By Benjamin Weinstock, Esq.
The intuitive reaction of most entrepreneurs and their lawyers is to recoil at the mere mention of a guaranty. Others chant that a guarantor is “a fool with a pen.” Nevertheless, guaranties remain a significant component of commercial leasing transactions, and the “Good Guy Guaranty” is ubiquitous among them. An understanding of the consequences and issues relevant to this form of guaranty is critically important, as it presents many opportunities for costly mistakes.
Guaranties generally fall into three broad eponymous categories – payment, performance and collection. The most commonly used forms are the guaranties of payment and performance. Due to its limitations, a guaranty of collection is undesirable and rarely used.
Payment and performance guaranties are further classified in to “full guaranties” or “limited guaranties”. The good guy guaranty is not a new species of guaranty. Rather it is almost always a “limited payment guaranty” and, therefore, is governed by the rules of construction and enforcement that are applicable to other forms of limited payment guaranties. Some of its unique problems, from both the landlord and tenant’s perspectives, are the focus of this article.
The good guy guaranty began as a means to protect landlords from the unwanted situation of having a non-paying tenant in possession of the premises, which frequently occurs in bankruptcy cases. Landlords found that when a tenant filed for bankruptcy protection, the tenant was virtually immune from suit and could not be evicted. Even non-bankrupt tenants could manipulate the judicial process in summary proceedings to achieve lengthy delays before being evicted. Months of costly delay frustrated landlords. They had no practical recourse. This problem led to the creation of the good guy guaranty, which, at its inception, simply provided that so long as the tenant remained in possession, the guarantor was responsible for the rent.
The crucial limitation of a good guy guaranty is that the guarantor’s liability ceases to accrue when the tenant has vacated the premises and surrendered possession to the landlord. Notably, once the tenant has vacated the premises, the guarantor has no liability for rent accruing for the remainder of the original lease term. Because a guarantor is usually united in financial interest with the tenant, this gives the tenant a healthy economic compulsion to be a good guy and not continue in possession after it has stopped paying rent. As compared against a full guaranty, a “good guy” guaranty is relatively easy to obtain. After all, how can a prospective tenant and guarantor refuse to be “good guys”? Would they dare tell a landlord during the courtship period (lease negotiations) that they intend to remain in possession without paying rent?
Minimum Term and Buildout Costs
From the landlord’s perspective, a bare-bones good guy guaranty does not go far enough. Consider the impact on a landlord that has invested a significant sum in building out the space for the tenant and paid a brokerage commission, only to have the tenant fail before it ever takes possession, or soon after. A good guy guaranty that merely covers payment of rent while the tenant is in occupancy provides no recompense for the landlord’s up-front leasing expenditures. To overcome this, a good guy guaranty should, if possible, provide that the guarantor or the tenant will pay rent for a pre-determined length of time sufficient to allow the landlord to recoup its initial investment. In the alternative, the good guy guaranty could provide for a liquidated termination liability to cover these items, which will decrease over time during the term of the lease.
Similarly, the basic good guy guaranty offers no protection for the losses a landlord will suffer during the period of vacancy that follows a defaulting tenant’s surrender of possession while the landlord looks for a replacement tenant, builds out the space and pays more brokerage commissions. The solution is obvious. The good guy guaranty should also require a period of advance notice before the tenant can surrender and vacate. In the alternative, the lease and guaranty should require the tenant and guarantor to pay a liquidated sum at the time of surrender to cover these costs.
Free Rent and Workouts
To induce tenants to sign leases, many landlords offer a rent concession at the commencement of the lease term, or they spread the concession over a period of years. In either case, landlords calculate the value of the free rent as an expense that should amortize over the term of the lease. In other words, the landlord expects to receive all the rent reserved under the full term of the lease to defray the concession. Some carefully drafted leases include a provision that permits the landlord to recoup all or a part of the value of the so-called “free rent” if the tenant fails to pay rent through the end of the lease term. If such a lease is backed by a good guy guaranty, specific language in the guaranty should address whether the guaranty covers this rent recoupment. If not, the guarantor will surely dispute liability on the theory that this obligation, which arises only after the lease terminates, does not constitute “rent” due from the tenant while it was in possession of the premises.
This concept also applies to good guy guaranties that are frequently used in situations where a tenant has fallen on bad times and failed to make timely rent payments or where a tenant is only making partial rent payments. Rather than evict the tenant, a landlord may prefer to enter into a work-out agreement with the tenant reducing the tenant’s monthly rental payment until its financial health is restored. In such cases, the good guy guaranty should include a provision that if the tenant defaults in the payment of rent during the work out period, the guarantor will not only be liable for the reduced rent, but for the full amount that would have been payable during such period had the rent abatement not been granted. This provides additional incentive for the tenant to make timely payments.
End of Term Obligations
Finally, the landlord wants to assure that upon the early termination of the lease the tenant will perform its end-of-term obligations, particularly those relating to the condition of the premises and the performance of any restoration work. These are considered fair game for inclusion in a good guy guaranty, which does not otherwise provide any coverage for these items.
Watch out for “Additional Rent”
Any guarantor wants to limit its liability to the payment of base rent and perhaps tax and operating expense escalations. A guarantor certainly does not wish to be exposed to liability for any non-monetary defaults of the tenant that are later converted to liquidated sums. Therefore, the guarantor should hesitate to sign a good guy guaranty that promises to pay all obligations constituting “additional rent.” Leases almost universally allow the landlord to convert non-monetary obligations of the tenant (even those which the guarantor did not intend to cover) into financial obligations of the tenant collectible as additional rent and, thus, included under a broadly worded good guy guaranty. Therefore, from a guarantor’s perspective, a good guy guaranty should be limited to the unpaid fixed or basic rent plus those specific charges and escalations the guaranty expressly identifies. The guarantor should avoid assuming any blanket agreement to pay all “additional rent,” a phrase that could produce an unwelcome surprise for the guarantor.
Rent Acceleration and Post Termination Damages
Similarly, from the guarantor’s point of view, any accrual of financial liability under the guaranty should end when the tenant delivers vacant possession. For that reason, the guarantor will probably not intentionally agree to a clause in the guaranty that accelerates the rent for the unexpired term. This could occur unexpectedly, though, if the lease provides for the acceleration of all rent after a default. If the acceleration occurs at any time before surrender, it becomes part of the rental obligation that accrued before termination of the lease and, therefore, probably falls within the broad promise to “pay all rent accruing under the lease prior to the surrender of the term.”
The message is clear. Guarantors must read more than the guaranty to understand the scope of their exposure. They must pay careful attention to the default and remedy provisions of the lease in addition to those in the guaranty. Even then, the guarantor will want the “good guy” guaranty to state specifically that any rent acceleration provisions and other default damage clauses, such as payment for reletting expenses, costs of eviction, restoration and the like, are not part of the guarantor’s obligation under the guaranty regardless of when they accrue under the lease.
The Security Deposit
Many negotiators of the good guy guaranty focus on the treatment of the tenant’s security deposit, or more specifically, whether the security deposited will be credited against the good guy guarantor’s obligations. Absent a specific provision in the guaranty to the contrary, the guarantor’s liability will usually be reduced by application of the tenant’s security deposit. This will occur because the security deposit will be applied in partial satisfaction of the tenant’s defaulted rental obligation, thus commensurately reducing the guarantor’s exposure. That result follows the general suretyship principle that when a debtor (the tenant) surrenders to the creditor (the landlord) the security in the creditor’s possession, the creditor discharges the surety’s liability at least to the extent of the security, if not entirely. The rationale for this rule is that the release of security to the landlord impairs the ability of the guarantor to exercise its potential right of subrogation against the tenant. Therefore the guarantor is entitled to a partial or total discharge of its liability.
Naturally, the landlord would prefer to retain the security deposit without benefiting the guarantor. The landlord would argue that the security deposit is intended to help cover the other costs the landlord will suffer from the tenant’s default and early termination of the lease. One solution that has been suggested is, where the guaranty is silent, the landlord should not apply the security deposit to unpaid rent accruing before the tenant’s surrender. Rather, the landlord should apply the security deposit against only those obligations excluded from the good guy guaranty, typically reletting expenses or the restoration of the premises. I am skeptical that a court would enforce this election. Therefore, I recommend that the disposition of the security deposit, whether it will be credited in reduction of the guarantor’s obligation, be stated clearly in the good guy guaranty and appropriate language also be included in the security deposit clause of the lease.
What to many seems at first to be a simple guaranty, is hardly simple at all. The good guy guaranty has become more sophisticated and complex with each expanded use and version. I am certain that even more comprehensive forms will evolve. Attorneys must be vigilant and thoughtful when dealing with these instruments.