Negotiate Three Limitations on Guarantor’s Obligations

When a prospective tenant isn’t as financially strong or experienced as you’d like, your choices aren’t limited to either taking a substantial risk or passing on an otherwise valuable leasing opportunity. You can secure the tenant’s lease obligations by getting a guaranty for additional financial security. If the tenant is willing to provide a third-party guarantor, you’ll need to negotiate the scope of the guaranty. It’s key to strike a balance between making the guarantor liable for any tenant-caused losses and allowing reasonable limitations on the guarantor’s liability.

     We’ll tell you how to negotiate a guaranty with a fair and balanced scope and give you a Model Agreement: Carefully Limit Obligations of Tenant’s Guarantor, which you can adapt for the guaranty you sign with your tenant’s guarantor. You can also use our Model Agreement: Let Guarantor Off Hook with Written Release of Guaranty, to release the guarantor from its obligations.

Triggers to Release from Liability

What’s a typical owner looking for in a guarantor? “Someone who could make the owner whole—that is, cover the amount of damage—such as lost rent or allowance money—that would occur in the event of a tenant default,” says Virginia attorney David S. Houston. But a guarantor will want to take on as little risk and potential liability as possible. Agreeing to release the guarantor from liability at some predetermined point in time or upon the fulfillment of some condition is a good compromise.

     “Conditions and reductions of a guaranty are usually negotiated up front between the parties in the terms of the guaranty,” says Houston. The eligibility of the guarantor to be released or have its liability reduced is usually conditioned upon the tenant never being in default,” he points out. The following are three additional conditions that could trigger a release:

     Certain time has passed without tenant default. Often, an owner wants a guaranty because the tenant has an unknown track record. Consider limiting the guaranty for a fixed period during the early years of the lease term. If a certain period of time—say, three years—has passed and the tenant has complied with the lease and has sufficient financial strength or business knowledge that you could look to it alone to perform under the lease, it would be safer to release the guarantor. “In that scenario, your risk has been reduced from the time you first signed the lease, because at that point in time you didn’t know what you were going to get from the tenant, and now you know that it’s reliable,” says Houston [Agr., par. 3].

     It’s also reasonable to reduce the obligations contained in the guaranty at some future point in time or upon meeting some condition—for example, reducing the sum of the guarantor’s liability to three months’ rent or some agreed-upon dollar amount, says Houston. This is a good compromise if you’re still skittish about relying on the tenant alone, and want some additional security that you’ll be reimbursed for default-related expenses.

     Tenant meets certain net worth requirement. You may feel that, even if your risk of being on the hook for the tenant’s default has been reduced by a history of timely payment and compliance, there’s no assurance that the tenant’s financial situation will be significantly greater at the end of a guaranty period that’s shorter than the lease term, or that its good performance will continue into the future. Conditioning the release of the guarantor on the tenant’s attaining a certain level of net worth can solve this problem. For example, if the tenant’s net worth reaches an amount that you’ve agreed upon, the guarantor is released. But make sure to specify that, even if the net worth is reached, the tenant mustn’t be in default of any lease terms or conditions [Agr., par. 1].

     Liability reaches certain limit. Another compromise is to limit the amount of damages the guarantor would owe—for example, setting a maximum sum it would be liable for. This could be a fixed dollar amount or it could be calculated using a method like figuring the sum ofthe number of consecutive months of annual minimum rent and additional rent being paid by the tenant on the date of its default (including applicable escalations as provided in the lease) [Agr., par. 2].

Practical Pointer: Draft the guaranty as a separate agreement in a separate document from the lease. It’s often attached to the lease, but the guarantor isn’t the tenant, so it’s not necessarily a party to the lease itself. Nevertheless, it’s standard to include the words: “the guarantor hereby assumes all the obligations of the tenant.”

No Release for Assignment, Transfer

You have three viable options for reducing or releasing a guarantor for your tenant, but what happens when a tenant decides to exercise its right to assign its or otherwise transfer its lease? Assignments or other transfers can pose additional risks for owners; be very wary of leaving yourself vulnerable in this situation by letting the original tenant or guarantor off the hook and having no one to look to if there’s a problem with the assignee.

     “As a general rule of thumb, an owner wants to keep as many people on the hook as possible so it can enforce guaranties that would help compensate it for its entire loss in the event that a tenant defaults,” says Houston. There are several positions that an owner could take when a tenant with an assignment right asks for its guarantor to be released upon assignment. The decision you make depends on whether the request is for an assignment and release of either tenant or guarantor, or both, and the amount of leverage, if any, that the tenant has.  

     “Generally, the owner wouldn’t let the guarantor out of the guaranty in the event of an assignment, and the guaranty should expressly provide for the guarantor's obligations to survive assignment,” Houston notes. “The point of the guaranty is to try to keep as many deep pockets available to you in the event of a default,” Houston stresses. “Because the guarantor is probably the one with the stronger financial credit in the first place, an owner’s first position would be that it won’t let the guarantor off the hook, even if it allows the tenant to assign the lease,” he says.

     Some tenants, especially national tenants or tenants that are vital to create the owner’s desired mix for its shopping center, have room to negotiate. The owner’s second position might be proposing a compromise. “You would negotiate up front conditions under which the guarantor and the tenant would be released from liability in the event of an assignment, but in most situations this would only happen if the assignee taking over the lease has the financial wherewithal to perform under the lease and pay the rent,” Houston says.

     Frequently, when the tenant notifies the owner that it wants to assign the lease, the owner looks at the financial statement of the prospective assignee. If the assignee isn’t strong enough in the owner’s opinion, the owner would seek an additional guarantor. (That would be negotiated as part of the owner’s consent to an assignment of the lease. In that case, it could end up requiring an amendment to the lease to confirm the transfer, subject to the new guaranty. There would also be a new, separate guaranty agreement.)

     “The owner would want to look at the entire scenario before releasing anybody. If there was an assignment and the assignee had no creditworthiness itself, but has a strong guarantor, the owner could become satisfied with the new guarantor’s net worth to the extent it could release or reduce the liability of the original guarantor or the tenant,” Houston says. “If an assignee meets some financial threshold or other test, some owners might be willing to release the original guarantor and possibly the original tenant,” he adds.

Substitutions for Guaranty

If a highly desirable tenant balks at providing a guarantor, how can you rent to it and still have some additional assurance that you won’t be left floundering in the event of a default? There are substitutions for a guarantee.

     “Whether the owner gets a guarantor depends on the relative bargaining position of each side,” notes Houston. “If the tenant is a use or a name tenant that the owner really wants at the center because it’ll upgrade the entire property, it might be willing to take more of a risk to get that name or that tenant, even if the tenant isn’t willing to put up a third-party guaranty,” he says.

     A large security deposit that would cover at least several months of rent plus any allowance that the owner gave up front for a build-out of the space could suffice. But usually when you have a tenant without financial strength, it’s not likely to be able to come up with the cash or other forms of security for such a large deposit.

     “This is a risk that all owners have to factor in to their decision to allow such a substitution for a guaranty,” warns Houston. He suggests looking at the tenant’s other locations, business plan, concept, and any other relevant experience that could be an indicator of the likelihood that it’ll succeed.

     Ideally, you want to have a strong guarantor with sufficient means to cover your losses. But that’s not always possible. “Sometimes the owner is in the driver’s seat, but sometimes it’s the tenant who can call the shots, and that’s when the owner really has to determine how it’ll minimize its exposure,” emphasizes Houston.

Insider Source

David S. Houston, Esq.: Reed Smith LLP, 3110 Fairview Park Dr., Ste. 1400, Falls Church, VA 22042; www.reedsmith.com.