LOS ANGELES – California's Second District Court of Appeals has reversed a decision by a trial court that granted anti-deficiency protection for a company that claimed it was both the borrower and guarantor of a loan. 

According to court documents, the case dates back to April 2007 when Festival Retail bought property in Beverly Hills. A month after purchasing the property Festival Retail formed a single purpose entity (SPE) that took over the title of the property called Festival Retail Fund. The business also created Festival 357 as the general partner of the property, court documents stated. Festival Fund was a limited partner in Festival 357.

Then in October 2007, Festival 357 borrowed $25 million from Anglo Irish Bank and took over the title to the property. Festival Fund signed a written guarantee of $1.5 million of the loan amount.

“Pursuant to civil code section 2856, the guaranty contained an express waiver of any anti-deficiency protections Festival Fund might have otherwise had under California law,” according to court documents.

In the summer of 2011, Festival 357 defaulted on the loan. The bank “assigned all of its rights in the loan to LSREF2 Clover LLC, which then assigned its rights to Wells Fargo Bank N.A.,” court documents state.

Wells Fargo issued a default notice to both Festival 357 and Festival Fund in November, claiming $23 million was still owed, along with other charges totaling $600,000. It demanded payment from both companies. Neither responded.

In July 2012, Wells Fargo assigned Clover the loan and guaranty. As the lender’s assignee, LSREF2 Clover Property 4 foreclosed on the property and purchased it from the trustee sale for $1.75 million. Clover also set out to claim the $1.5 million guarantee from Festival Fund. However, Festival Fund claimed it was protected by California’s anti-deficiency statutes. It claimed, due to its partnership with Festival 357, it was a principal obligor on the loan and protected.

University of California Davis school of law’s professor John Hunt told the Northern California Record that sometimes the sale of foreclosure collateral does not raise enough money to cover the debt.

“In that case, there is a deficiency. Sometimes the creditor can go after the borrower personally to recover the deficiency,” Hunt told the Northern California Record. “But California has a couple of anti-deficiency statutes that preclude the creditor from doing that."

Hunt said the actual borrower was protected by the anti-deficiency statute but the anti-deficiency statute doesn’t protect against a guarantor.

"So what this person, the defendant, tried to claim in this case was that the guarantor was the same person as the borrower. So that the anti-deficiency statute protected the guarantor because they are the same as the borrower," he said.

The parties agreed to a bifurcated trial to test Festival Fund’s defense and see if it was valid. The trial court accepted Festival Fund’s argument and ruled in favor of the company.

“The court found that Festival Fund was protected by anti-deficiency laws because it was, in reality, the primary obligor on the loan and the loan guaranty was effectively a sham,” appeals court documents stated.

Despite the trial court’s ruling, Hunt said the claim seemed to be a “cobbled-together” defense.

“Normally, corporations try to keep themselves separate from one another to protect themselves from liability. It is a very unusual thing to say that, ‘I didn’t respect corporate formality. I didn’t keep these entities separate.’ in order to benefit from the anti-deficiency statute. That is pretty unusual I think," he said.

However, in October 2015, the decision of the trial court was reversed by California’s court of appeals.

“Substantial evidence does not support a conclusion that Festival Fund was a principal obligor on the loan. Rather, Festival Fund itself structured the transaction and determined that its affiliate – a separate legal entity – would take out the loan and take title to the property. The trial court therefore erred in applying a sham guaranty defense and entering judgment in favor of Festival Fund," court documents state.

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