Not So Fast Getting Out of that Guaranty! (A story about a real estate loan and guaranty.)

By: Jack Easterbrook, Esq.

The enforceability of the guaranty of a commercial real estate loan is a question presented to the courts with regularity. A new case, LSREF2 Clover ** testing whether a lender can enforce its guaranty, was decided by a California Court of Appeals in October 2016. Broadly speaking, the court held that under California law properly written guaranties will be enforced notwithstanding the fact that, among the borrower and guarantor, a complicated structure of affiliated entities and control is involved. This is precisely the sort of sophisticated structure often found when the borrower is a special or single purpose entity (SPE). The court rejected the argument that these loan structures are intended to avoid California’s single action and anti-deficiency rules, which could leave the guaranty unenforceable.

Some of the “take away” points made by the court, which provide guidance to lenders and guarantors alike, are highlighted in the last section below.

Summary of the Loan

A limited partnership known as Festival Fund entered into a purchase and sale agreement to buy commercial property and then approached the Lender to obtain a loan. A term sheet was issued by the Lender indicating the borrower was to be a single purpose entity to be determined and Festival Fund was to be a limited guarantor. (The original lender was Anglo Irish Bank, but after several assignments and by the time of the lawsuit, the lender was RSLEF Clover Properties 4, LLC. We will refer to these collectively as the Lender.) Festival Fund subsequently set up 357 LP to be the borrower and FRF1 LLC to be the general partner of the borrower. Festival Fund entirely controlled general partner FRF1 LLC, which held a .01% interest in borrower 357 LP while Festival Fund itself retained the remaining 99.99% interest in 357 LP.

The loan was made for approximately $25 million in 2007 and Festival Fund signed a limited, $1.5 million guaranty, but by 2011 the loan was in default and Lender commenced foreclosure proceedings. As well, Lender made demand under the guaranty by Festival Fund and it was this guaranty that was eventually litigated.

The Guarantor’s Position

Guarantor Festival Fund asserted that it was actually the primary obligor on the loan and the guaranty was a sham and, therefore, not enforceable. In support of its position Festival Fund made a number of arguments, including: (1) the Lender required it to enter into the guaranty; (2) FRF1 LLC was entirely controlled by Festival Fund and there was a unity of interest between FRF1 LLC and Festival Fund making Festival Fund the de facto general partner of borrower 357 LP (and, thus, the primary obligor); (3) the Lender had required Festival Fund to submit its organizational documents and financial information for review and was actually relying on Festival Fund for repayment; (4) the Lender had drafted all of the loan documents; and (5) some of the loan document provisions could be interpreted to say that Festival Fund was an obligor on the loan, not just a guarantor.

The Court’s Decision and the Take-Aways

The Appeals Court did not buy these arguments and the opinion provides lenders and guarantors with some guidance concerning the situations in which guaranties will be enforced, as was the case here.

  1. The guarantor created and implemented the SPE-borrower and guarantor structure, including establishment of a new borrower and its general partner, before the time the loan was granted. The organizational architecture, the court held, was designed by the guarantor and not the Lender.
  2. Both lenders and borrowers can benefit from the SPE structure and it does not imply an intention to circumvent single action-anti deficiency rules.
  3. The fact the Lender requires submission of financial information of a guarantor does not mean the guarantor is the borrower. There is a significant difference between a Lender requiring for review the organizational and financial documents of a guarantor and positioning the provider of that information – the guarantor – as a primary obligor of a loan.
  4. The lender’s analysis of the project and property is evidence that it is primarily relying on the cash flow of the property and the SPE borrower for loan repayment, not the guaranty.
  5. Guarantor Festival Fund was not a party to the loan agreement and could not use the purported language of the loan agreement referring to it as an obligor to claim it is the primary obligor.

In short, the court said that the fact a guarantor may have control over a borrower through direct or indirect interests does not mean it is the borrower. The use of the SPE borrower structure with partial or full guaranties by principal parties is not improper if appropriately done. This sort of loan and guaranty structure is frequently used today by institutional and commercial lenders for real estate loans.

Caveat: We continue to note that the recent cases, LSREF2 Clover included, do not delve into the situation in which the lender requires the intended borrower to switch positions and become a guarantor, and set up or identify a wholly new borrower for the loan immediately before closing. If the purported guarantor can show real duress resulted from a lender’s last minute demand to change the loan and guaranty structure, the outcome could possibly be different. This is the situation described in the often cited 1995 case of River Bank America v. Diller . Thus, a final tip for lenders might be to make decisions about the acceptable loan structure early in the process and stick to it.

** See, LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP, 2016 Cal App Lexis 844 and 2016 WL 5765423

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.