If a borrower for a loan secured by commercial real property applies for the loan in the person’s own name, the lender is likely to insist that the property and the loan be in the name of a Single-Purpose-Entity (SPE). The lender does this in order to qualify for expedited relief from the automatic stay in bankruptcy, if the borrower tries to slow down or stop foreclosure by filing for bankruptcy. The lender also usually requires a guaranty by the parent company or owner of the SPE. If the money recovered in a foreclosure does not satisfy the loan, almost always the lender cannot recover the shortage from the borrower, but it can recover it from the guarantor. An important exception and defense for the guarantor is available where the lender required the borrower to be an SPE as a subterfuge to circumvent the anti-deficiency laws which protect the borrower against such a claim for the shortage. The law refers to such a lending structure as a sham guaranty.
A recent Court of Appeal decision holds that the sham guaranty defense is not available if the borrower applied for the loan to be in the name of an SPE, but only available when the owner or parent of the SPE applied for the loan directly and was re-directed to the SPE-and-owner/parent-guaranty structure by the lender.
California is one of just a couple of states which has laws enacted during the Great Depression of the 1930s, to protect property owners against still owing money to their lenders even after the lender has foreclosed on the real property which was given as security for the loan. For owner-occupied homes, the lender’s only remedy is to take the home. If the home isn’t worth enough to pay back the loan, there’s nothing more the lender can do. Its sole remedy is to take the property.
For commercial loans, the lender has two choices. It can do a private foreclosure sale, which takes 4-5 months and is not very expensive. In that case, it gets the money from the foreclosure sale or it gets the property, because the lender is the high bidder or only bidder, and that’s all. If the lender chooses to take advantage of the private foreclosure sale, then it cannot sue the borrower for any deficiency.
The other choice is to sue in court for a judicial foreclosure. The court then determines whether the property is worth less than the loan. If so, the court sells the property and gives the lender a judgment for any deficiency. This process takes about a year, is much more complicated and expensive, and when it’s all over, the borrower has a one year right to get the property back by paying the buyer at the foreclosure sale whatever it paid for the property. Lenders almost never bother with judicial foreclosure.
The way lenders get around this is with personal guaranties. If an individual borrows the money, all the protections above apply. If a company borrows the money and the owners of the company guaranty the loan, all the protections apply to the company, but they don’t apply to the guarantors. That means the lender can hold a private foreclosure sale, bid half or less of what the property is worth, and then sue the guarantors for the difference between that bargain foreclosure price and the loan amount.
Due-On-Sale. If you elect to buy a property and borrow the money personally, rather than through a company, you still will want to convey the property to a corporation or limited liability company soon, in order to limit your liability for third party claims, such as creditors claiming they had not been paid for goods or services or persons injured due to a dangerous condition or activity on the property. A risk of making such a transfer is that it will be a breach of the due-on-sale clause in the deed of trust.
Under the California Supreme Court decision in Wellenkamp v. Bank of America, such clauses were held to be unenforceable, but Congress enacted the Garn-St. Germain Act which says that such clauses are enforceable, if the lender is a federally licensed or insured bank or lending agency. Unless your lender is an unlicensed private company, the due-on-sale clause is enforceable.
How likely is the lender to find out or care?
In the 1980s, when there was inflation above 10% and interest rates rose from 10% to as much as 18% from week-to-week, lenders would enforce the due-on-sale clause in order to get low interest loans paid off and replaced by higher interest loans. Loan rates have been very stable for a long time. Even if the Federal Reserve Bank were to raise its lending rates, it would only do so a little. There should be an increase in commercial loan rates, but not enough to warrant searching for violations of due-on-sale clauses and enforcing them. Banks concentrate a lot on collecting loan fees. Still, competition is stiff enough that loan fees remain modest, and probably would not justify searching to find due-on-sale violations in order to force violators to refinance and incur new loan fees or consent-to-assignment fees.
In a real estate slump, this could create a significant risk if you need to refinance or your lender chose to enforce the due-on-sale clause. For example, assume that you bought the property for $900,000.00, and borrowed $600,000.00 to pay that portion of the purchase price. If the market went down one-third (1/3), your property would be worth only $600,000.00, and a new lender would probably not lend you more than $400,000.00. In order to pay off the prior $600,000.00 loan you would need to pay cash of $200,000.00, or you would lose the property, your $300,000.00 downpayment, and any money you spent on repairs and improvements.
Violation of the due-on-sale clause is not without risk, but it may appear to you to be sufficiently unlikely that the protection against being sued in the event the business is unsuccessful, for a deficiency under a personal guaranty is more important. You need to balance these two risks.
As mentioned above, after you sign the contract to buy the property personally and apply for the loan personally, your lender may insist that you use an SPE, single purpose entity. Then you can comply with the lender’s requirement, put the loan and the property in the company from the close of escrow, sign the personal guaranty, hope that the business is successful, but if it’s not, you’ll have the possible defense that the guaranty was a sham guaranty designed to allow the lender to avoid the anti-deficiency laws. It’s not a sure thing, but it’s enough to force the lender to compromise and accept a lesser amount, rather than take the risk of losing completely at trial.