Use Five Safeguards to Avoid Getting Burned by Guaranty with Decreasing Dollar Cap

Tenants and their guarantors often demand that a decreasing “dollar cap” be put on a guaranty. This limits the guarantor's liability to a set dollar amount, and then the cap decreases—or “burns off”—over the lease term. While agreeing to a decreasing dollar cap can close your deal, you could lose more than you bargained for if you're not careful. For instance, if the dollar cap starts out too low or the cap burns off too quickly, and the tenant goes bust early in the lease term, you might not get enough money from the guarantor to cover even your out-of-pocket costs.

To help you avoid that situation, CLLI, with the help of New York City attorney Robert P. Reichman, New Jersey attorney Marc L. Ripp, and Denver attorney Mark A. Senn, will give you five safeguards to use if you must agree to a guaranty with a decreasing dollar cap. There's a Model Guaranty Clause on p. 3 that you can adapt to your situation and then put into the guaranty.

How Decreasing Dollar Cap Works

Before you can set up a decreasing dollar cap in a guaranty, Ripp notes that you, the tenant, and the guarantor will need to negotiate these four points:

• The initial amount of the dollar cap;

• The length and timing of the burn-off period;

• The date(s) each decrease will take effect (these dates often fall on the anniversary of a key lease date, such as the lease's commencement date); and

• The amount of each decrease.

There are many possibilities for when and how much the dollar cap will decrease. For example, if the tenant signs a 15-year lease, you might agree on a burn-off period over the first 10 years of the lease term, with the dollar cap decreasing by .10 multiplied by the original amount of the dollar cap per year. Or you might agree that the dollar cap will decrease twice during the 10-year period: by one-half in the fifth year of the lease term and then eliminated entirely in the 10th year.

The outcome of your negotiations on those four points will depend on several factors, such as 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, says Reichman. Be aware that if the tenant has lots of negotiating power, you may be forced to accept a rapidly decreasing dollar cap over a short period of time.

Five Decreasing Dollar Cap Safeguards

If you're compelled to accept a decreasing dollar cap on the guarantor's liability, then include these five safeguards in the guaranty:

Safeguard #1: Start cap high enough to cover up-front lease costs. Start the dollar cap at a level high enough to cover at least your out-of-pocket lease costs, says Reichman [Clause, par. a]. 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, buildout 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 #2: Exclude certain costs from cap. Make sure that the dollar cap doesn't apply to certain costs, notes Reichman. For instance, don't cap your collection costs or attorney's fees, he says. Otherwise, you'll lose money for enforcing the lease or guaranty. 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, says Ripp [Clause, par. a]. But Senn doesn't believe that a guarantor should be liable for those losses.

Safeguard #3: Avoid cap tied to rent payment. Once you've agreed to the initial amount of the dollar cap, be careful of the wording you use in the guaranty, warns Senn. A sneaky guarantor might try to initially 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 specific dollar amount, excluding certain costs, he says [Clause, par. a]. 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.

Safeguard #4: Set three conditions for each decrease: Don't allow a dollar cap decrease unless the following three conditions are met, says Ripp. Note that these conditions must be met each time the dollar cap is scheduled for a decrease, he adds:

Guarantor must give notice. Condition each dollar cap decrease on the guarantor's sending you written notice demanding such decrease. You should require this notice within a limited time period before the decrease is scheduled to take effect. For instance, you might require the notice at least three months—but not more than six months—before the next scheduled decrease, says Ripp [Clause, par. b(i), c(i)]. If the guarantor doesn't send its notice within that limited time period, the dollar cap won't make the scheduled decrease, he says.

Practical Pointer: A savvy guarantor or tenant will likely ask for a longer time frame in which the guarantor can send its notice, to reduce the risk that the guarantor won't send you the notice on time, says Ripp. You may have to give in on this point if the tenant or guarantor has some negotiating power.

Guarantor mustn't have defaulted. Don't let a guarantor that has defaulted under the guaranty in the past or is currently in default take advantage of a dollar cap decrease, says Ripp. Instead, condition the decrease on the guarantor's not having defaulted and not being in default under the guaranty, he advises [Clause, par. b(ii), c(ii)].

Tenant mustn't have defaulted. If a tenant has defaulted or is currently defaulting under the lease, you don't want the guarantor's liability to decrease. Rather, you may need to take legal action against the guarantor to carry out the defaulting tenant's lease obligations. So condition the dollar cap decrease on the tenant's also not having defaulted and not being in default under the lease, says Ripp [Clause, par. b(iii), c(iii)].

Practical Pointer: Expect a savvy tenant or guarantor to argue that the second and third conditions should require only that the guarantor and tenant not commit a “material”—that is, important—default or a monetary default (exceeding a certain dollar amount) under the guaranty or lease. Otherwise, a minor default—such as not following the proper procedure for mailing a notice could block the dollar cap decrease. You may have to give in on this point. Also, the tenant might argue that if it cures—that is, fixes—its default within the time period required by the lease, the dollar cap decrease must still occur. But to avoid getting burned by a tenant that habitually defaults and cures, place a limit on how many times in a year the tenant can default and then cure its default before the decrease will be blocked, says Ripp.

Safeguard #5: Tenant and guarantor stay on hook for unpaid obligations. Say in the guaranty that the dollar cap decreases won't release the tenant or guarantor from:

• Any debts—such as base rent or additional rent—still owing as of the date that the dollar cap is eliminated, even if those debts weren't billed yet; or

• Guarantor's obligation to pay all of your attorney's fees to enforce the terms of the guaranty, environmental contamination fees, and losses you suffered because of the tenant's negligent or intentional conduct [Clause, par. d].

CLLI Sources

Robert P. Reichman, Esq.: Partner, Siller Wilk LLP, 675 Third Ave., New York, NY 10017-5704; (212) 421-2233; RReichman@sillerwilk.com.

Marc L. Ripp, Esq.: Counsel, The Gale Co., 100 Campus Dr., Ste. 200, Florham Park, NJ 07932-1007; (973) 301-9500; MRipp@TheGaleCompany.com.

Mark A. Senn, Esq.: Shareholder, Senn Visciano Kirschenbaum P.C.; 1801 California St., #4300, Denver, CO 80202-2604; (303) 298-1122; MSenn@SennLaw.com.