CRE Basics: Guaranties of California CRE loans
When enforcing loans, it is common to hear arguments made by guarantors’ counsel that their clients did not understand that they would be liable to pay up to the entire amount of the borrower’s debt, even if the lender took back the real property collateral for the loan through a nonjudicial trustee’s sale.
While some of this argumentation may be intentionally misleading or, more charitably, an advocate’s attempt to put the best spin on the circumstances facing his or her client, most guaranties of California real property loans are complicated and hard to read. However, they generally are enforceable (subject to certain limitations): California law allows a third party guarantor to guarantee a loan made to a borrower and secured by the borrower’s real property. Such a guaranty gives the lender the right to collect the debt from the guarantor pursuant to its guaranty, as well as to collect the debt from the property pursuant to its rights under the deed of trust, and to collect from the borrower on the note (through a judicial foreclosure).
Why are such guaranties hard to understand?
They are highly complex documents. The wording of a guaranty is important and highly technical: if a guarantor does not waive its protections under California law, including its one-action and anti-deficiency protections, a lender would have to pursue that guarantor in one lawsuit (that would also include the borrower) to foreclose the real property collateral because, in general, a guarantor’s obligations may not be more burdensome than those of the principal (e.g., the borrower) per Civil Code Section 2809. (However, some case law has held otherwise.)
Alternatively, in the absence of a waiver by the guarantor, if a lender first enforces its deed of trust by a nonjudicial trustee’s sale and then seeks to collect from the guarantor, Civil Procedure Code Section 580d might preclude the lender from obtaining the deficiency from the guarantor because the lender made the choice to enforce its loan through nonjudicial foreclosure.
Since enforcing a loan through judicial foreclosure is much more expensive than doing so through a nonjudicial trustee’s sale and action against the guarantor, and since the former may easily take two years, while a trustee’s sale typically yields at least a partial recovery within about 4 months, most lenders require any guarantors to execute and deliver such waivers (sometimes referred to as “Section 2856 waivers” or “Gradsky waivers”.
Making sure such waivers are effective requires compliance with some rather complex laws. The law in this area is complex for two main reasons.
First, the state’s Depression-era antideficiency and one-action protections for borrowers were sometimes also applied to guarantors as well, in a set of inconsistent and fact-specific cases. The confusion in the earlier case law was clarified by the legislature in 1994 and 1996 when it enacted and later amended Cal. Civil Code Section 2856. That statute clearly provides that guarantors are allowed to waive the anti-deficiency and one action protections applicable to borrowers under California law.
Second, California law originally made some significant distinctions between sureties and guarantors, and provided a lengthy set of protections and defenses against claims to each of them, many of which are codified at Cal. Civil Code Sections 2787 through 2855 and must be waived. While the distinctions between sureties and guarantors were eliminated by the legislature in 1939, when it enacted Cal. Civil Code Section 2787, older case law in this area remains somewhat murky and is frequently misquoted by lawyers seeking to persuade courts of their clients’ positions.
Careful waiver of all of these rights and defenses is essential in California if a lender wants to be able to foreclose nonjudicially by a trustee’s sale of the real property collateral pledged by the borrower and also to pursue the guarantor.
Substantial controversy arose over time among the various California courts, as to which waivers (of suretyship rights and defenses in general or of “one action” and “antideficiency” protections in particular) by guarantors are enforceable, and how those waivers must be worded in order to be enforceable. There were cases holding that waivers were allowed, were not allowed, or were allowed if they were detailed enough so that the guarantors could understand the consequences of the waivers – but there were suggestions that if they were too detailed, such waivers would be unenforceable because they’d be too confusing.
To address lending industry concerns about the enforceability of guaranties, the California Legislature enacted two different versions of Civil Code Section 2856, one in 1994 and another in 1996. In its current form, Civil Code Section 2856(a) contains three basic rules regarding guarantor waivers:
1. A guarantor may waive its rights of subrogation, reimbursement, indemnification and contribution and any other rights and defenses that are or may become available to the guarantor by reason of Civil Code Sections 2787 through 2855.
2. A guarantor may waive any rights or defenses the guarantor may have in respect of its obligations as a guarantor by reason of an election of remedies by the creditor.
3. A guarantor may waive any rights or defenses it may have because the principal’s obligation is secured by real property, including any rights or defenses based on the application of Section 580a, 580b, 580d or 726 of the Code of Civil Procedure to the principal’s obligation.
Civil Code Section 2856(b) adds that “[a] contractual provision that expresses an intent to waive any or all of the rights and defenses described in [Section 2856(a)] shall be effective to waive these rights and defenses without regard to the inclusion of any particular language or phrases in the contract to waive any rights and defenses or any references to statutory provisions or judicial decisions.” So no specific language is required for such a waiver to be enforceable.
On the other hand, Civil Code Section 2856(c) and (d) provide specific “safe harbor” language for creating effective waivers. If the safe harbor language of Section 2856(c) and (d) is not employed, the validity of the waivers in a guaranty may depend on compliance with the requirements of earlier reported case law.
The model waivers in Section 2856(c) and (d) do not deal with all of the rights and defenses described in the first of the three Section 2856(a) rules described above. Accordingly, waivers of the type described the first of these three rules should contain a description of the defenses being waived and arguably may need to include some description of the consequences of such waivers.
In making real estate loans in California, lenders often use guaranties as a credit support, but must be careful to include the accepted model language of Section 2856 and certain other specific waivers to assure against the risk that a guarantor will assert one of these highly technical defenses. In the absence of other defenses to the enforcement of a guaranty (such as the argument that it is a sham guaranty made by a person already liable for the underlying debt, or other defenses to enforcement), a guaranty that includes the waivers described above should be enforceable: it should allow a lender to foreclose nonjudicially by obtaining a trustee’s sale of the property collateral of the borrower, and also separately to pursue the guarantor on its promise to pay the borrower’s debt in the original amount and on the original terms through a state court action.
As a result of the many rights and defenses applicable to guarantors under California law, guaranties are some of the most technically complicated documents to draft, and will likely remain difficult for a layman to understand. However, despite that complexity, lenders need to understand that the language they use in their guaranties can determine whether or not their guaranties are enforceable. Guarantors need to understand that if they are signing a properly drafted guaranty, they are and will be responsible for repayment of the borrower’s debt even if the real property is sold through a trustee’s sale for far less than the amount of the debt.