Guaranteed Confusion on Guarantor Liability

By Christopher R. Graving and Thomas A. Lerner | Related Practice: Financial Services

The Stokes Lawrence Financial Services attorneys circulate bulletins about new developments in the law that affect creditor remedies. The discussion below bears on a lender’s ability to recover against guarantors following a nonjudicial foreclosure, and the strategic decision confronting lenders in light of inconsistent appellate rulings.

Last week, in Washington Federal v. Gentry, the Washington Court of Appeals issued a new pro-lender decision, holding guarantors liable following a nonjudicial foreclosure.  The decision is in stark contrast to First-Citizens Bank & Trust Company v. Cornerstone Homes &Development, LLC et al., an appellate decision issued in December by a different appellate court.  The Cornerstone case held that a lender could not seek a deficiency judgment against a guarantor after a nonjudicial foreclosure, based upon certain language in the deeds of trust.  This is a significant issue for lenders originating loans with guaranties, as well as foreclosing lenders where there is a solvent guarantor.  Given that the two decisions are in direct conflict, the Washington Supreme Court will likely be called upon to resolve the issue.

Washington is geographically divided among three Courts of Appeals, based on where the lawsuit was filed.  Gentry was decided by the Court of Appeals for Division One, arising out of King County.  Cornerstone was decided by Division Two, reviewing a Pierce County case.  Any time two or more Courts of Appeals reach different results on similar legal issues, review by the State Supreme Court is appropriate, though the Supreme Court has discretion on whether to review the issue.

Both Gentry and Cornerstone arose after the lender nonjudicially foreclosed on deeds of trust securing commercial loans and then sought a deficiency judgment based on the personal guaranties of the principals.  However, the two courts interpreted the Deed of Trust Act (and particularly RCW 61.24.100(10)) differently.  The statute, which controls when a lender may obtain a deficiency judgment after a nonjudicial foreclosure, states:

“A trustee’s sale under a deed of trust securing a commercial loan does not preclude an action to collect or enforce any obligation of a borrower or guarantor if that obligation, or the substantial equivalent of that obligation, was not secured by the deed of trust.”

In the Cornerstone decision, Division Two of the Court of Appeals interpreted the statute to preclude a deficiency judgment where the guaranty was secured by the deed of trust.  Addressing the deeds of trust in that case (which appeared to have been LaserPro forms), the court found the guaranties were an obligation secured by the deeds of trust because the definition of the secured obligations included a reference to “Related Documents.”  Related Documents, in turn, were defined in the deeds of trust to encompass the guaranties.  Accordingly, when the deeds of trust were foreclosed upon, so too were the guaranties.  Therefore, the Cornerstone court held the lender could not obtain a deficiency judgment on the guaranties.

In last week’s case, Washington Federal v. Gentry, Division One of the Court of Appeals held that the statute was not a prohibition at all and expressly rejected the reasoning applied in Cornerstone.  Rather, the court held that the statute simply stated that if the guaranty was not secured by the deed of trust, the obligation could be enforced, but not the opposite (i.e., that if the guaranty was secured by the deed of trust, it could not be enforced).  The court then concluded that only the obligations of the borrower and guarantor were secured by the deeds of trust, disregarding the reference to “Related Documents” and its inclusion of the reference to the guaranties.  Absent from the discussion was an examination of the actual obligations secured by the deeds of trust or the relevant definitions.  The omission of a discussion of the obligations secured by the deeds of trust may have been intentional, as the court would then have had to reconcile its holding with the inclusion of the guaranties in the definition of “Related Documents.”  This would have made it more challenging for the court to reach its ultimate conclusion. 

Until the Supreme Court resolves the conflict between these two appellate courts, a more cautious approach favors assuming that the more correct statement of the law is that described in the Cornerstone case.  The practical effect for lenders will be to proceed by judicial foreclosure when the lender wants to be confident that it can pursue post-foreclosure remedies against guarantors.  The risk of relying upon the Gentry decision is that if the Supreme Court later disagrees with it, lenders may lose their right to pursue guarantors.  Further, if the lender has commenced a post-foreclosure action against a guarantor in misplaced reliance on Gentry, the lender could be at risk of having to pay the guarantor’s attorney fees.  In short, until the Supreme Court resolves this conflict, lenders are better served by pursuing their remedies against guarantors in the context of judicial foreclosures.

As you may recall from our earlier bulletin on Cornerstone, less may be more in drafting loan documents.  The deed of trust should be clear that the obligations it secures are only those contained in the Promissory Note and the Business Loan Agreement and that it only secures the obligations of the borrower and grantor.  Lenders are generally sufficiently well protected by each instrument’s own enforcement mechanism, as well as by common cross-default language.  They need not wrap the guarantor’s obligations into all other loan documentation; the guaranty can stand and be enforced on its own.

Lenders considering foreclosure should first determine whether a solvent guarantor exists and whether the guaranty is secured by the deed of trust.  If so, lenders should evaluate whether obtaining the deficiency judgment is worth the 12-month redemption period following a judicial foreclosure.  Where the answers to these questions are “yes,” lenders should proceed with a judicial foreclosure.