California Loan Guaranties | What You Need to Know Before You Sign One
Before you sign a loan guaranty, make sure you understand the risks associated with doing so and what could happen in the event that there is a borrower loan default.
What is a loan guaranty?Lenders sometimes require a guaranty from a person or entity affiliated or associated with the borrower. The guaranty is a contractual obligation whereby this third-person (or entity or trust) agrees that, upon the event of a default under the loan and guaranty instruments, the lender may collect on the debt from him/her/it either instead of or in addition to collecting from the borrower or liquidating the loan collateral and applying the proceeds (e.g., where the liquidating results in a recovery that is inadequate to pay for the debt that has since accrued).
Guaranty obligations are often required by lenders when making a real estate secured loan (i.e., where the collateral for the loan is real property). Often, the guarantor is a principal of the borrower entity. For example, the borrower is often a newly-formed limited liability company and the managing member of that LLC will be the personal guarantor for the subject loan, which loan may be secured by real property.
A simplified, watered-down explanation of California's one form of action rule (for this purpose).California's one form of action rule is complicated. But for purposes of explaining this particular topic, it can be summarized as follows.
Under California law, when a lender makes a real-estate secured loan (i.e., takes real property as collateral to secure the loan obligation), the lender generally CANNOT, after the loan goes into default, decide to forego the collateral and instead sue the BORROWER for breach of written contract. Instead, the lender must first look to the collateral - meaning that the lender must either judicially or non-judicially foreclose the underlying property and apply the proceeds to reduce or eliminate the balance owed on the debt.
For purposes of this guide, all you need to understand is that the lender must look to the collateral to get paid and generally cannot forego the collateral and sue the borrower on the contract. The lender can do this in one of two ways: (a) sue for JUDICIAL foreclosure - which is a long, expensive process but has the upside of allowing the lender to obtain a court-ordered money judgment for any deficiency that may arise after the property is sold (i.e., where the amount owed exceeds the amount collected from the proceeds of the sale); OR, alternatively, (b) do a non-judicial trustee's sale of the collateral, take what the lender can get and release the BORROWER from further obligation on that debt forever - which is much more commonly utilized because it is generally a much faster procedure that does not require lawyers and judges.
How do loan guaranties play a role in the deficiency issue arising from default?Loan guaranties are separate, independent contractual obligations between the loan guarantor (e.g., the principal or family member of a borrower that has agreed to take responsibility for the debt after default) and the lender. The key here is that the guaranty is different and independent from the loan obligation. Related, yes; but separate.
The guaranty often becomes an integral part of the post-default, lender collection process. Lenders will often "dual track" the collection process by initiating a trustee's sale (non-judicial foreclosure) process while at the same time suing the guarantor in court for breach of his/her/its payment obligations under the guaranty.
In fact, some lenders will not only do the foregoing, but will (as a prophylactic measure and often to frighten the borrower and force the borrower to spend money in court) also such the BORROWER for JUDICIAL foreclosure; all the while initiating the trustee's sale process as well. (ASIDE: Often the lender will simply dismiss, without prejudice, the lender's JUDICIAL foreclosure cause of action against the borrower and simply proceed to closing via a trustee's sale.)
But back to the guarantor. The guarantor is often in a very precarious situation. Most loan guaranties are intentionally UN-secured; meaning that there is no collateral for the obligation of the guarantor to the lender. This helps the lender in that once a default occurs, the lender does not have to worry about California's one form of action rule in enforcing the guaranty obligation against the guarantor. Instead, the lender can simply sue the guarantor in court for breach of written contract and seek money damages (usually the deficiency between the proceeds recovered by the lender from the trustee's sale of the real property collateral securing the BORROWER's loan obligation and the larger amount of the debt). This is generally not an option vis-a-vis the lender-BORROWER relationship because, as discussed above, once the loan is real-estate secured, the lender must either pursue a JUDICIAL foreclosure proceeding against the borrower (and wait a long time and spend a lot of money on attorneys in order to get paid) or forget about the borrower all together and just take when the lender can get via trustee's sale, instead.
Can the lender forget about the collateral and the Borrower and look only to the Guarantor?A properly drafted guaranty agreement will often include the necessary and appropriate language (i.e., guaranty waivers) that will empower the lender to wholly ignore the borrower and the collateral and simply sue the guarantor for money damages (i.e., for the total amount of the outstanding balance of the unpaid debt). Again, this is not permissible as against the BORROWER where the loan is real-estate secured. So in this way, the guarantor is more vulnerable that the borrower is.
Of course, it is important to recognize that where the real estate collateral securing the loan has sufficient equity to pay the lender in full, the lender will almost always proceed by way of non-judicial foreclosure (trustee's sale), liquidate the property, get paid and move on without the need to waste time chasing the guarantor in court for a money judgment. But sometimes, like after 2008 when the real estate markets crashed, the real property collateral is underwater and the lender ends up eating a large deficiency - which is when lenders will usually decide to chase a guarantor for the deficiency balance. Other examples include where the real property collateral is "in trouble" for some reason (e.g., lender has discovered, after the default, that the property is contaminated with environmental toxins that will cost a fortune to clean up and, therefore, is not interested in foreclosure).
In a trustee's sale context, can the lender CREATE a deficiency to use against the guarantor?ABSOLUTELY. Lenders can bid as much or as little as they see fit when "credit bidding" at a trustee's sale that they themselves have caused to occur after the borrower defaulted. (Credit bidding means that the lender can bid at the auction sale of the property using the debt owed to them without making any out of pocket payment towards the purchase price; thereby reducing the balance owed to them.) For example, a lender that is owed $1,000,000 on a loan secured by a property valued at $2,000,000 can decide, should it see fit in its sole and absolute discretion, to credit bid only $200,000 at the auction. Sometimes, that may be sufficient to win the auction and take title to the property. In such an event, the debt is reduced to $800,000; this notwithstanding the fact that the property could theoretically have fetched $2,000,000 had it been sold outside of foreclosure on the open market after a reasonable amount of marketing time. In this example, the borrower is off the hook completely; but the GUARANTOR is not. The lender may elect to pursue the guarantor in court for the alleged deficiency (even though the lender got a windfall by virtue of acquiring title to the property for only $200,000).
Stated differently, the lender acquired title to a $2,000,000 property for only 1/10th of its true value and can now, as the new owner, market and sell it on the open market via traditional sale methods and reap a $1.8 million upside while at the same time successfully suing the guarantor for $800,000. Setting aside lost opportunity costs, attorneys fees (which are often recoverable by the lender against the guarantor) and the hassle of litigation, the lender could theoretically have a $1.6 million windfall (i.e., debt: $1 mil.; upside on foreclosure and re-sale: $1.8 mil.; upside from suing guarantor and collecting thereon: $800k). All of this is perfectly legal and routinely occurs when loans go into default, believe it or not.
What kinds of defenses do guarantors have when sued for breach of guaranty?Among other things, guarantors can defend breach of guaranty lawsuits on several grounds, some more exotic than others. Defenses include the "sham guaranty" defense (which is too complicated to summarize in this guide efficiently). Other defenses include the argument that the guaranty is not enforceable because of the failure of the lender to include all necessary and appropriate suretyship waivers (again, too complicated to summarize here). Yet other defenses may include the argument that the guaranty was made "without consideration" to the guarantor (i.e., that the guaranty cannot be enforced against the guarantor because the guarantor received nothing in exchange for taking on the obligation). The no consideration defense can be asserted where, for example, the guarantor's relationship to the borrower is so attenuated that it does not make sense to hold the guarantor responsible for the borrower's breach (e.g., where the guarantor is merely a friend of the borrower - not family and not a principal of the borrower entity). This is only a sampling of available defenses and others exist so if you are in legal trouble on your guaranty obligation, make sure to consult legal counsel as soon as possible.