Traps for Creditors in Structuring and Enforcing Guaranties and Secured Obligations

April 15, 2009 - The current financial maelstrom engulfing the globe has again shown that creditors must be careful in structuring credit transactions and enforcing their rights as creditors. A credit transaction carelessly structured at the outset, or a misstep in enforcing a secured obligation, can handcuff a creditor’s ability to recover.

A few simple examples can illustrate this point. The Bank makes a $1 million loan to Mary who signs a promissory note evidencing the loan. To secure the note, XYZ Corp. -- in which Mary is an officer, director and shareholder -- gives a deed of trust on real property owned by XYZ. Because it pledged its real property as collateral for a loan given to Mary, XYZ is a “surety” -- which is a fancy word for a guarantor -- under California law. If Mary defaults under the promissory note, she has all the defenses available under California’s anti-deficiency statute and the one action rule because the note is secured by real property. It matters not that Mary is not the owner of the real property. If the Bank conducts a non-judicial foreclosure sale of its real property collateral and receives only $600,000 from the foreclosure sale, the $400,000 deficiency becomes uncollectible -- even if Mary has lots of assets to pay the deficiency -- by operation of California’s anti-deficiency statute. California Code of Civil Procedure § 580d.

Changing the facts slightly can result in a dramatically different outcome. If the $1 million loan is made to XYZ which signs the promissory note instead, and Mary signs a personal guaranty of the note that contains all the usual guarantor waivers -- including a waiver of any rights or protections under California’s anti-deficiency statute or the one action rule -- the Bank should be able to enforce the $400,000 deficiency against Mary under her personal guaranty. Rather than recovering only $600,000 from the foreclosure sale, the Bank can recover the full $1 million -- $600,000 from the foreclosure sale and the $400,000 deficiency from Mary under her personal guaranty.

Another example of a potential pitfall that awaits unwary creditors is where a guaranteed obligation is secured by “mixed” collateral – i.e., secured by both real and personal property – pledged by the primary debtor. For example, the Bank makes a $1 million loan to XYZ secured by certain real property and personal property owned by XYZ. Mary personally guaranties the loan. Under Division 9 of California’s Uniform Commercial Code (UCC) which governs security interests in personal property, Mary is a “secondary obligor” – another fancy term for a guarantor – and is entitled to the same protections afforded XYZ upon default, including the right to receive advance notice of any sale of the collateral and the right to have the Bank conduct the sale in a commercially reasonable manner. If the Bank fails to give proper notice or fails to conduct the sale in a commercially reasonable manner, it can jeopardize the Bank’s right to recover a deficiency from Mary after foreclosure.

The UCC gives secured creditors holding mixed collateral the option of conducting a “unified” sale of both its real and personal property collateral in a single foreclosure sale conducted under real estate laws. Unlike the UCC, California’s real estate laws governing foreclosure of real property do not include any “commercial reasonableness” requirement and guarantors are not automatically entitled to receive notice of the foreclosure sale. However, the “unified” sale option is generally available only if the real property and personal property are closely related – for example, real property operated as a hotel and personal property like furniture and equipment used at the hotel -- so that it is commercially reasonable to conduct a “unified” sale. Once a commercially reasonable decision to conduct a “unified” sale has been made, the foreclosure is governed entirely by real estate laws.

On the other hand, if the personal property collateral is unrelated to the real property -- for example, vacant land owned by XYZ and inventory, accounts receivable and equipment of XYZ’s tire wholesale business -- it would not be commercially reasonable to conduct a “unified” sale of such dissimilar assets. Under these circumstances, to protect its right to recover any deficiency from Mary, the Bank should foreclose the vacant land under real estate laws and separately foreclose the personal property under the UCC.

In summary, creditors should be careful in structuring credit transactions at the outset so they are not inadvertently handcuffed when they try to enforce their rights upon default. Creditors should also be careful to avoid potential pitfalls when enforcing secured obligations, especially where a guarantor is involved. Experienced and knowledgeable counsel can assist creditors at each stage.

By: Samuel S. Oh
Partner
Lim, Ruger & Kim, LLP