, with its so-called nonrecourse carve-outs. A lender has little use for a personal judgment against a debtor whose sole asset is encumbered by a first trust deed in favor of the lender. It is nonetheless commonplace for lenders to carve out certain liabilities on the part of the debtor from the lender's agreement not to seek a personal judgment against the debtor. These nonrecourse carve-outs are gradually becoming standardized in loan documentation, to such an extent that lawyers often resort to arguments about whether a particular carve-out is "market."

The bulk of the nonrecourse carve-outs are for those acts or omissions that fall under the "bad boy" rubric. These include waste, fraud, and other intentional acts of misconduct injurious to the lender. For California lawyers, one way to approach most nonrecourse carve-outs is to ask whether a debtor would be liable to the lender for the act or omission if the deed of trust had been foreclosed nonjudicially. If a debtor is liable to a lender for an act or omission following a nonjudicial foreclosure despite Section 580d, the act or omission is (or should be) a nonrecourse carve-out.

Nonrecourse carve-outs may extend beyond bad boy acts or omissions and often do, encompassing such actions as filing a bankruptcy, using rents for purposes other than the operation and maintenance of the real estate security, violating environmental laws or being in breach of specified environmental covenants, or violating due-on-sale and due-on-encumbrance clauses.

As a source of repayment for bad boy acts or omissions, an SPE is of little worth to a lender. Enter the nonrecourse carve-out guaranty, which is a guaranty of the SPE's nonrecourse carve-out liabilities by the SPE's parent company (or by members or principal shareholders). The guaranty form is substantially the same, except for the obligation guarantied. As the obligation guarantied is potentially less than the amount of the debt, or may not even be measured by the debt, the guaranty should address the order in which payments received by the lender are to be applied. From the lender's perspective, no payment--and no bid at a foreclosure sale--should be applied to the nonrecourse carve-out liabilities until the loan and all other sums owing to the lender are paid in full. In the absence of such a provision, the guarantor is certain to argue that the lender received payment on the nonrecourse carve-out liabilities out of the foreclosure sale or previous payments made by the debtor.

Measuring Loss and Liabilities

Nonrecourse carve-out liabilities generally are described in terms of the losses suffered by the lender as a result of the debtor's actions, although under some nonrecourse carve-outs, the loan may become full recourse for certain egregious acts by the debtor. When the lender's recovery is limited to the amount of loss suffered by the lender, an issue generally left unaddressed is how to measure this loss.

After the Dombrow court addressed whether the guarantor should receive credit for the fair market value of the foreclosed real property in determining the extent of the guarantor's liability for a deficiency, the legislature provided, under Section 2856, that a guarantor could waive the right to such a credit. All guaranties contain these waivers, even nonrecourse carve-out guaranties. The question that remains is whether the waiver adequately addresses what the guarantor and lender meant by losses or injuries suffered by the lender arising out of the bad boy acts or omissions of the borrower. The guarantor has a strong argument that the lender suffered injury or harm only to the extent the debt and any losses suffered by the lender from the bad boy acts or omissions exceeded the fair market value of the foreclosed real estate--not the amount bid by the lender for the foreclosed real estate. If the lender desires a different result, the lender will need more than a Section 2856 waiver to achieve it.

The measure of a guarantor's liability is an issue that applies not only to limited guaranties but also to completion guaranties, which are given to guaranty the completion of projects that are being funded by construction loans. The issue is similar to that posed by the nonrecourse carve-out guaranty. How does one measure the injury to the lender by the borrower's failure to complete the building? The guarantor under the completion guaranty does not actually declare that if the borrower fails to complete the building, the lender can force the guarantor to complete it. The completion guaranty often contains language stating that if neither the guarantor nor the borrower completes the building, the lender may complete it and charge the guarantor for the cost of completion. Perhaps fearing a staggering bill for completion of the project, guarantors and their counsel often try to negotiate elaborate provisions permitting the guarantor to step into the shoes of the borrower and complete construction with the use of the lender's loan funds. These negotiations are likely to be pointless should the borrower fail to complete the construction, because the completion guarantor is generally a principal of the borrower and the only source besides the lender of funds for the borrower. If the borrower cannot complete the building, the completion guarantor is not likely to be able to either.

Moreover, the completion guarantor's fear may be baseless. Under Glendale Federal Savings & Loan v. Marina View Heights Development Company, the lender may not be able to recover for sums expended by the lender in finishing the building the borrower and completion guarantor failed to complete.13 The completion guaranty is merely a promise by the completion guarantor to pay the loss in value to the security resulting from the failure to complete.14 Indeed, if the lender is fully secured on the date of foreclosure, there is no recovery under the completion guaranty. The court in Marina View Heights did not specifically address how to determine whether a guarantor is fully secured, but generally the fair market value of the foreclosed property is used, not the foreclosure sale price.

The completion guaranty also is not a guaranty of the deficiency arising by virtue of the difference between the amount of the debt and the value of the collateral. This deficiency may be attributable to a downturn in the economy or a decline in the value of comparable properties. A deficiency that is a result of these market factors would not be covered by a completion guaranty. The completion guaranty is a guaranty that the lender will receive the promised performance, which is the value of the real property security with the completed building. The loss to the lender is measured by the value of the real property collateral as if it had been completed, less the value of the real property in its unfinished state and the cost to complete.

Borrowers use SPEs generally because lenders want them to, although there is a benefit to a borrower in spreading assets among various entities to prevent one troubled property from infecting an entire real estate enterprise. Loan applications often state that the real property is to be owned by an SPE and that a person or entity with an interest in the SPE is to guaranty the loan. In a line of cases, California courts were confronted with guarantors who argued that their guaranties were sham guaranties because the lender had required the guarantor to place the property into an entity and then guaranty the entity's debt.15 By requiring the guarantor to form an entity and guaranty the entity's debt, the lender had in effect obtained a waiver of the one-action and antideficiency rules that otherwise would have protected the guarantor, who in those cases would have remained as the debtor. If the guarantor was successful in its argument, the guarantor would have no liability on its guaranty, as the one-action and antideficiency rules are not waivable by the debtor.16

In these sham guaranty cases, the guarantors were using a variant of the alter ego theory to shield themselves from liability. The question that may confront courts if the real estate market slows down and SPE structures are tested for the first time is whether the lender's requirements that the property be held by an SPE and guarantied by an owner of the SPE are comparable to compelling the true borrower--that is, the guarantor--to waive the benefits of the one-action and anti-deficiency rules. Unlike lenders in the earlier cases addressing sham guaranties, the lenders who require the deep-pocket-entity borrower to set up an SPE are doing so for reasons other than the right to go after the deep pocket entity as a guarantor for a deficiency. Moreover, the guaranty itself in most cases is for bad boy acts or omissions, which are outside the protections afforded by the one-action and antideficiency rules. Nonrecourse carve-out guaranties made by the parent entities of SPE borrowers are, therefore, unlikely to be struck down as sham guaranties, despite the overt structuring that lenders engage in when they are negotiating the terms of their loans. To suggest that courts should not strike down these guaranties as a sham is not to suggest that lawyers will not make this argument when lenders seek to recover on the guaranties.

Guarantors may be foolish, or just a tad overly optimistic, and perhaps California courts will always hesitate, at least for a moment, before imposing liability on this quondam protected class. It is likely, however, that the simple idea of the guaranty--that a guarantor will do what the principal fails to do--will continue to be expressed in lengthy documents echoing the ancient wisdom of the English Chancery and the more modern struggles of Gradsky and Dombrow.

Endnotes

1 Civ. Code §2787.
2 Civ. Code §2819.
3 Civ. Code §§2787-2856.
4 Civ. Code §2856.
5 Union Bank v. Gradsky, 265 Cal. App. 2d 40 (1968).
6 Code Civ. Proc. §580(d).
7 Civ. Code §2856.
8 Western Sec. Bank v. The Superior Court of Los Angeles County, 15 Cal. 4th 232 (1997).
9 Id. at 249-50.
10 Bank of S. Cal. v. Dombrow, 19 Cal. App. 4th 1457, ordered not to be published (Mar. 14, 1996).
11 Code Civ. Proc. §580(a).
12 Geiger, Roberts & Waldman, The Legal Opinion, in California Real Estate Practice: Strategies and Forms §§8.23, 8.29 (2d ed. 2004). See also Peter S. Munoz, The Guaranty, in California Real Estate Practice: Strategies and Forms §§6.21, 6.30, 6.66 (2d ed. 2004).
13 Glendale Fed. Sav. & Loan v. Marina View Heights Dev. Co., 66 Cal. App. 3d 101, 123-25 (1977). See also Raymond T. Sung, Issues in the Enforcement of Carry Guaranties and Completion Guaranties: Anti-Deficiency Rules, Suretyship Statutes, and Common Law, 37 U.C.L.A. L. Rev. 225, 257 (1989).
14 Marina View Heights, 66 Cal. App. 3d at 123-25.
15 Union Bank v. Dorn, 254 Cal. App. 2d 157, 158 (1967); River Bank Am. v. Diller, 38 Cal. App. 4th 1400, 1420 (1995); Dennis B. Arnold, Guaranties of Indebtedness under California Law: Issues in Drafting and Enforcement, 2 Cal. Real Prop. J. 19, 22 (1983).
16 See Riddle v. Lushing, 203 Cal. App. 2d 831, 836 (1962); Cadle Co. II v. Harvey, 83 Cal. App. 4th 927, 932-33 (2000).

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