Limiting Your Personal Guaranty
As discussed in a prior blog entry (click here: http://azleaselaw.wordpress.com/2010/03/15/landlord-lien-rights-on-tenants-personal-property/), there are three primary forms of security used for tenant’s payment of rent: a security deposit (in the form of cash or a letter of credit), a personal or corporate guaranty, and landlord lien rights on the tenant’s personal property located within the leased premises. A few years ago, it was common for landlords to require full personal guaranties from each principal of the tenant entity. In the current commercial leasing market, tenants are able to negotiate for less security, including limited or no personal guaranties.
In most cases, the tenant should expect to provide some security for its performance under the lease. However, it may be excessive for the landlord to require the principal(s) to personally guaranty the tenant’s performance for the entire lease. Following are common limitations that I have negotiated for tenants and their principals:
1. Limiting the Personal Guaranty to a Specific Dollar Amount. Assuming a gross lease with a 5 year term at $5,000 per month, the entire value of the lease is $300,000. If the principal of the tenant guaranties the entire performance by tenant, the principal’s potential exposure is the entire $300,000 value of the lease (subject to the landlord’s duty to mitigate damages). It is reasonable to expect that the landlord should bear some risk in the event of a tenant default. Depending on a variety of factors (e.g., tenant incentives at the start of the lease, extent of tenant improvements paid for by landlord), the principal may only guaranty a year or two years worth of rent ($60,000 or $120,000). The amount is negotiable.
2. Limiting the Personal Guaranty to a Specific Duration. It also is reasonable to allow the principal off the hook if the tenant performs for a certain initial duration. First, this proves that the tenant is likely to continue its performance under the lease if it performs its obligations for an initial period of time. Second, this allows the landlord to ensure it will recapture its initial investment in the tenant by collecting rent for a guarantied period of time. Again depending on a variety of factors, the principal may only guaranty the tenant’s performance for the first one or two years of the term. The duration is negotiable.
3. Limiting the Personal Guaranty to a Tenant Default Due to the Failure to Pay Rent. This limitation is rarely used, but I believe should be used more often. The primary reason for a personal guaranty is to guaranty the tenant’s payment of rent. Accordingly, the personal guaranty should be limited to a tenant default for failure to pay rent only, and not for other defaults. For example, if a tenant’s employee intentionally sets fire to the leased premises and insurance proceeds do not cover the damage, the lease guarantors could be held responsible for payment. The guarantors did not intend to serve effectively as an insurance policy for the landlord, and only intended to stand behind the viability of the business operations of the tenant.
An additional note on personal guaranties in Arizona: Arizona is a community property state. In order to bind the community assets of a married individual (which typically includes most of the valuable assets of that individual), both the principal and the principal’s spouse must be guarantors and execute the personal guaranty. Otherwise, only the principal’s sole and separate property will be subject to the personal guaranty. Most Arizona brokers and attorneys are aware of this issue, but occasionally when dealing with out-of-state landlords that handle lease negotiations “in house,” the landlord overlooks this critical point.
Finally, personal guaranties are a business term that should be negotiated initially in the letter of intent. A good real estate broker will make sure to negotiate all forms of tenant security up front in the letter of intent.
Prior to using any language or concepts from this blog entry, consult with an attorney.
Ryan Rosensteel is a real estate and construction attorney licensed in Arizona. You can contact him at firstname.lastname@example.org.