The Power of a Sham

By: Anna Greenstin Kudla

Sham Guaranty Defense is a distinct way individual guarantors, partners, trustors/trustees, corporate executives and shareholders can avoid liability when an underlying loan is in default. While this defense may be influential in assisting a select few in certain situations, it is rarely used because it applies only in limited circumstances.

Application of the Sham Guaranty Defense requires proving that the guarantor is actually the principal obligor and thus entitled to the same unwaivable protection of the anti-deficiency statutes. Civil Code § 2787 defines a true guarantor as, "one who promises to answer for the debt, default, or miscarriage of another." A Sham Guaranty arises when a principal obligor purports to take on additional liability as a guarantor. Below are some examples of how California courts have made distinctions (between different types of borrowers and/or guarantors) in the application of the Sham Guaranty Defense.

Trustors and Trustees. If a trust is the principal borrower and the guarantees are executed by the Trustors and Trustees of that trust, the guarantees may be considered unenforceable. Asserting a Sham Guaranty requires proof that the principal obligor of the debt, the trust, is a mere pass-through entity that does not award any separation or protection to the trust principals or the guarantors.

The most well-known, and highly cited case in this area is Torrey Pines Bank v. Hoffman (1991) 231 Cal.App.3d 308. In the Torrey Pines matter, a husband and wife, who were the trustors, trustees and the primary beneficiaries of their revocable living trust, signed personal guarantees in connection with a construction loan to their personal trust. The court applied the "instrumentality" test, defined as whether the trust was "anything other than an instrumentality used by the individuals who guaranteed the debtor's obligation, and whether such instrumentality actually removed the individuals from their status and obligations as debtors." ( Id. at 320) The court determined that the structure of the trust made no significant distinction between the guarantors and the borrower. Thus, the husband and wife were deemed the primary obligors that could not guaranty their own debt. Therefore, the guarantees were deemed unenforceable.

This pivotal case does not protect all trusts. In Torrey Pines the court recognized that the greater the degree of separation between trustors, trustees and beneficiaries that exists, the more difficult it will be to establish guarantor protection. Such was the case in the matter of Talbott v. Hustwit (2008) 164 Cal.App.4th 148. In the Talbott case the court made several distinctions. For example, the husband and wife guarantors were secondary, not primary, beneficiaries of their trust. Moreover, they were not the named trustees, but rather used a limited liability company as trustee, thus limiting their personal liability for their trust's obligations. In Talbott, the court deemed the husband and wife as true guarantors because the trust arrangement "actually removed the[m] from their status and obligations as debtors." ( Id. at 153) Therefore, the guarantees were deemed enforceable.

Partners. Similarly if a partnership is the principal borrower, guarantees signed by the partners may be held to be a Sham. In Riddle v. Lushing (1962) 203 Cal.App.2d 831, real property was purchased in the name of a partnership. The promissory note and deed of trust were signed by each partner. The partners also individually guaranteed the note. The partnership defaulted. The court focused on whether the transaction created different liabilities for the partners as guarantors. Since, by law, partners were already jointly and severally liable for debts of the partnership, the court permitted the "guarantors" to invoke the protections of anti-deficiency law.

The above examples relate to real estate properties, individuals and partners. To draft an exhaustive article addressing various loans, lender's responsibilities, and the many defenses that can be applied to corporate executives and shareholders, would require this author to draft a dissertation. We urge you to contact Anna Greenstin Kudla, or any of the litigation attorneys at Kring & Chung, to discuss what defenses or claims could be asserted on behalf of or against, borrowers and guarantors.

Anna Greenstin Kudla is an Associate with Kring & Chung, LLP's Irvine, CA office. She can be reached at (949) 261-7700 or agreenstin@kringandchung.com.