Make Tenant Pay Extra Security If Its Guarantor Has Financial Problems

In these uncertain times, securing rock solid assurances against tenant default is of paramount importance. The challenge is great. COVID-19 has left many tenants strapped for cash and unable to scrape together a security deposit. As a result, landlords are having to ask for third-party guaranties from tenants’ corporate owners and affiliates.

Unfortunately, corporations that guarantee tenants’ performance—“guarantors”—aren’t immune from financial struggles, either. And because a guaranty is only as good as the guarantor standing behind it, landlords would be well advised to seek additional recourse in case tenants’ guarantors wind up experiencing financial difficulties.

Of course, cash is almost always the best assurance. One approach to consider: Require tenants to provide additional cash security if their guarantor’s net worth falls below a specifically stated dollar amount. Provide that failure to come up with the additional cash security constitutes a default under the lease.

Here’s a look at the strategy and how to negotiate it. We'll also give you a Model Clause: Require Guarantor to Maintain Minimum Net Worth, and a Model Lease Clause: Get Right to Demand Security Deposit Increase from Tenant.

The Leasing Strategy

The guaranty and lease clauses work in tandem. The former establishes your right to demand financial statements from the guarantor on a regular basis—or more frequently if you have reasonable justification to suspect that the guarantor’s net worth has fallen below the required minimum. The language also makes it a material default under the guaranty for the guarantor to fail to provide the required financial statements in a timely manner, or if those statements indicate that the guarantor’s net worth is below the required minimum.

The lease language gives you the right to require the tenant to increase the security deposit by an agreed-to amount if the guarantor commits either of the defaults described in the guaranty clause. It also states that the tenant’s failure to pony up the additional security deposit money is a material default activating your right to evict and exercise other remedies under the lease.

In the real world, you may not want to actually evict the tenant, especially if the market is soft. But simply having the right to do so increases your leverage and puts you in position to command some form of concession in subsequent negotiations.

Example: A landlord would like a small office tenant to pay a security deposit of at least $500,000 on a lease with annual base rent of $600,000. The tenant, a newly formed corporation with a low net value, can come up with only $100,000. But since the tenant is a subsidiary of a larger, established corporation, the landlord is willing to accept $100,000, provided that the parent corporation guarantees its lease obligations.

The deal makes sense for the landlord as long as the parent remains financially stable and maintains a net worth of at least $12 million. But just to be sure, the landlord requires the tenant to pay an additional $400,000 in security if its parent’s net worth falls below the $12 million minimum at any time during the lease term. The landlord is now in a position to evict or collect $400,000 (or at least a healthy chunk of the additional security owed) if the parent experiences financial difficulties down the road.

Negotiating the Arrangement

Having laid out the concept, let’s focus on how to negotiate the actual arrangement. There are two key negotiating points, namely, the amount of:

• The minimum net value the guarantor must maintain; and
• The additional security deposit the tenant must pay if the guarantor sinks below the minimum net value.

There are three factors to consider in setting these amounts:

Factor 1: The tenant’s financial strength. First, you need to do your due diligence on the tenant’s financial strength. At a minimum, evaluate the tenant’s balance sheet, financial history, nature of its business, strengths and weaknesses of its industry, long-term debt, and banking relationships. The weaker the tenant’s financial position, the higher the minimum net value you’ll want the guarantor to maintain and the bigger the security deposit you’ll want upfront.

Factor 2: Tenant’s lease obligations. Landlords commonly determine the minimum required net worth of a tenant’s guarantor as a multiple of the rent payable under the lease. For example, a landlord willing to settle for a security deposit equal to two months’ base rent might insist on a guaranty by a corporation with a net worth of more than twice the total base rent payable under the lease. If the guarantor’s net worth falls below the required minimum, the landlord may then demand that the tenant increase the security deposit to one year’s worth of base rent.

Factor 3: Landlord’s leasing expenditures. Landlords may also want to take into account the expenditures they make to get the lease signed and the tenant moved into the space, including brokerage commissions, the costs of building out the space, and the value of any rent concessions. If such expenditures are low or nonexistent, the landlord may be apt to reduce its demands on the minimum net worth and security deposit issues.

Negotiating Strategy: The longer the lease lasts, the lower your potential losses become, and the greater the value you incur from your initial expenditures. Accordingly, you may want to consider agreeing to reduce the minimum net worth and/or additional security deposit amounts as the lease term progresses.

Secondary Issues to Consider

Nail down the kind of net worth verification you want the guarantor to provide. Our model guaranty language requires the guarantor to provide audited financial statements that its president or CFO certifies as being fair and accurate. However, you can also impose even stricter requirements, such as requiring the financial statements to be audited by one of the big accounting firms.

Getting financial statements will probably be easier if the guarantor is publicly traded and thus subject to U.S. Securities and Exchange Commission public disclosure requirements. However, private companies that don’t regularly prepare such statements may push back and insist on the right to provide simpler forms of verification, like a statement from a certified public accountant certifying that the company’s net worth is at or above the required minimum without furnishing all of the financial details.

Another secondary negotiating issue is how much time you want to give the guarantor to provide net worth information and the tenant to come up with the additional security deposit when and if you demand it. Our clause provides for 10 days to perform these functions, but guarantors and tenants may want something more on the order of 30 days.