United States: The Commercial Lease Guarantee: An Overview For Landlords And Tenants

Last Updated: December 10 2015
Article by Henri Chalouh

Gone are the days of corporate impunity—in the context of a lease agreement, that is. There was once a time when a commercial tenant could sign a lease and hide behind the corporate protections of its signatory entity, which often was nothing more than a shell company.

As soon as its business began to tank, it would drag its feet—holding onto possession of the leased space for as long as possible and continuing to conduct business rent-free—until it was finally evicted, sometimes months after its initial failure to pay rent. To make matters more difficult for its landlord, no real justice ever followed. Not only would the landlord never see a penny of any future rent due during the remainder of the leased term, but it also would likely lose out on all unpaid rent already incurred and inevitably be forced to absorb legal and other fees in evicting the tenant, to boot. Such consequences were a natural product of doing business with judgment-proof shell entity tenants; even a money judgment issued in favor of the landlord would be near worthless, for there would be no money to collect. In an effort to protect themselves from these maneuvers, landlords have grown more accustomed to demanding some form of personal (or corporate) guarantee covering the tenant obligations contained in the underlying lease. In light of these developments, all commercial landlords and tenants should be well-versed in lease guarantee principles; familiarity with the topics and tips covered below may help a party confidently navigate lease and guarantee negotiations and have a clearer picture of precisely what is included within the bounds of its guarantee and what is not.

Is It Necessary for This Deal?

The first issue to be addressed in guarantee negotiations— even if implicitly—is whether a guarantee is warranted altogether for purposes of protecting the respective interests of the parties to the lease. If a tenant plans to execute the lease in his or her individual capacity and personally possesses sufficient assets to answer for the tenant's obligations under the lease, it may be unnecessary to require a guarantee. Similarly, if a tenant agrees to submit a cash security deposit or letter of credit large enough to safeguard its landlord from undue potential loss, a tenant may be able to get away with not having to execute a guarantee.

In determining whether a guarantee is warranted for any given transaction, as well as the circumstances under which a security deposit would weaken the need for a guarantee, landlords should keep an accounting of all the costs they incur in completing the transaction and to which they should be entitled if a tenant reneges, including the unamortized value of (i) the costs of marketing the space and any broker's commissions; and (ii) any build-out costs associated with preparing the subject premises for the tenant's use. Moreover, landlords should be aware of present and anticipated market conditions and estimate the amount of time potentially required to find a replacement tenant, if a new tenant were to default or abandon the premises, or the landlord is forced to evict an existing tenant.

In scenarios where a tenant intends to execute a lease in his or her individual capacity or where a personal (as opposed to corporate) guarantee is a component of the deal, another factor that landlords must consider is the nature of title the tenant (or personal guarantor) has over his or her assets and whether he or she has a spouse. Some jurisdictions recognize a type of ownership known as a tenancy by the entirety, where a married couple will each own an undivided interest in the entirety of the assets in question. In such instances, a creditor of only one spouse cannot pursue assets owned under a tenancy by the entirety; only a creditor of the couple as a unit will be granted access to these assets for the satisfaction of a judgment or debt. For landlords' purposes in such jurisdictions, this means that ascertaining the specific assets owned solely by the spouse who is the tenant/guarantor is key to determining how best to proceed with the deal. In cases where the substantial worth of assets is owned under a tenancy by the entirety, landlords have the option of insisting that both spouses sign as co-tenants under the lease or, alternatively, as co-guarantors.

Full Guarantee vs. Limited Guarantee

The traditional version of the lease guarantee is a "full" guarantee whereby the subject guarantor pledges to perform all of the tenant's obligations under the lease for the entire term of the lease and potentially any renewals and modifications of the lease. Providing for such wide coverage has proven to be most pertinent for landlords who intend to lease a larger/retail space, expend sizable sums of money preparing the space for a tenant's use, possibly charge below market rents, and/or require a relatively smaller security deposit, in an effort to incentivize tenant acceptance of their offer. In these scenarios, landlords will likely expose themselves to substantial costs with little in the way of security; the presence of a "full" guarantor provides an extra source of funds for potential recoupment of these costs, if the tenant should default under the lease. By no means is "full" coverage a standard requirement of a commercial lease; every deal contains unique circumstances that may call for varying degrees of guarantee coverage, placing the scope and extent of the guarantee up for negotiation and introducing the possibility of a "limited" guarantee.

LIMITATIONS ON GUARANTEE COVERAGE

A limited guarantee falls short of guaranteeing all of the underlying tenant's obligations under the lease. Assuming the parties have agreed that a limited guarantee is appropriate for their transaction, the next step is deciding precisely how to limit the guarantee's coverage. This can be achieved in a number of ways, each of which can be utilized in its own right or combined with another one or more guarantee limitations, some of which are outlined as follows: (i) limiting the types of tenant obligations covered by the guarantee; (ii) limiting the temporal extent to which a guarantor is liable for a tenant's lease obligations; (iii) fixing the dollar amount of maximum guarantor liability possible under the guarantee; (iv) providing for a full guarantee during some initial portion of the term after which, in the absence of a tenant default during such initial period, full coverage is limited in some way thereafter; and (v) providing for a "Good Guy" guarantee.

Within the Scope or Without: Which Tenant Obligations Make the Cut?

Parties to a lease can specify the tenant obligations for which a guarantor will be responsible under the terms of the guarantee. A landlord may propose that performance of all monetary as well as non-monetary tenant obligations should fall within the scope of the guarantee. This will include: (i) all fixed rent payments; (ii) all recurring additional rent due under the lease—including payment for utility bills, common area maintenance costs, real estate taxes, and insurance premiums—and other non-recurring fees that are also commonly classified as additional rent, such as late charges, landlord review fees, professional and attorneys' fees incurred in enforcing the lease and/or guarantee, as well as indemnity protections, among other payments; and (iii) all other charges the tenant is required to pay under the lease.

Perhaps most importantly, such a broad guarantee will also require a guarantor to physically perform any non-monetary tenant lease obligations, such as completion of any improvements or alterations at the premises for which the tenant is responsible, covenants that require the tenant to open for business by a specific date and to continuously operate, and end of term removal and restoration obligations, to name a few. To the extent possible, guarantors are strongly advised to negotiate performance of nonmonetary obligations out of the scope of the guarantee. At the very least, if a landlord persists, perhaps the guarantee can provide that upon a tenant default, the landlord—and not the guarantor—is to perform these obligations where possible, but that the latter will be liable for the cost of such performance. Moreover, if additional rent is to be guaranteed, guarantors should do their absolute best to limit such coverage to recurring additional rent payments under the lease and eliminate any reference to "all other charges." Doing so will ensure that a guarantor will not be committing to open-ended and potentially limitless liability. In any event, it is always advisable for guarantors to spell out precisely which payments are to fall within the scope of the guarantee and, to the extent the parties can agree on fixing a dollar amount as the maximum liability under the guarantee, inclusion of the fixed amount will add clarity to the document. Otherwise, failing to provide a hard numerical cap on liability may allow for the possibility that a court will later incorrectly interpret the amount of liability under the guarantee.

To encourage tenants to sign leases, landlords commonly grant a rentfree period in the early stages of the term of the lease, offer a rent abatement for certain months throughout the term during which a tenant is exempt from making rent payments, and provide a tenant improvement allowance for the preparation and build-out of the leased space. Perhaps just as commonly, landlords will also attach a conditional limitation to these concessions, providing for their immediate rescission in the event of a tenant default. To that end, landlords should consider including such conditional limitations within the scope of the guarantee, ensuring that the guarantor will be responsible for these concessions upon a default by the tenant. Moreover, for deals involving substantial tenant improvements, landlords should attempt to provide for a guarantor obligation to carry out lien-free completion of these improvements. This may help to prevent a tenant from defaulting under its lease after the tenant commences construction and accrues debt to contractors who may file a lien against the landlord's property, leaving the landlord with an unfinished project and an unpaid tab.

Landlords regularly provide that a guarantor will also be on the hook for any costs incurred in enforcing the terms of the lease and/or guarantee, including reasonable attorneys' fees. Guarantors should insist that their liability for such costs should extend only to those incurred in disputes where the landlord is found to be the prevailing party. After all, why should a guarantor be required to sponsor a landlord's misguided attempts to enforce its rights?

Limited Guarantee Periods: Rolling or Stationary?

Determining the scope of liability is a qualitative analysis— it explores the kinds of tenant obligations for which a guarantor is responsible. An additional or alternative limitation of liability available to a guarantor is one based on time; it is a quantitative determination as to the extent of guarantor liability. For example, the parties to a lease whose term spans ten years may agree that the tenant's principal is to guarantee five years' worth (extent) of fixed rent (scope) payable under the lease. Without further clarification, the extent of liability can be construed in two drastically different ways: (i) the guarantor is committing to pay every fixed rent payment due during the first five years of the term that the tenant fails to tender, in which event the extent of liability under the guarantee ceases at the end of the fifth year of the term and, even if the tenant subsequently defaults in payment of fixed rent, the guarantor will have already stepped out of the picture; or (ii) the guarantor is agreeing to pay every fixed rent payment payable during a rolling five-year period, in which event the extent of liability applies to the first five years' worth of defaulted fixed rent payments; in other words, liability under the guarantee will not cease until the tenant has actually defaulted on five years' worth of fixed rent payments for which the guarantor is responsible, or the term has expired.

Using our example, if the tenant timely pays every fixed rent payment for the first five years of the term and suddenly defaults on every subsequent payment for the remaining five years, the difference between a stationary and rolling guarantee can mean a world of difference for the guarantor; the former would leave him free and clear of any liability and the latter would be accompanied by a bill for five years' worth of fixed rent. In cases of a stationary guarantee, it is crucial for a guarantor to demand language that explicitly calls for a reduction as to the extent of liability with every passing payment made by tenant. As applied to our example, perhaps such language would read as follows: "Guarantor shall be liable for the first sixty (60) monthly payments of fixed rent payable under the Lease, as and when the same shall become due, it being understood, however, that (i) Guarantor's aggregate liability hereunder shall reduce with each passing monthly payment of fixed rent made by Tenant under the Lease such that, upon Tenant's submission of sixty (60) monthly fixed rent payments, Guarantor's liability will equal zero; and (ii) Guarantor shall have no liability for any fixed rent payments that shall become due under the Lease following the initial sixty (60) month period.

COMMUTED SENTENCE ON ACCOUNT OF GOOD BEHAVIOR

Another creative way parties can abbreviate a guarantor's liability is to condition such abbreviation on the tenant's good behavior. One approach is as follows: a landlord and tenant agree that the guarantor is to be fully responsible for the performance of all tenant obligations and payment of all charges due under the lease for the entire term; if, however, the tenant does not default under any of the terms of the lease during some initial portion of the term—say, the first four years—the full guarantee is to transform into a rolling 12-month guarantee of fixed rent and recurring additional rent payments only. This arrangement is beneficial for both parties because it incentivizes the tenant to be on its best behavior during the most difficult portion of the term—preparing the leased space for occupancy, opening for business, and staying afloat—in exchange for more favorable guarantor treatment later in the term, when the tenant has presumably developed its business, has more to lose, and is less likely to default. If such a deal is reached, the guarantor should take extra care to provide that only a tenant default that persists beyond all applicable notice and cure periods would disqualify the guarantor from the potential abbreviation of liability under the guarantee. Doing so increases the likelihood of the guarantor's eligibility for commuted liability and precludes the possibility that an inadvertent default— perhaps a rent check lost in the mail—will undo potentially years of good behavior.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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