Get Flexibility in Applying Security Deposit if Tenant Gives You ‘Good-Guy’ Guaranty

A security deposit and a guaranty protect an owner against damages that arise if a tenant defaults. A guaranty known as a “good-guy” guaranty limits the amount an owner can collect by making the guarantor responsible for only the tenant debts that arise after the tenant gives back—or “surrenders”—its space to you (for example, rent that comes due after the tenant vacates the space). If an owner isn't careful, however, it may accept a good-guy guaranty containing a loophole that unnecessarily impedes the owner's ability to collect still other damages resulting from a tenant default.

The loophole to which we're referring exists when a good-guy guaranty doesn't address whether the security deposit is applied to either the tenant's pre-surrender debt (for example, the rent the tenant didn't pay before surrendering the space) or its post-surrender debt (such as rent that becomes due after the tenant surrenders the space and the costs of reletting the space). As a result, you may be forced to apply the security deposit to the tenant's pre-surrender debt. This will benefit the guarantor and reduce the guarantor's liability, warns New York City attorney Robert P. Reichman. This also reduces the guaranty's protections because the guarantor is responsible for the pre-surrender debt not covered by the security deposit, he says. And if the security deposit is enough to cover the pre-surrender debt, but inadequate to cover the tenant's post-surrender debt, you would have to sue the tenant for the post-surrender debt because a good-guy guarantor isn't responsible for post-surrender debts. If the tenant doesn't have enough money to pay you, you're stuck with the loss.

Owner Loses Benefit of Good-Guy Guaranty

In one case in which Reichman's firm represented the guarantor, a tenant gave an owner a $193,250 security deposit in the form of a letter of credit (L/C) and a good-guy guaranty. Later, the tenant stopped paying rent. The owner drew down the L/C's proceeds and kept them in a security deposit account. The tenant then surrendered its space years before the lease's expiration date. The owner refused to apply the security deposit against the tenant's pre-surrender debt and demanded that the guarantor pay that debt.

A federal court ruled that the owner must first apply the security deposit to the pre-surrender debt and then the guarantor would pay any deficiency. Because the owner had drawn down on the L/C before the tenant surrendered the space, and the guaranty didn't give the owner the right to apply the security deposit solely to the tenant's post-surrender debt, the court reasoned that the owner must use up the security deposit before enforcing the guaranty. The court noted that a general rule in New York requires security deposits to be applied first to the earliest debts—which, in this case, was the pre-surrender debt. After the owner applied the security deposit, it could require the guarantor to pay the deficiency [L&B 57th St., Inc. v. E.M. Blanchard, Inc., 1998].

How to Plug Loophole

To avoid giving up more than the right to collect damages for tenant debts that arise after the tenant vacates the owner's space, owners who settle for a good-guy guaranty should make sure the guaranty allows the owner to apply the tenant's security deposit to either the tenant's pre-surrender or post-surrender debt. To get that flexibility and plug the loophole, have the guarantor agree in the guaranty that you're not required to apply the tenant's security deposit to the tenant's pre-surrender debt and you can determine, at your sole discretion, how to apply the security deposit, says Reichman. That way, you can choose instead to apply the security deposit solely to the post-surrender debt and make the guarantor responsible for paying the pre-surrender debt, he says.

Have a tenant add the following language to a good-guy guaranty before you'll accept it, says Reichman:

Model Guaranty Language

Guarantor agrees that Landlord shall not be required to apply any security deposit being held by Landlord under the Lease to any defaults, debts, or obligations of Tenant arising or accruing on or prior to the Surrender Date (as such term is defined in Clause [insert #] hereof) and Landlord may apply such security deposit as Landlord determines, in its sole discretion.

Insider Source

Robert P. Reichman, Esq.: Partner, Siller Wilk LLP, New York, NY.