Bootcamp For Commercial Real Estate Lenders
A California Court of Appeals Case, LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP, decided in October, 2016, 3 Cal. App. 5th 1067, looks at the value of a guaranty in an affiliated transaction. The Court discussed the issue of “sham guaranties” based upon the fairly common facts described below.
The court held that a guarantor’s waiver of anti-deficiency protections under Code Civ. Proc. Section 580d was enforceable because a sham guaranty defense under Civ. Code Sections 2287 and 2856 lacked merit absent substantial evidence that the lender structured the transaction to avoid anti-deficiency laws.
The court found, as a matter of law, that the evidence could not support the sham guaranty defense as: the fund was not the general partner of the single purpose limited liability company holding title, the fund structured the borrowing entity arrangements in accordance with its exiting practices, and there was no evidence that the lender acted to conceal the identity of the true obligor by accepting the ownership structure of the parties. The court of appeals reversed the judgment of the trial court in favor of the guarantor and remanded the case to the trial court. The court stated that an underwriting requirement of a guaranty from an affiliated person or entity does not, in itself, indicate a likelihood that the guaranty is a sham. The court noted that the Lender did not ignore the borrower’s ability to repay the loan as the Lender obtained an appraisal of the real estate and took an assignment of leases and rents in the loan documents. Another factor against the “sham guaranty” concept was the guarantied amount was small relative to the loan amount.
The facts are as follows. Festival Retail Fund, (“FF”), a real estate investment fund, was looking to acquire and finance commercial real property in Beverly Hills, Ca. To that end, a single purpose limited liability company was formed to hold title to the real estate (“F357”). The general partner of F357 ( to be called “FRF1”) was a limited liability company with membership interests owned by F357 and FF. FF obtained two term sheets from the proposed lender, showing FF as the guarantor, and initially showing the borrowing entity as “TBD” and later identifying the borrower as F 357. In connection with the loan, the lender obtained organizational documents for F357, FRF1 and FF, an appraisal of the property and financial statements from FF. The loan closed in the amount of $25,025,000 with FF providing a $1,500,000 partial guaranty of the loan. The loan went into default and the Lender made a demand on FF to pay the partial guaranty amount. Following assignment of the loan from Lender to appellant (“Clover”), Clover foreclosed on the real property collateral and filed this action to recover under the guaranty.
At the trial court level, Clover’s motion for summary judgment to enforce the guaranty was denied, finding there were triable issues of fact as to whether the guaranty was a sham. After a bench trial, the court denied enforcement of the guaranty, holding in favor of the guarantor. The trial court theory was that the lender had required that FF enter into the guaranty, the Bank had drafted the loan documents and that there was a “unity of interest” between FRF1 and FF which formed a “single business enterprise”. The guarantor argued that it functioned as the borrower’s de facto general partner for purposes of Corp. Code Section 15904.04 under this alter ego theory based upon the failure of the general partner, an affiliate of the guarantor, to observe corporate formalities. These arguments did not persuade the appellate court.
What do we learn from this case? Real estate lending always requires careful underwriting and due diligence. Because of lender liability issues, lenders do not want to dictate the corporate structure of the borrower and/or its affiliates. Due diligence must include property value, cash flow, sources of repayment and properly drafted loan documents. Also, if lenders are going to securitize these loans, certain conformity must apply to the various loan products.