The Case of the Vanishing Guaranty—Issues Facing Commercial Real Property Lenders Regarding Revocable Trust Borrowers

byKenneth Miller

I have recently received numerous questions from commercial lender clients regarding structuring and enforcing commercial real property loans involving revocable trusts. Their concerns have largely centered on how to structure a real property secured loan with a revocable trust as borrower and the trust’s settlor, trustee and/or beneficiary as a guarantor, and whether a court will enforce the guaranty under California law following non-judicial foreclosure of the deed of trust. The short answer is the structure of the loan transaction and the enforceability of the guaranty will largely depend on the nature of the trust and the relationship between the guarantor and the revocable trust borrower. This discussion applies to a standard estate planning trust, which remains revocable and for the sole benefit of the settlor during the lifetime of the settlor and becomes irrevocable following the death of the settlor. Although California case law has developed a few general rules regarding when a guaranty made by the settlor, trustee and/or beneficiary of a revocable trust borrower will be enforceable, these rules do not and cannot cover all fact patterns. As a result, it is imperative that the lender carefully read the trust documents and understand the relationship between the trust and the proposed guarantor to properly structure the real property loan involving a revocable trust, especially if it wishes to have any hope of enforcing a guaranty of the loan given by the settlor, trustee and/or primary beneficiary of the revocable trust.

In order to better understand the relationship between California trust law and real property law, a brief review of both California trust law as well as real property law is helpful. A trust involves a relationship among three parties – (1) the trust settlor, (2) the trust beneficiaries, and (3) the trustee. In general, the trust settlor transfers the property to the trustee. Upon the transfer of the trust property, the trust becomes the owner of the property, and the trust property or “res” is managed by the trustee in accordance with the trust documents. The trust settlor may fully enjoy any property that is placed in the revocable trust during his or her lifetime and may even serve as trustee of the revocable trust. Alternatively, the trust settlor may appoint someone else as trustee to manage the property for his or her benefit and in fact, the trustee need not be a natural person. During the lifetime of the settlor of a revocable trust, the settlor can amend or revoke the trust as often as the settlor may wish. However, upon the death of the trust settlor, the revocable trust becomes irrevocable, and the trustee is required to carry out the trust terms on behalf of the trust settlor, pursuant to the terms of the trust agreement. Under California law, the property of a revocable trust is subject to the claims of the trust settlor’s creditors, provided that the settlor retains the power to revoke the trust either in whole or in part.

California law regarding the enforceability of a guaranty agreement that guaranties a commercial loan secured by a deed of trust on real property can get tricky, especially following foreclosure of the deed of trust. The California one form of action rule found in the California Code of Civil Procedure Section 726(a) provides that, once the commercial loan is in default, a secured creditor cannot take any action against the borrower to enforce the loan besides proceeding with foreclosure of the deed of trust. The California anti-deficiency statutes prohibit in most instances a lender from obtaining a deficiency judgment following non-judicial foreclosure of the deed of trust.

Neither the one form of action rule nor the anti-deficiency statutes prohibit the enforcement of a guaranty agreement that guaranties a real property secured loan following non-judicial foreclosure, provided that the guaranty agreement is not secured by a deed of trust and the guaranty agreement contains the appropriate waivers. However, by definition, a guaranty is not enforceable unless it guaranties an obligation owed by an entity other than the guarantor. What has troubled California courts regarding the enforceability of guaranty agreements that guaranty real property loans made to revocable trusts is whether the guarantor and the borrower are in fact the same entity when the guarantor is the settlor, beneficiary and/or trustee of the revocable trust borrower.

The case of Torrey Pines Bank v. Hoffman, (1991) 231 Cal. App. 3rd 308 provides a good starting point. In the Torrey Pines Bank case, the court ruled that a lender will be barred from enforcing a guaranty of a commercial real property loan made to a revocable trust, following foreclosure of the deed of trust, if the guarantor is the settlor, trustee and primary beneficiary of the revocable trust borrower. In reaching this ruling, the Torrey Pines Bank court focused on whether the borrower is an instrumentality of the guarantors or, put another way, whether the guarantors were anything other than the borrower under a different name. Looking at the transaction as a whole including the fact that the financial information provided to the lender for the borrower was nearly identical to the financial information provided by the guarantors, the Torrey Pines Bank court reasoned that the guarantors were not “true” guarantors and were nothing more than the borrower under a different name. The Torrey Pines Bank court was also helped by the fact that at the time the loan was made, California Probate Code Section 18000 required that the guarantors, as trustees of a revocable trust, were also personally liable for the loan.

The Torrey Pines Bank court, however, was clear that its holding was limited to the facts of that case and expressly stated that its decision did not establish a blanket rule applying to all revocable trusts if there were “a greater degree of separation of interest” between the trust borrower and the guarantor.

California Probate Code Section 18000 has since been amended and now provides that a trustee is not personally liable on contracts that the trustee entered into in his or her capacity as a trustee of a trust unless the contract specifically states otherwise. In light of the change in the law, can a guaranty of a real property loan be enforceable if the loan is made to a revocable trust, and if the guarantor is the settlor and beneficiary of the trust, but is not the trustee of the revocable trust? The answer may depend on whether the guarantor is the primary beneficiary or a secondary or contingent beneficiary of the revocable trust borrower.

The case of Talbott v. Hustwit, 164 Cal. App. 4th 148 (2008) would seem to indicate that a guaranty of a real property loan made to a revocable trust may be enforceable if the guarantor is not the trustee of the trust borrower. Like the Torrey Pines Bank case, the Talbott case dealt with the enforceability of a guaranty agreement, guarantying a loan made to a revocable trust that was secured by a deed of trust, following the foreclosure of the deed of trust. Like the Torrey Pines Bank case, the guarantors were the settlors of the revocable trust borrower. However, unlike the Torrey Pines Bank case, the guarantors were the secondary or contingent beneficiaries of the revocable trust borrower and were not the trustee of the trust. Primarily focusing on the fact that the guarantors were not the trustees of the trust, the Talbott court ruled that the guaranty agreement was enforceable since the trust arrangement removed the guarantors from their status and obligations as the borrower and provided a greater degree of separation than the guarantors in the Torrey Pines Bank case.

However, more recent case law may limit the extent of the ruling in the Talbott decision. In the unpublished case of Pacific Capital Bank v. Rivera, 2012 WL 968006, the lender brought an action to enforce a guaranty made by the trustee, settlor and primary beneficiary of the revocable trust that was the original borrower of the loan made by the plaintiff lender, although the deed of trust that secured the loan was assigned to a limited liability company shortly after the loan closed, with the consent of the lender. The lender sought to distinguish the Torrey Pines Bank decision based on the changes to California Probate Code Section 18000. Finding that the bargain between the parties was that the limited liability company, and not the revocable trust, was to be the borrower, the court refused to rule whether the guarantor was in fact a true guarantor based on the guarantor’s relationship with the original trust borrower. However, the court in the Pacific Capital case suggested in a footnote in this opinion that the change in California Probate Code Section 18000 was unlikely to disturb the ruling in the Torrey Pines Bank case based on the fact that a settlor with the power to revoke a revocable trust retains full ownership and control over any property transferred to the revocable trust. As a result, property that a settlor transfers to a revocable trust is deemed to be the property of the settlor even after the property is transferred to the trust.

Although the Pacific Capital case has not been published and has limited precedential value, it was cited with approval in the recent case of In re Brock, 494 B.R. 534 (D. Colo. 2013). In the Brock case, a Colorado bankruptcy court, applying California law, held that a guaranty of a commercial real property loan made to a revocable trust borrower was not enforceable following foreclosure of the deed of trust since the guarantors were the settlors, trustees and primary beneficiaries of the trust borrower. This result is not surprising in light of the Torrey Pines Bank decision. However, the court in the Brock case put a different spin on the ruling in the Talbott decision. Whereas the Court in the Talbott case found the guaranty enforceable based primarily on the fact that the guarantor was not the trustee of the revocable trust borrower, the Brock court, in analyzing the Talbott decision, put a much greater emphasis on the fact that the guarantors were not the primary beneficiaries of the borrower revocable trust. In fact, the Brock court reasoned that when property is held in a revocable trust, the settlor and primary beneficiary have the equivalent of full ownership of the trust property, thereby minimizing entirely the relevance of the identity of the trustee of the revocable trust.

But see California Probate Code Section 15800(b) which provides that while a trust is revocable, all of the trustees duties are owed to the person with the power to revoke. This would seem to eliminate any legal distinction between whether the settlor is the “primary” beneficiary or just a “secondary or contingent” beneficiary.

The common thread underlying the Torrey Pines, Talbot, Pacific Capital and Brock decisions is that there is no simple “one size fits all” rule when structuring a loan to a revocable trust with a guaranty from the settlors, trustees or beneficiaries of the trust. Based on the Torrey Pines Bank case, it appears likely that a lender will be barred from enforcing a guaranty of a commercial real property loan made to a revocable trust, following foreclosure of the deed of trust, if the guarantor is the settlor, trustee and primary beneficiary of the revocable trust borrower. Under the Talbott decision, a guaranty may be enforceable if the guarantor is the settlors of the trust and the secondary or contingent beneficiaries of the revocable trust borrower, provided the guarantor is not the trustee of the revocable trust. However, especially after the Pacific Capital and Brock decisions, the Torrey Pines Bank and Talbott cases leave many issues unresolved. For example, is a guaranty of a real property loan made to a revocable trust borrower enforceable if the guarantor is the settlor and primary beneficiary of the trust but not the trustee of the revocable trust? Applying the Brock decision, the answer appears to be that the guaranty would not be enforceable but the Brock case was not decided by a California court and relied heavily on the Pacific Capital decision that was not published. The answer to such issues which were not resolved by the Torrey Pines Bank and Talbott decisions can only be ascertained after a thorough reading of the trust documents and an understanding of the “degree of separation” between the borrower and the guarantor.

I want to thank my partner Jeff Merriam for his help on this post. His knowledge of probate and trust law was invaluable.

This publication is intended to present an overview of current legal trends in commercial lending and risk management issues; no article should be construed as representing advice on specific, individual legal matters, but rather as general commentary on the subject discussed. Your questions and comments are always welcome. Please do not hesitate to contact me at kmiller@ecjlaw.com or (310)281-6321 to further discuss this article or to answer any questions.