Get Right to Demand Alternative Security if Guaranty Becomes Worthless
A lease guaranty is only as good as the guarantor who stands behind it. And while the individual or corporate guarantor may be viable and creditworthy when the lease is signed, a lot can happen over the course of the lease. For example, a corporate or individual guarantor may have financial troubles and declare bankruptcy, an individual guarantor may die, or a corporate guarantor may dissolve.
Whatever the change in the guarantor's status, you face a grim reality: The guaranty you've been relying on is now essentially worthless. The guarantor can't—or won't—fulfill the lease obligations if the tenant doesn't. And if your lease is like many we've seen, it will offer you no protection in this situation.
But there's an innovative strategy that you can use to protect yourself when signing a lease that's backed by a guarantor: Give yourself the right in the lease to demand alternative security from the tenant if you discover that the guaranty has become essentially worthless due to a guarantor's change in circumstances, says New Jersey attorney Marc L. Ripp. That is, make the tenant provide some other security instead of the guaranty to ensure that it will be able to pay its lease obligations, he says. There's a Model Lease Clause on p. 3 that you can adapt and use to include this strategy in your leases.
What Changes Trigger Alternative Security Requirement?
To use this strategy, there are several issues you'll need to negotiate with the tenant. First, you'll want to agree on a list of changes in the guarantor's circumstances that will make the guaranty unacceptable—and will trigger the requirement to give alternative security. Here's what Ripp suggests:
Guarantor's creditworthiness drops. Normally, when you accept a guaranty, the guarantor is in better financial shape than the tenant. But what if an individual or corporate guarantor's net worth plummets? Most leases say that the guaranty will still be enforceable even if the guarantor becomes insolvent. But if the tenant fails to fulfill its lease obligations, you can't collect on a guaranty from an insolvent guarantor. So make sure you have the right to demand alternative security if, in your sole judgment, the guarantor's creditworthiness falls below a level that's acceptable to you, Ripp suggests [Clause, par. a(i)].
Practical Pointer: The tenant may insist on setting a dollar amount threshold for its net worth instead of relying solely on your judgment about its creditworthiness. That is, you may demand alternative security only if the guarantor's net worth falls below, say, $500,000, Ripp explains. You may have to agree to this point.
Guarantor goes bankrupt. Most leases say that the guarantor's obligations won't be discharged even if it goes bankrupt. But in reality, a bankrupt guarantor will force you to stand in line with all the other creditors to get your money—and it's unlikely that you'll ever collect the full amount owed. In the event of a bankruptcy, you're better off if you have a right to insist on alternative security from the tenant, says Ripp [Clause, par. a(ii)].
Guarantor violates guaranty. Suppose the guarantor violates the guaranty but the tenant hasn't yet violated the lease. For example, the guarantor may send you a letter saying that he has no intention of honoring his guaranty obligations. You'll have to sue the guarantor if you ever need to collect. Even though your guaranty should clearly state that it's unconditional, you may not want to waste time and money going to court to enforce it. In those circumstances, you want the right to instead require the tenant to give alternative security, recommends Ripp [Clause, par. a(iii)].
Guarantor dies. There's always the risk that an individual guarantor will die during the lease. The typical lease says that the guaranty will be binding on the guarantor's heirs. But it's still a good idea to get the right to make the tenant give alternative security if the guarantor dies, Ripp advises [Clause, par. a(iv)]. Some states will let you collect from the deceased guarantor's estate, but this can become very complicated—especially if the tenant doesn't violate the lease until years after the guarantor has died. The estate could be drained completely by then, says Ripp.
Guarantor dissolves. There's also the risk that a guarantor that's a corporation, partnership, or limited liability company will dissolve during the lease, says Ripp. When a company “dissolves,” it winds up its affairs, distributes its assets, and then stops doing business completely, he explains. The dissolution might be voluntary—for example, the members of a limited liability company might agree to dissolve the company because it's not profitable. Or the dissolution might be involuntary—for example, a state government may decide to dissolve a corporation because it didn't pay its taxes. Either way, although the guaranty may say that it's binding on the guarantor's “successors and assigns,” a dissolved company may not leave behind any successors or assigns, Ripp warns. That's why you must get the right to make the tenant give alternative security if the guarantor dissolves, he advises [Clause, par. a(iv)].
What Alternative Security Can You Demand?
There are several forms of alternative security that you can demand, such as:
Cash security deposit. You may want to require the tenant to pay you a cash security deposit—or increase an existing security deposit, says Ripp. To do this, spell out in the lease how much extra the tenant must put up—that is, give a specific dollar amount, he says [Clause, par. c (i)].
Letter of credit. Another choice is to require the tenant to get a letter of credit in an amount that you determine to be appropriate, says Ripp. Also, the terms of the letter of credit should comply with the requirements that you set out in the lease's letter of credit clause, says Ripp [Clause, par. c (ii)]. Many tenants will balk at this choice and argue that letters of credit are expensive and tough to get.
Substitute guaranty. You could instead require the tenant to find a substitute guarantor that you determine is creditworthy. Have the tenant get the substitute guarantor to sign a guaranty that's the same as the guaranty that you attached to the lease as an exhibit, says Ripp. And require the tenant to give you a copy of the substitute guaranty with original signatures, he adds [Clause, par. c (iii)].
Practical Pointer: Require the tenant to give you the additional cash, new letter of credit, or substitute guaranty by a set deadline—for example, no later than 30 days after the tenant gets your notice for alternative security, says Ripp [Clause, par. a].
Should You Get Right to Terminate the Lease?
Should you demand the right to terminate the lease as soon as the guaranty becomes worthless, without bothering to ask for alternative security? Ripp doesn't recommend this. After all, you don't want the tenant out of the space; you merely want a reliable form of security in case the tenant violates the lease, he explains.
But you should get the right to terminate the lease if you asked the tenant to give you alternative security, but the tenant failed to do so within the time set in the lease, says Ripp [Clause, par. b].
CLLI Source
Marc L. Ripp, Esq.: General Counsel, The Gale Company, 100 Campus Dr., Ste. 200, Florham Park, NJ 07932; (973) 301-8057; MRipp@thegalecompany.com.
Sidebar
* Keep Track of Guarantor's Creditworthiness
It's important to keep track of the guarantor's creditworthiness and of any bankruptcy proceeding filed by or against the guarantor, so you'll know if you're entitled to alternative security, says New Jersey attorney Marc L. Ripp. To do this, have the guaranty require the guarantor to give you a detailed and accurate financial statement whenever you ask for it, he says. Then make sure that you ask for that information periodically, because the tenant's creditworthiness could drop quickly.
The guaranty should also require the guarantor to promptly send you any notice of any bankruptcy proceeding filed by or against it, Ripp adds. Also, make sure the lease requires the tenant to notify you immediately if the guarantor dies or dissolves, says Ripp.