This article reviews the defenses and liability imposed on third-party guarantors of trust deed notes.
first tuesday Form 439 accompanies this article. To follow along with the article, Form 439 is available for download here.
Lenders and carryback sellers reduce the risks
A seller lists his residence for sale. Under the terms of the listing agreement, the seller indicates he is willing to carry back a note secured by a first trust deed or an all-inclusive trust deed (AITD) on the property sold.
The seller’s broker locates a young couple interested in purchasing the residence. The couple’s income is sufficient to make monthly payments on a carryback note based on the terms sought by the seller. However, the couple has not accumulated enough savings to make a significant down payment.
The seller is willing to sell the property to the couple with little or no down payment, but he wants additional protection against the risk of the couple defaulting on note payments.
Both spouses’ parents are willing to assist the couple by assuming liability for payment of the carryback note. The question for the seller and the seller’s broker becomes one of how to document the parents’ liability for the couple’s debt.
The seller has three basic choices for documenting the promises of someone other than the actual buyer. The buyers’ parents can be asked to:
- become co-owners of the residence with the buyers, and sign the note and trust deed;
- co-sign the note only, holding no ownership interest in the property sold; or
- guarantee the note.
Alternatively, private mortgage insurance (PMI) may be available to insure losses arising out of a default by the buyers and foreclosure. The broker would need to:
- contact a PMI carrier willing to underwrite carryback notes and trust deeds; and
- comply with their underwriting guidelines to qualify the buyers for PMI.
Co-owner liability for carryback notes
The seller is correctly advised by his broker that including the couple’s parents as co-owners of the property and signors of the carryback note and trust deed adds no assurance anyone will pay the note.
All carryback notes signed by buyers and secured solely by the property sold are nonrecourse debts, legally called purchase-money paper, which bars the seller from enforcing collection against the buyers for any deficiency in the property’s value at the time of foreclosure, called antideficiency protection. [Calif. Code of Civil Procedure §580b]
Since the parents would join the couple on title as buyers and co-owners of the residence, the parents would have the same anti-deficiency protection as the couple should the seller seek judicial foreclosure and a deficiency judgment.
Thus, the parents add nothing to the seller’s ability to enforce collection of money on his carryback note by their becoming co-owners and signing the note and trust deed. The seller’s only resort in case of a default is to foreclose on the property sold – he may recover nothing from the couple’s parents.
Co-signor liability on a secured note
The seller, to avoid the parents’ co-ownership of the property, considers the liability to the parents should they co-sign the note, but not the trust deed, since the parents will not take title.
As co-signors of the note, the parents sign as makers, personally liable for payment of the debt, a situation for co-signors legally known as accommodation parties.
An accommodation party is an individual who:
- signs a note to incur liability for payment of the debt evidenced by the note; and
- receives no direct benefit from the debt. [Calif. Commercial Code §3419(a)]
The parents will not benefit from the credit extended by the seller, such as receiving an interest in the property sold. Thus, the parents would receive no direct benefit by undertaking liability for the debt.
On default in payment, the carryback seller (creditor) can make a demand on the co-signor for payment of the debt in full. However, the co-signor can require the carryback seller to first foreclose on the property, called the one-action, security-first defense. [CCP §726]
However, if the carryback seller forecloses by trustee’s sale, the trustee’s foreclosure relieves both the co-signor and the buyer from liability for any deficiency due to a decreased value in the property and an underbid at the trustee’s sale. A deficiency judgment is barred after a nonjudicial (trustee’s) foreclosure sale. [CCP §580d]
Similarly, if the carryback seller were to judicially foreclose, he would still be barred from recovering any deficiency from the co-signor since carryback paper secured only by the property sold is nonrecourse paper. [CCP §580b]
Anti-deficiency defenses are available to the co-signor since the note signed by the co-signor evidenced a debt secured by real estate.
Only a lender holding recourse paper who judicially forecloses may seek a deficiency judgment against both the borrower and any co-signors.
Like the parents who sign the note as buyers of the property, the parents who do not become buyers and only co-sign the carryback note add nothing to the seller’s ability to collect the entire amount due on the carryback note from the parents.
However, if a co-signor pays off the note on demand from the seller, the co-signor has the right to an assignment of the note and trust deed, called equitable subrogation. As the assignee and holder of the note and trust deed, the co-signor can then enforce the note and trust deed by foreclosing on the property. [Com C §3419(e)]
Personal guarantees
The carryback seller’s best approach for recovery of the amounts due on the nonrecourse note should the property value drop due to market conditions, is to obtain the personal guarantee of the parents of the couple who execute the carryback note.
As guarantors, the parents do not become co-owners or co-signors. Instead, the parents become personally responsible on a default to pay the seller on demand a sum equal to all amounts due on the note, and do so before the foreclosure sale.
A guarantee, also spelled guaranty, is an independent promise. It is an obligation of one person, a third party, to pay the entire debt owed by another person, the buyer, to a lender or carryback seller. [See Form 439 accompanying this article]
Thus, a guarantee is a separate obligation from the note and trust deed. Also, few defenses are available to the guarantor to avoid payment on the guarantee.
The guarantor does not sign the note and trust deed. Rather, the guarantor signs a guarantee agreement in which the guarantor agrees to purchase the note and trust deed on default and on demand from the lender or seller for the amount owed on the note – a sort of put option held by the lender or carryback seller.
Since a guarantee is itself an obligation to pay money, its performance can also be secured by a trust deed on real estate, usually real estate owned by the third-party guarantor. [See first tuesday Form 451 §18]
Editor’s note — Third-party guarantees must not be confused with guarantee agreements executed by the seller of an existing note, or by a broker on a loan or assignment of a loan he has arranged.
The guarantor’s obligation
A buyer or borrower who is primarily obligated as the payer on a note cannot guarantee the note he has signed. A borrower’s or buyer’s signature on a guarantee agreement adds nothing to his obligation – he already owes the money under the note.
For example, a general partner who guarantees a note executed by the partnership adds nothing to the general partner’s liability, since he is already generally liable for the partnership’s debts. [Union Bank v. Dorn (1967) 254 CA2d 157]
A guarantee agreement signed by a buyer or owner of real estate guaranteeing payment on either a recourse or nonrecourse note is unenforceable as against public policy. Enforcement of the guarantee would deprive the buyer or owner of his anti-deficiency protection in the event of a foreclosure. [Palm v. Schilling (1988) 199 CA3d 63]
On the other hand, limited partners, LLC managers and members, and corporate officers and stockholders commonly guarantee loans made to their business entities. Limited partners, LLC managers and members, and corporate officers are not persons who are initially liable for the debts of their respective entities.
For example, a note executed by a corporation is personally guaranteed by one of the corporate officers under a guarantee agreement naming him individually as the guarantor. The officer enters his corporate title following his signature on the guarantee agreement.
The corporation later defaults on the note. The lender makes a demand on the officer under the guarantee agreement to pay the amount which remains unpaid on the note.
The officer claims he is not personally liable under the guarantee since his corporate title accompanying his signature indicates he merely signed it on behalf of the corporation, and not individually as a third-party guarantor.
Here, the corporate officer is held to have personally guaranteed the note as a third party since that is the only reasonable interpretation of the guarantee agreement which named him individually as the guarantor. As a third-party guarantor, the officer became liable for payment of an amount equal to the entire remaining debt. In turn, on payoff, the corporate officer is assigned the note and trust deed since, in essence, a guarantee is an agreement to purchase debt on default. [Home Federal Savings & Loan Association v. Ramos (1991) 229 CA3d 1609]
Recourse to guarantor
If the borrower defaults on a guaranteed note, the lender may immediately pursue the guarantor for recovery of the total amount remaining unpaid on the note.
However, the right of the lender to recover from the guarantor is not without limitations. Guarantors have the right, unless waived, to force the lender to proceed first against the borrower by foreclosing on the property securing the debt before enforcing the guarantee agreement. [Calif. Civil Code §2845]
However, the right of the guarantor to require the lender to proceed first against the debtor and foreclose on the property can be and is validly waived in nearly all guarantee agreements. [Union Bank v. Ross (1976) 54 CA3d 290; see Form 439 §5.7]
If the borrower defaults, the lender should notify the guarantor of the default and of the lender’s intention to foreclose. The guarantor will then have the opportunity to pay the amount owing on the debt and receive an assignment of the note and trust deed from the lender before foreclosure costs are incurred.
Should the guarantor fail or refuse to pay the lender on demand, the lender can either:
- foreclose and collect from the guarantor any deficiency remaining after the foreclosure sale due to an underbid; or
- enforce the guarantee agreement without first foreclosing the note and trust deed.
The guarantor’s defenses
Since the guarantor is essentially agreeing to purchase the note on the borrower’s default, the guarantor, like a co-signor, is entitled to an assignment of the note and trust deed after paying off the lender under the guarantee, called equitable subrogation.
Due to the right to an assignment on payoff, the lender must not impair the guarantor’s right of equitable subrogation, unless the right to an assignment has been validly waived. If the lender, by its actions, destroys the guarantor’s ability to be assigned the guaranteed note, the guarantee is unenforceable.
For example, consider a lender who forecloses nonjudicially on a property securing a recourse note which is guaranteed.
In the guarantee agreement, the guarantor waives his right to demand the lender first foreclose on the note before proceeding against the guarantor. However, the guarantee agreement does not also waive the guarantor’s right to an assignment on payoff.
A deficiency remains after the trustee’s sale due to an underbid. The lender now seeks to recover the amount of the deficiency from the guarantor.
Since the guaranteed note is recourse paper, the lender was entitled to recover a deficiency judgment against the owner after a judicial foreclosure. However, since the lender foreclosed on a recourse debt through a trustee’s sale, any deficiency judgment on the note is barred. [CCP §580d]
The lender’s nonjudicial foreclosure on a recourse note barred any deficiency judgment against the borrower which was otherwise available. Thus, the guarantor is deprived of his equitable subrogation rights on payment of the deficiency – the right to recover the amount paid under the guarantee through an assignment of the note and trust deed or money judgment and enforcement of the debt assignment.
Here, the right of assignment was not waived and the recourse lender’s trustee’s sale destroyed the right to collect the deficiency from the borrower. Thus, the lender may recover nothing from the guarantor since the guarantor’s ability to recover the deficiency from the owner was destroyed. [Union Bank v. Gradsky (1968) 265 CA2d 40]
The guarantor’s ability to avoid liability after a trustee’s foreclosure sale on recourse paper is often referred to as the “Gradsky Defense“. However, the Gradsky Defense is not applied to nonrecourse notes, such as carryback paper, to allow guarantors to avoid liability after a trustee’s sale.
On nonrecourse paper, such as a carryback note and trust deed, no deficiency judgment may be awarded against the buyer who executes the carryback note, regardless of how the lender chooses to foreclose.
Thus, the lender’s election to pursue a trustee’s foreclosure on nonrecourse paper does not affect the guarantor’s rights to recover a deficiency from the buyer of the property since no right to recover a deficiency exists. Accordingly, the lender may recover a deficiency from the guarantor due to an underbid at a trustee’s foreclosure sale on a carryback note. [Bauman v. Castle (1971) 15 CA3d 990]
Editor’s note — A guarantor on nonrecourse paper must ensure he is adequately protected from loss.
A recorded Request for Notice of Default (NOD) will alert the guarantor of the lender’s commencement of a foreclosure. [CC §2924b; see first tuesday Form 412]
Thus, on receiving an NOD, the guarantor has the opportunity to pay off the amount due on the note and receive an assignment of the note and trust deed, or alternatively, purchase the property at the foreclosure sale.
The guarantor at least has the property if a foreclosure sale results in a loss due to the deficient value of the property to cover the debt. The guarantor then has the economic use of the property to help reimburse him for any amount paid in excess of the property’s current value – and possible full recovery after a period of renewed inflation or appreciation.
Waiver of assignment rights
As with the guarantor’s right to require the lender to first foreclose on the owner’s property, the guarantor’s right of equitable subrogation is also validly waived in most guarantee agreements. [See Form 439 §17]
However, the requirement for structuring a valid waiver of the guarantor’s subrogation rights has undergone change.
Formerly, a waiver of the guarantor’s right to an assignment on payoff was invalid unless the right to an assignment was specifically stated in the waiver provision. [Cathay Bank v. Lee (1993) 14 CA4th 1533]
Now, however, a waiver of the guarantor’s right to an assignment is effective without detailing the assignment rights the guarantor is waiving – except in guarantees on a debt for personal, family or household purposes secured by a trust deed on owner-occupied one-to-four residential units. [CC §2856]
For example, a corporation obtains a loan secured by a trust deed to construct improvements on real estate it owns. The loan is guaranteed by a corporate officer. The guarantee agreement contains a provision stating the lender can recover a deficiency from the guarantor after a trustee’s foreclosure sale.
The corporation later defaults on the trust deed and the lender begins a trustee’s foreclosure.
However, a deficiency is incurred due to an underbid at the foreclosure sale. The lender makes a demand on the officer as guarantor for the deficiency.
The guarantor claims he is not liable for the deficiency since the waiver in the guarantee agreement did not specifically state which subrogation rights he waived.
However, the waiver clearly stated and made the guarantor aware he would be liable for any deficiency remaining after a trustee’s sale, a sale which destroys the lender’s ability to assign the note and trust deed to the guarantor on payoff.
Thus, the guarantee was effective and the guarantor was liable for the deficiency produced by the underbid at the trustee’s sale. [In re Pon (1994) 164 BR 322]
On the other hand, for a waiver of the guarantor’s right to an assignment on payoff of a debt which is a recourse home improvement loan or a home equity loan, the lender seeking a waiver must reference statutes and judicial decisions detailing the rights the guarantor is waiving.
Editor’s note — first tuesday Form 439 satisfies the requirements to validly waive the guarantor’s right to require the lender to first foreclose, and the guarantor’s subrogation rights on loans which are other than for personal, family or household purposes and secured by an owner-occupied one-to-four unit residential property.
Notice of foreclosure
Finally, although waiver of the guarantor’s right to an assignment on payoff under the guarantee agreement may be given to the lender in the guarantee agreement, to eliminate any surprise for lack of knowledge of a default and foreclosure, the guarantor should insist he receives:
- a notice of delinquency (NODq);
- a notice of default (NOD); and
- a demand for payment before the foreclosure sale.
If the guarantor has not requested and does not receive notice of the trustee’s sale, or a prior demand from the carryback seller or lender by agreement in the guarantee, the lender can underbid at the trustee’s sale, purchase the property at a price below its fair market value and collect the deficiency from the guarantor – a double recovery in part or in full.
Thus, the agreed to demand for payment prior to foreclosure protects the guarantor by allowing him time to pay the amount of the demand and become equitably subrogated to the position of the lender by an assignment of the delinquent note and trust deed. The NODq and NOD further protect the guarantor by giving him a chance to pay the amount remaining unpaid on the note and receive an assignment or appear and bid at the trustee’s sale to ensure the property is sold for a fair value. [See Form 439 §§3, 4]
