The California Court of Appeal decision in LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP (2016) 3 Cal.App.5th 1067, struck another blow to California’s “sham guaranty” defense – highlighting a recent string of decisions seeking to limit the defense. The sham guaranty defense has long provided guarantors of loans with a defense to lenders looking to obtain a deficiency judgment – often giving a guarantor at least a basis to defeat a lender’s attempt to obtain summary judgment and forcing the case to trial.

A guaranty is an unenforceable “sham” when a lender actually looked to the guarantor at the time the loan was made as the primary obligor, structuring the loan to avoid anti-deficiency protections. See River Bank America v. Diller (1995) 38 Cal.App.4th 1400, 1420. While California courts have not established a specific test for determining what constitutes a sham guaranty, there are certain factors considered in the analysis, including: (1) whether the language of the guaranty imports an obligation on the purported guarantor, making him a primary obligor for the loan and not secondarily liable (First Security Co. v. Storey (1935) 9 Cal.App.2d 270, 273); (2) whether the named borrower was a “dummy” or shell entity created for the sole purpose of entering into the underlying loan (Paradise Land & Cattle Co. v. McWilliams Enters. Inc., 959 F.2d 1463, 1467 (9th Cir. 1992)); and, (3) whether the lender actually relied on the financial information and condition of the guarantor rather than the named borrower. River Bank, 38 Cal.App.4th at 1423.

Recently, in LSREF, the California Court of Appeal held that “where the lender neither structures the transaction nor knows, at the time of making the loan, of a borrower’s (or an affiliate’s) failure to follow corporate formalities, there generally will be no basis to apply the sham guaranty defense.” Id. at 1082. LSREF makes clear that a lender can likely defeat the sham guaranty defense by not selecting the borrowing entity or its form which, in many real estate transactions, is a single purpose entity created concurrent with the loan for a specific development. Being mindful of the creation of the borrowing entity, and giving-up control over its formation, can significantly bolster a lender’s ability to effectively enforce a personal guaranty given as security for a loan.