It is common when entering into a commercial lease for a third-party guarantee to be provided to the landlord.
In this article we consider:
- How are guarantees used in commercial leases?
- Who can be a guarantor for a commercial lease?
- Signing a commercial lease as an individual
- Do you need guarantee insurance?
- What happens if a guarantor cannot pay rent?
- What’s the difference between a guarantee and an indemnity in commercial leases?
- Alternatives to guarantees
How are guarantees used in commercial leases?
Guarantees are used in many forms of commercial documents. They play a particularly important role in commercial leases by providing landlords more comfort that lease terms will be complied with. In simple terms, a guarantee is a legal promise given by one party that another party will meet its obligations. It is common that the guarantor also agrees to step into the shoes of the defaulting party if required.
Given that a tenant is often committing to significant liabilities under a commercial lease (including the payment of rent and varying degrees of requirement for repair of the property) a landlord will often wish to obtain a guarantee. This may be particularly necessary where the tenant is perceived to have poor ‘covenant strength’ (which means there is some question of its ability to meet its obligations under the lease) or the tenant is a limited company, especially if it is a relatively newly incorporated company. A guarantee provides the landlord with a form of security.
If the tenant defaults on its obligations, an effective guarantee will allow the landlord to recover monies from the guarantor and/or insist that the guarantor fulfils the obligations. Depending on how the lease and guarantee are drafted, it is not ordinarily necessary for the landlord to be required to serve any form of ‘formal’ demand on the guarantor. A demand will normally be made on the tenant pursuant to the terms of the lease (which creates the principal liability) and the guarantor will be liable without the need for any further notice.
Where a lease is assigned from the original tenant to a new tenant, often as part of the landlord’s permission to assign, it will require an authorised guarantee agreement (AGA). The AGA is a guarantee from the original tenant that the new tenant will fulfil its obligations under the lease, and as a consequence, the original tenants retains liability for these obligations in the event that the new tenant defaults. This is distinct from a third-party guarantee and a landlord may have the benefit of both a third-party guarantee and an AGA.
If a landlord forfeits a lease then, as the guarantee is linked to the lease, arguably the guarantor will no longer be liable. Depending on how a guarantee is drafted, the landlord may be able to elect for a guarantor to either take a new lease (in place of the tenant) or simply make a payment to meet a liability.
Who can be a guarantor for a commercial lease?
Any individual or any company with capacity can be a guarantor for a commercial lease. That said, a landlord should be cautious about who they are dealing with and be cautious of statutory protections offered to guarantors. This includes risks that some of the terms of the guarantee could be deemed ‘unfair’. Often it is sensible to ensure that a guarantor obtains independent legal advice on the terms of the guarantee.
The term ‘with capacity’ is important. Ideally if a company is giving a guarantee it should have specific powers to do so under its memorandum or articles of association. It is also important for directors of companies to show that they are acting within their power, in order to promote the success of the company.
In addition to the question of capacity, guarantees should be drafted and entered into with care. There are various circumstances where a guarantee may not be upheld as enforceable and factors relevant to this include:
- Basic contractual issues (such as whether the key components of a contract: offer, acceptance, intention to create legal relations and consideration have been met). Normally a guarantee will be signed as a deed, as it is possible that there is a lack of any consideration (a deed does not require consideration, but a simple contract does)
- Statutory requirements (it must be in writing and signed by the guarantor)
- Complexities owing to corporate structures (holding company, subsidiaries and other affiliates)
- Any legal limits on authority (the Companies Act prohibits or limits certain forms of financial assistance)
- Any duress, undue influence or misrepresentations
As noted above, in the event that a lease is assigned, it is common that the original tenant will be required to give an AGA. This is a form of guarantee.
Signing a commercial lease as an individual
If a tenant is an individual, then they will take on personal liability for the obligations under the lease. A landlord will wish to ensure that the individual is of sufficient financial standing to meet its liabilities. A third-party guarantee can provide security in such circumstances.
As an individual does not have the benefit of limited liability that exists within a limited liability company, it should be clear that when entering into a guarantee, that all of his or her personal assets are at risk in the event of default. From a landlord’s perspective, obtaining a guarantee from an individual can be useful, but this depends on the financial standing of the individual. An individual may be more inclined to ensure that the demands under the guarantee are met, in order to avoid risking their personal assets. However, if the reality is that the individual is of limited means and incapable of meeting the demands, then this offers little comfort to the landlord.
Do you need guarantee insurance?
A potential guarantor should seek appropriate advice as to its suitability for insurance. Personal guarantee insurance (PGI) provides insurance cover for those giving guarantees. The purpose of the insurance is to protect the guarantor in the event that the guarantee is called in.
As with many insurances, the policy will likely include a level of cover and certain limitations.
What happens if a guarantor cannot pay rent?
If a tenant has defaulted on its obligations to pay rent and, the landlord having called in the guarantee, finds that the guarantor is also unable (or unwilling) to pay the rent then the landlord may wish to consider the following:
- Is there a rent deposit deed in place? This will provide a quick source of funds to discharge the arrears
- Is it favourable to retain control of the property? If so, the landlord may be able to forfeit the lease, either by peaceful re-entry or by seeking an order from the court
- Are there any other forms of security in place that could be called in (charge on a third party property)
- Has the property been previously assigned and if so, is there an authorised guarantee agreement from the previous tenant in place?
- Are the tenant and guarantor genuinely unable to pay the arears? Commencing legal proceedings for a debt recovery action may force payment
- Serving a statutory demand (which is a pre-curser to winding up or bankruptcy proceedings)
- Commence a bankruptcy or winding up petition (which may or may not result in a payment to creditors, of which the landlord will be one)
- Negotiate with the tenant and/or guarantor to secure a repayment plan
What’s the difference between a guarantee and an indemnity in commercial leases?
When considering the difference between a guarantee and indemnity, the following is relevant:
- An indemnity is a principal liability, whereas a guarantee is a secondary liability (this means that an indemnity is given directly and independently of any other parties’ obligation. A guarantee is linked to the principal liability given by the third party).
- There are no particular prescribed requirements for an indemnity to be valid. A guarantee must be in writing and signed by the guarantor (or someone authorised on its behalf).
- Normally a claim can be brought under a deed within 12 years (known as the limitation period). However, in the case of claims for rent arrears, these must be brought within six years from the date the rent became due. If an amount claimed by a landlord from a guarantor relates to rent under a lease, the limitation period will be six years
- Importantly, as a guarantee is linked to the lease, if the lease is found to be unenforceable in any respect, then the guarantor will not have liability. An indemnity, however, stands on its own and will not be automatically invalid due to the invalidity of any other document.
Alternatives to guarantees
The parties may consider the following alternatives to guarantees:
- A rent deposit deed
- A charge over a property or other asset
- Including additional parties as joint tenants to the lease
A rent deposit is an advance payable by the tenant to the landlord. It is used to secure payment of the rent and, commonly, as further security for the fulfilment of other obligations under the lease. This can be a valuable form of security for the landlord as funds are readily accessible to draw upon in the event of the tenant failing to meet its oblations. The landlord does not need to go to the effort of pursuing a third party or commencing legal proceedings to enforce the obligations under the lease.
Depending on the length of term of the lease, the potential magnitude of liabilities and the ‘covenant strength’ of the tenant, it may be considered appropriate to obtain a charge over a property. Similar to a bank taking security over a property as a mortgage, a landlord could require a tenant to offer up security over a property. In the event that the tenant cannot meet its liabilities, the landlord would look to call in the security to pay the liabilities.