Uninsured Risk or Conventional Wisdom

[originally published on Globest.com]

The strategy of holding title to investment real estate in single purpose entities as a liability shield often passes for conventional wisdom. Yet many savvy real estate entrepreneurs hold and borrow against real estate without a layer of corporate “insulation.” What do they know that you don’t?  This is a “big dollars” issue that has been hiding in plain sight for years.

Suppose you plan to purchase an office building. The conventional approach is to create a “single asset” entity—often an LLC—to hold title. This arrangement will indeed provide you with insulation against liability claims. When sued on various tort claims, you will point out that the entity owns the building and you do not. In less stressful times, when you are not facing a tort claim, you will likely think and speak of yourself as the true owner of the building. And, in an economic if not a legal sense, you are.

All of this is familiar stuff.  Less widely understood is that the strategy of holding title to commercial property in a liability-shielding entity can create massive liability exposure for the economic owner in the form of personal guaranties. Your bank knows that a loan made to your LLC will effectively be non-recourse because the office building is the LLC’s only asset. The bank will therefore very likely require that you and any partners personally guaranty a loan to your LLC. Therein  lies an uninsured risk far greater than the fully-insurable risk of personal injury and similar claims.

In California, a borrower on a mortgage or trust deed-secured loan enjoys a generous array of statutory protections against personal loan liability under anti-deficiency and “one action” laws. These strong and longstanding mortgage debtor protections cannot validly be waived by contract.  So trust deed borrowers are well protected from loan liability beyond loss of the property to foreclosure. Guarantors too enjoy generous statutory liability protections, but, crucially, those guarantor protections, unlike mortgagor protections, may freely be waived by contract. Every decent form of guaranty will have the guarantor waiving every last defense.

Due to this crucial difference in “waivability,” an ownership arrangement that has your entity serve as the borrower while you and your co-owners act as guarantors leaves you open to massive personal liability. When you plead—as you likely will—that this is not fair because “everyone knows” that your LLC is “really just you,” the response will be that you created the entity structure and would not describe the LLC as your alter ego in the face of a tort claim. This is a persuasive point.

So, how can you avoid this unintended consequence that creates liability when you sought to limit liability? You could refuse to give the guaranty, but this will likely kill the loan. You might offer to co-sign the note and trust deed instead of signing a guaranty.  This approach would give you considerable protection as co-borrower, but bankers often reject this arrangement as unfamiliar and unconventional. You could try to eliminate waivers or add negotiated contractual protections to your guaranty. But most institutional lenders insist on using standard unmodified guaranties. And raising issues about post-default matters during loan negotiations may be received as would mentioning divorce at an engagement party.

The best approach will often be to be the owner and borrower individually or as general partners, and to abandon “corporate shield” approaches (while maintaining good liability insurance coverage). The bank will be hard pressed to reject a conventional personal or general partnership ownership arrangement. And if the bank overrides your preferences and insists that you create an entity to be the borrower and give a personal guaranty, the resulting guaranty is legally vulnerable as a “sham” because the ownership structure was the bank’s choice and not yours.

Charles A. Hansen has more than 35 years of experience in real estate law. Since 1985, Chuck has taught advanced real estate courses to law and MBA students at the University of California, Berkeley Law (formerly Boalt Hall). The views expressed are the author’s own.