It’s Time to (Carefully) Secure that Guaranty
The 2021 increase to California’s homestead exemption to up to $600,000 stands to change the legal and economic relationship of guarantors with their lenders and vendors who make loans or sell goods or services on credit. Before examining this important change in California’s homestead exemption and its effect on guaranties, some perspective is needed on guaranties themselves.
In the stone ages when business loans were signed in a conference room with all parties present and exchanging pleasantries, I watched a borrower’s principal sign a personal guaranty and wondered how meaningful that really was when the size of the loan likely dwarfed the net worth of everyone in the room. After most everyone had left, and the ink was drying on the loan documents (my primary job was to guard the documents, especially the promissory note), I asked my supervising attorney that question. Without hesitation, he explained, “You just don’t understand. First, a guarantor is a fool with a fountain pen. Don’t ever sign one. Second, the bank really never wants to enforce that guaranty. If the loan starts to get into trouble, the bank wants to force the guarantor to tell his spouse, “honey, we have a problem and might lose the house.” The risk of that dinner conversation is what makes the borrower act reasonably. That’s the real value of most guaranties.”
Obviously, my cynical mentor’s viewpoint oversimplified the risks and benefits of guaranties of commercial loans and credit extended by vendors to businesses. Some creditors do sue to collect on personal guaranties. Because requiring a guaranty can be an abuse of the parties’ uneven bargaining power when a loan is made, and some guarantors do not understand the gravity of signing a guaranty, California law provides a long list of statutory defenses and protections to guarantors. Cal. Civ. Code 2787-2855. California courts have issued a myriad of decisions involving guarantor defenses. See, e.g., Bloom v. Bender, 218 Cal. 2d 793 (1957); Engelman v. Bookasta, 264 Cal. App. 2d 915 (1968); Wiener v. Winkle, 273 Cal. App. 2d 774 (1969). But because of the utility of guaranties to lenders, vendors, landlords and others, guaranties are viewed as essential to the availability of credit to companies and other limited liability entities, California courts generally enforce them Mariner Savings v. Neil, 22 Cal. App. 3d 232 (1973). California law even provides the proper language to waive guarantor defenses. Cal. Civ. Code 2856 (d).
Because of the perceived importance of making a “real person” liable for loans or credit extended to limited liability entities, guaranties are often included in contracts that do not, on their face, call themselves a personal guaranty. Guarantor language often is included in real property leases, equipment leases, conditional sale contracts and vendor supply agreements. California law broadly defines a surety or guarantor as anyone which promises to answer for the debt, default or miscarriages of another. Cal. Civ. Code 2787. Thus, courts and legislatures wrestle with the dueling considerations of the possible unfairness but economic importance of guaranties. All of which leads back to my mentor’s belief that the real value of a guarantor is the specter of that uncomfortable conversation to the effect of, “we have a problem and might lose the house,” which may motivate a reasonable resolution of a loan to an otherwise limited liability borrower.
Effective January 1, 2021, that conversation changed. California raised the homestead exemption from $100,000 for most married couples to a maximum of $600,000 in the counties with the most expensive real estate. (Cal. Code of Civ. Proc. 704.730) The amendment, which came together in a few days in Assembly Bill 1885 before the legislature adjourned in August 2020, raised the amount exempt from creditors’ judgments to at least $300,000, and up to $600,000 in counties where that is the median price of a house. The amount shall be adjusted annually for inflation beginning on January 1, 2022. The amount of the exemption is determined in the year in which the exemption is claimed.
Exemptions, of course, presuppose that the creditor has obtained a judgment and seeks to enforce it against the judgment debtor’s residence But exemptions do not apply to consensual liens, such as the borrower’s home mortgage, home equity loan, or other voluntary liens approved by the fee owner of the real estate. Thus, the primary target of the increased exemption is a nonconsensual lien such as those created by judgments. Thus, if the guarantor (typically the principal of a business who signed a guaranty of her company’s building lease, vendor supply agreements or bank loan) owns a $3 million house with a traditional first mortgage and a second mortgage securing a home equity line of credit in the total amount of $2.5 million, her $500,000 of accumulated equity is completely protected from judgment creditors by means of the new $600,000 exemption.
The question of whether increasing the homestead exemption to $600,000 is sound policy is obviously left to the legislature. Creditors, however, need to be aware that getting a business’s principal to guaranty a building lease, vendor supply agreement, or bank loan does not create the same incentives as they did before the 2021 change of the law. How should that new reality be addressed, if the guaranty was meaningful to the economics of extending the credit? Because an exemption does not protect the judgment debtor from consensual liens, the creditor will need to consider a consensual lien to avoid the effect of the increased exemption. For most creditors, their immediate focus may turn to a junior deed of trust on the residence. That’s likely a bad instinct. Taking real property collateral raises other issues, including California’s Anti-deficiency and One Action protections. Cal. Code of Civ. Proc. 726 (One Action) and 580 (Anti-deficiency). Not only does the creditor then stare up at existing deeds of trust and real estate taxes that are senior in priority to the new deed of trust, the creditor’s rights are limited by the procedural requirements of the One Action Rule coupled with the limitations of the Anti-deficiency law. Wise lawyers often counsel their clients not to take real estate collateral, as superficially tempting and easy as it might seem to be, because of these practical and legal limitations.
But there is another practical approach. The better option often is to secure the guaranty with assets other than real estate. In the past, the underwriting and diligence for this seemed to be more trouble than warranted, but the increased $600,000 homestead exemption, coupled with the One Action rule and Anti-deficiency limitations, change the analysis. The creditor or lender presumably obtained the principal’s financial statement, and there may be discrete, non-real estate assets that would be meaningful collateral to secure performance of the guaranty. This analysis, however, also must recognize other exemptions, such as exemptions created for ERISA-protected pensions and retirement accounts, as well as dozens of other exemptions. But there may be several types of assets that make sense as non-exempt collateral, such as that highly appreciated Jackson Pollack painting, the 1972 Porsche, or non-pension brokerage account, that would prompt a conversation starting with, “I have a problem and we might lose the artwork in the den.” Again, the creditor must carefully review all of the available exemptions from judgement enforcement, but this is the new reality in 2021, and personal property collateral valued by the guarantor may be the best approach to consider, despite the additional underwriting and diligence required by personal property collateral.
It’s true that most creditors and banks do not want to sue on a guaranty; they simply want to motivate a business’s principal not to rely on the limited liability nature of her company to act unreasonably in trying to resolve a bad loan or credit. The dramatic increase in California’s homestead exemption to $600,000 makes this analysis more urgent and legally complex than ever before.