Negotiating a Lease Guarantee: 6 Bottom-Line Issues — Checklist Included
Landlords often require a personal or corporate lease guarantee, a separate document executed simultaneously with the lease, which makes the guarantor liable for the tenant’s defaults. The landlord and guarantor have conflicting interests regarding the desired scope of the guarantee. Landlords want an unconditional and unlimited guarantee, holding the guarantor liable for all of the tenant’s defaults. Guarantors, on the other hand, want a conditional, less sweeping guarantee. Following is a discussion of bottom-line issues as well a a checklist with points to consider when negotiating a limited guarantee.
Set a Maximum Dollar Cap
The parties can set a maximum dollar cap on the guarantor’s liability. The amount of the cap generally bears some relationship to the landlord’s potential losses and the tenant’s creditworthiness.
Decrease Dollar Cap Over Time. If the tenant does not default for a period of time, the landlord’s risk presumably decreases, and guarantors argue that in this case the maximum liability should decrease over time. For example, if the guarantor’s maximum liability is set at $500,000 for a 10-year lease, the parties can agree that the guarantor’s maximum liability will decrease by one-tenth ($50,000) with the passage of each default-free year.
Set a Formula-Based Liability Cap
Another option is to limit a guarantor’s liability by setting a cap based on a formula that will cover the landlord’s likely losses in the event of a tenant default. Generally, the formula includes lost rent, the amount of the unamortized tenant improvement allowance and brokerage fees, costs to restore the premises to the condition required under the lease, and attorneys’ fees and costs incurred in evicting the tenant. If, for example, the landlord estimates a maximum of 12 months as the time required to lease the premises following the termination of the tenant’s lease, the guarantor’s maximum liability could be set by adding:
- twelve months rent and common area expenses,
- unamortized tenant improvement allowance and brokerage commissions, and
- costs to restore the premises to the condition required under the lease.
Good Guy Liability
There are variations of the Good Guy Guarantee, but generally the guarantor will be released from liability under the guarantee if (a) the guarantor provides advance notice of tenant’s vacation of the premises (e.g., three months, which will allow the landlord time to market the premises), (b) the premises are delivered to landlord in the condition required under the lease, and (c) the tenant is not in monetary default at the time of the guarantor’s notice or the date on which the tenant vacates the premises.
A Good Guy Guarantee does not cover all of the landlord’s potential losses. Therefore, it is often used in conjunction with a dollar or formula-based cap on the guarantor’s liability. In this scenario, the guarantor will be liable for the capped amount and rent from the date of tenant’s monetary default until the date on which the tenant turns over possession of the premises to the landlord in the condition required under the Lease.
A Good Guy Guarantee creates an incentive for the guarantor to be a good person and make sure the tenant vacates the premises in the condition required under the lease prior to monetary default.
Bad Acts Liability
Under a “Bad Acts Guarantee,” the guarantor is liable for so called “bad acts” such as hazardous substance contamination, grossly negligent or intentional damage to the premises, fraud, or misappropriation of tenant funds by the guarantor. As with a Good Guy Guarantee, a Bad Acts Guarantee is often used in conjunction with a dollar or formula-based cap on the guarantor’s liability and/or a Good Guy Guarantee.
Attorneys’ Fees, Costs of Collection
Attorneys’ fees and costs of collection incurred in pursuing recovery from the guarantor should not be credited against caps on guarantor’s liability. If this were not the case, a landlord could find itself spending more on attorneys’ fees and collection costs than the guarantor is obligated to pay, giving the guarantor a perverse incentive to litigate rather than pay under the guarantee.
Guarantee Termination, Tenant’s Benchmarks
A guarantee (or certain liabilities thereunder) can also terminate with the passage of time or if tenant hits a financial benchmark. Landlords want a guarantee because they are not confident that the tenant has the financial wherewithal to support the monetary obligations under the lease. If the tenant does not default under the lease or if the tenant’s financial situation changes for the positive, there may no longer be a strong rationale for requiring a guarantee.
Guarantee Termination at a Point in Time. Under this approach, if the tenant has not defaulted after a predetermined period of time, the guarantee terminates. For example, the parties can agree that the guarantee will terminate after the third year if the tenant has not defaulted under the lease.
Predetermined Financial Benchmarks. Certain predetermined financial benchmarks can be negotiated which, if met, will terminate the guarantee. Examples of benchmarks are:
- an agreed-upon net worth of the tenant,
- an agreed-upon level of tenant’s gross sales, or
- any other financial target the parties agree upon.
While this article provides a basic framework for negotiations between landlords and guarantors, there are many other financial considerations and legal nuances that are beyond the scope of this discussion. Some of them are financial. Examples include the (a) application of the security deposit to reduce the guarantor’s liability, (b) joint and several liability – and potential limitations on such liability, and (c) the release and substitution of guarantors, which may arise upon an assignment of the lease or the removal and replacement of partners. Other considerations are inherent legal issues, such as defenses against enforcement, subrogation, bankruptcy, and local law issues. These considerations should be taken into account by both parties before entering into any guarantee.
LEASE GUARANTEE CHECKLIST:
- The guarantee can be (i) limited, or (ii) unlimited.
2. If the guarantee is limited, select one, two or all three of the following to include in the guarantee:
a. Cap guarantee (choose one)
i. Dollar cap. Dollar cap can decrease over time if tenant does not default.
ii. Formula-based cap.
b. Good Guy Guarantee
c. Bad Acts Guarantee
3. Terminate a limited or unlimited guarantee, or portions thereof, if tenant (i) does not default for a specified period of time, or (ii) reaches financial benchmarks.
4. Attorney’s fees and costs incurred in pursuing the guarantor should not credited against or subject to limitations on guarantor’s liability.
If you have any questions or comments, email Rick.