Avoid Getting Burned by Three Common Limits on Guaranties

As the market softens, you're likely to find tenants and their guarantors demanding certain limits on guaranties. There are several common limits they may ask for—for example, a dollar limit on the guaranty. Although you may have to agree to one or more of these limits, if you're not careful when spelling them out in the guaranty, you may lose more than you bargained for. For instance, if a tenant's guarantor sets a dollar cap that's too low, and the tenant goes bust soon after signing your lease, you might not even get enough money from the guarantor to cover your out-of-pocket costs.

To help you avoid giving up too much, CLLI, with the help of New York City attorney Robert P. Reichman and Denver attorney Mark A. Senn, has noted three limits that tenants and guarantors commonly demand on guaranties. And we've listed safeguards that are designed to protect you.

Guaranty Limit #1: Dollar Cap

One common limit a savvy tenant and its guarantor may demand is that the guarantor's liability be capped at a specific dollar amount, says Reichman. If you agree in the lease to accept a “dollar cap” limit, include these three safeguards in the guaranty:

Safeguard: Set cap high enough to cover upfront lease costs. Set the cap high enough to cover at least your out-of-pocket lease costs, says Reichman. Although this may be a fraction of the total rent the tenant owes, it will cover your downside if the tenant commits a violation early in the lease, he explains. These out-of-pocket costs include: broker's commissions, build-out costs and/or tenant improvement allowances, takeover costs (if you must buy out the tenant's existing lease to get it into your building or center), and rent concessions (for example, free rent).

Safeguard: Exclude certain costs from cap. Make sure that the cap doesn't apply to certain costs, notes Reichman. For instance, don't cap your collection costs or attorney's fees, says Reichman. Otherwise, you'll lose money for enforcing the lease or guaranty, he explains. And don't cap the amount the guarantor owes you for the tenant's environmental contamination at the space, says Senn, because environmental claims against you could be very large. Also, don't let the guarantor cap the amount it owes for losses you suffer because the tenant's conduct is negligent or intentional—for example, if the tenant intentionally sets fire to its space, he adds.

Safeguard: Avoid cap tied to rent payment. Once you've agreed to the amount of the dollar cap, be careful of the wording you use in the guaranty, warns Senn. A sneaky guarantor might try to cap its obligations by saying it guaranties only the “payment of $100,000 of rent” under the lease. That may mean that once the tenant pays $100,000 of rent, the guaranty terminates. You can't go after the guarantor if the tenant then stops paying rent.

To avoid that outcome, require the guaranty to say that the guarantor's liability won't exceed a certain dollar amount, excluding certain costs, he says. This way, the guarantor is responsible for payments up to that amount, and the tenant's previous rent payments won't be applied to the cap.

What guaranty should say. To use the above safeguards, require the following language in the guaranty:

Model Language

Guarantor's total monetary liability under this Guaranty shall not exceed $[insert #], exclusive of Landlord's costs of collection and attorney's fees, and all of Landlord's costs, liabilities, fines, damages, penalties, judgments, and losses arising from: (i) Tenant's default under Clause [insert # of clause discussing tenant's environmental duties and liabilities] of this Lease, or (ii) Tenant's willful misconduct.

Practical Pointer: Consider several factors if a guarantor or tenant asks for a decrease in the cap amount over time—also known as a “burn off,” says Reichman. Your decision should depend on the tenant's net worth, the kind of business it operates, its track record, its future prospects, the size of its security deposit, and each party's bargaining power, he says.

Guaranty Limit #2: Duration Cap

A tenant and its guarantor may demand that the guaranty last for less than the full duration of the lease—say, for only the first three years of a five-year lease. If you agree to accept a “duration cap” limit, follow these two safeguards:

Safeguard: Make sure duration is sufficient. Make sure that the duration is long enough to protect you, says Reichman. Obviously, the longer you keep the guarantor on the hook, the better, he adds. You might want to consider the same factors as you do for the dollar cap burn-off to help you decide how long the guarantor needs to stay on the hook, he says.

Safeguard: Require protection for liability “accruing” during duration. Make sure that the guaranty will protect you if an event occurs during the duration period, but a claim based on that event isn't made against you until after the duration period expires, says Reichman. You don't want the guarantor arguing that it's liable only for claims made during the duration period.

Example: The guaranty says that the guarantor “has no liability under the Guaranty after January 1, 2004.” The tenant contaminates the space with a hazardous chemical on Sept. 1, 2003. But a multimillion dollar claim for environmental contamination isn't made against you and the tenant until Feb. 1, 2004. Because of the wording of the duration cap, you can't force the guarantor to pay your defense costs or the environmental damage award, since the claim was made after Jan. 1, 2004.

To keep that from happening, require that the guarantor be responsible for any liability that “accrues” during the duration period, says Senn. That will make it clear that the guaranty applies if an environmental contamination occurs during the duration period, but a claim isn't made against you until after that duration period expires, he says. And it will make it clear the guaranty still applies if you sue the tenant for not paying rent during the duration period, but the court doesn't rule until after the duration period ends, he adds.

What guaranty should say. To do this, require the following language in the guaranty, where it describes the duration cap:

Model Language

Guarantor shall be responsible only for all liability of Tenant under the Lease accruing [insert duration, e.g., up to and including Jan. 1, 2004].

Guaranty Limit #3: Gross Income/Net Worth Release

When you're negotiating the guaranty, the tenant and guarantor may demand that the guaranty last only as long as the tenant's net worth or gross income is below a certain amount. So once the tenant's gross income or net worth goes above that amount, the guaranty will terminate.

Safeguard: Refuse this limit. Don't agree to this demand, says Reichman. Besides being hard to police, it's dangerous, he says. No matter how healthy a tenant seems to have become, it might experience a sudden financial downturn. For instance, suppose in the first year of the lease, the tenant's gross income or net worth reaches the amount at which the guaranty terminates. In the second year, the tenant's net worth plummets far below that amount. Since the guaranty terminated after the first year, you're left without any guaranty to protect you, he says.

For further information, see CLLI, Aug. 2001, p. 1: “Plug Costly Loopholes in Your Tenants’ Lease Guaranties.”

CLLI Sources

Robert P. Reichman, Esq.: Partner, Siller Wilk LLP, 747 3rd Ave., 38th Fl., New York, NY 10017-2803; (212) 421-2233.

Mark A. Senn, Esq.: Partner, Senn Lewis & Visciano, 1801 California St., #4300, Denver, CO 80202-2643; (303) 298-1122.