What is a Personal Guaranty and Why is It Important with a Commercial Lease?
At some point in their lives, most adults have signed a lease agreement, whether it be the leasing of an automobile, an apartment on campus while attending college or renting a home. Since most of these leases are standard forms offered on a “take it or leave it” basis by the lessor or landlord, negotiating the base rent and term of the lease is typically the main and only focus for the lessee.
When a business enters into a commercial lease however, the lease is usually signed by the business entity itself, which is typically organized as a corporation or limited liability company. By forming a corporation or LLC, the owners of a business can shield themselves from personal liability for the debts of the business in most situations. Accordingly, when a business entity signs a commercial lease to rent space in a commercial building, the entity signing the lease, as opposed to the owners of the business entity, is the one legally responsible for making the payments under the lease.
This dynamic is beneficial for business owners as they can enter into expansive long term leases for the business and be allowed to escape personal responsibility for the rent if the business fails. The business owner can simply walk away and start a new business in a new location. In order to better protect themselves, many commercial landlords require a personal guaranty, which has become ubiquitous in the commercial leasing realm, particularly for most small businesses.
What is a Personal Guaranty?
A personal guaranty is a separate document from the lease and is executed contemporaneously with the execution of the lease. The guaranty is typically a short one or two-page document that identifies an individual, or multiple individuals, or other business entities, which agree to be “guarantors” of the underlying lessee. This means that if the business entity signing the lease defaults on the lease or is otherwise unable to make lease payments, the guarantors promise to make the payments on behalf of the lessee. The landlord therefore can go after the guarantors personally if the business entity signing the lease goes bankrupt. The language in a personal guaranty can be as simple as the following:
Guarantor fully and unconditionally guarantees all of Tenant’s obligations under the Lease.
When the real estate market crashed in the mid-to-late 2000’s, a large focus was placed on the residential market as the value of homes plummeted across the country. As commercial property developers are aware, the market crash also significantly affected commercial real estate as well. For illustration purposes, Green Street Advisors publishes a Commercial Property Price Index (the “CPPI”) which “captures the prices at which commercial real estate transactions are currently being negotiated and contracted”. The Green Street CPPI was indexed to 100 in August, 2007 and indicates that the market went from being in the low 60’s in May, 2009 to reaching an all-time high of over 120 in March, 2017. Prior to the market crash, it was much more common for landlords to lease property to commercial tenants without requiring personal guarantees. Fast forward to today and the landscape is completely different. Unless you are dealing with a large national tenant, most landlords will consider the inability to obtain a personal guaranty when leasing to a small business a deal breaker.
Whether to sign a personal guaranty is therefore one of the most important terms to negotiate in a commercial lease. From the landlord’s perspective, signing a lease with a new small business without requiring a personal guaranty is a significant risk. If the business fails, as most new businesses unfortunately do, within the first few years of the lease, the landlord could be stuck with a lengthy vacancy for the leased property. If the market crashes and the lease was above market, meaning it was favorable to the landlord, the landlord will likely not be able to re-lease the property for the same price. In the case when a landlord enters into a below market lease, the landlord may have no interest in pursuing the guarantor as it may be more profitable to simply re-lease the property at a more favorable rate to the landlord. In either event, it is always beneficial for the landlord to have the guaranty as additional security.
The most important benefit of obtaining a personal guaranty is that most guarantors have assets the landlord could go after if the lessee fails to make lease payments and the guarantor refuses to make the payments on behalf of the lessee. However, there are also several additional benefits to landlords that obtain guarantees. First, businesses are more likely to take risky and questionable business decisions if there is no personal liability for the lease payments. Having an owner of the business personally liable for the lease payments ensures that the business will be more concerned about making timely lease payments. Second, the tenant will also be much less likely to cause damage to the building if the guarantor has agreed to be responsible for any damage. Third, by requiring a personal guaranty, the business has a strong incentive to prioritize making rental payments as opposed to paying other obligations which are not personally guaranteed in the event the business encounters financial difficulties.
Negotiating a Commercial Lease
So, what does all this mean for the small business owners who are interested in leasing space and are asked to sign a guaranty as part of the deal? Any person asked to sign a guaranty must think about the potential liability, which could be catastrophic, if the business fails. Therefore, it is important to be aware of the ramifications of signing a personal guaranty and even more important to negotiate the specific terms of the guaranty to limit exposure to the guarantor.
A potential guarantor is not without options. The first option for the potential guarantor is to refuse to sign any personal guaranty period. For many small businesses, this may not be an option since the landlord may simply search for a different tenant, but it is possible. The second option for the potential guarantor is to offer a Letter of Credit instead of signing a personal guaranty. A letter of credit is a negotiable instrument typically offered by banks to guarantee payment. In commercial real estate transactions, a tenant can obtain a letter of credit and offer it to the landlord as security in the event of a default. In order to obtain the letter of credit, the bank will typically require that the person requesting the letter has assets to offer as collateral or is creditworthy of receiving financing from the bank. A third option for a potential guarantor is to offer a corporate resume, historical financial records and a confidentiality agreement for the landlord to review. For established businesses, this option may be ideal as the landlord can use its own judgment to determine whether the tenant poses a serious risk of default.
In situations when the business signing the lease is large and has several owners, it may be difficult to find one person willing to be a guarantor for the entire business. This situation can usually be addressed by offering the landlord a sum of money as a security deposit in lieu of a guaranty. This way, the landlord can use the security deposit funds in the event of a default by the tenant as opposed to going after one of potentially many owners. The tenant in this case should negotiate the return of a percentage of the security deposit each year that the tenant fulfills all its duties under the lease. The parties should also discuss where the funds will be held, whether interest will be generated on the funds, and who is entitled to the interest. Each of these options would avoid the need for a personal guaranty. However, if the landlord insists on a personal guaranty, the potential guarantor still has some additional options.
First, the guarantor should ask for a limitation on the length or dollar amount of the guaranty. If the business is signing a ten-year lease, the guarantor should have serious concerns about potentially being responsible for ten years of lease payments if the landlord is unable to re-lease the property for the same price. The guarantor should negotiate the expiration of the guaranty if the tenant does not default within the first few years of the lease term. Second, in the event of a default by the tenant, the guarantor should ask for a limited period during which the guarantor is responsible for payments. Third, another possibility is to negotiate a maximum dollar amount that the guarantor will be liable for if the tenant defaults.
Another important provision to negotiate when giving a personal guaranty as part of a commercial lease transaction is to clearly outline the landlord’s duties to mitigate damages in the event of a default. While there is a general duty to mitigate damages under Michigan contract law, identifying with detail the specific tasks and requirements the landlord must complete to adequately mitigate its damages can drastically improve the guarantor’s position in the event the lease is breached.
Transfer or Sale of Business by Underlying Lessee
For the guarantor, a significant issue arises when the business is sold and/or the lease is assigned to a new entity. Since the guarantor is typically an owner, or a related person, of the business signing the lease, the guarantor will not want to be responsible for an unrelated third-party’s failure to make payments under the lease. To avoid this issue, the guarantor should demand that the landlord waive the guaranty if the business is sold or the lease is assigned to an unrelated party. The landlord may of course condition such a waiver upon the tenant finding a buyer or assignee to the lease that will also execute a personal guaranty to the landlord’s approval.
There are additional considerations that both landlords and guarantors in commercial lease transactions should be aware of. Since leases can be re-negotiated and amended, the landlord should be careful to ensure that the guarantor executes an acknowledgement or addendum to the guaranty to be bound by the amendments to the underlying lease. While some landlords include language in the guaranty stating that the guarantor agrees to guaranty and be bound by the terms of any amendments to the original lease, the enforceability of such provisions is questionable.
Michigan law generally provides that any “material alteration of a principal debt or obligation operates to completely discharge any guaranty of that debt or obligation.” Wilson Leasing v Seaway Pharmacal, 53 Mich App 359, 370, 220 NW2d 83 (1974). An alteration of the principal debt that increases that debt is material. Id. An exception to this general rule is where the alteration of the principal debt is “anticipated as a possibility” by the guaranty agreement in which case the surety is not discharged by the amendment. In re Bluestone Estate, 121 Mich App 659, 667, 329 NW2d 446 (1982). Harvard Drug Group, LLC v Linehan, 684 F Supp 2d 921, 936 (ED Mich 2010).
However, a recent decision from the United States District Court for the Eastern District of Michigan could potentially be used as authority to support the opposite position. In Pars Ice Cream Co, Inc v Conopco, Inc, the Court held as follows:
Although the personal guaranty stated that Traywick would be liable for “credit granted in the future by [Unilever] to [Pars Michigan],” she signed it while Pars Michigan and Unilever were operating in an open account arrangement. The Freezer Program Agreement and the Michigan and California Distribution Agreements significantly altered the nature of the business relationship between Pars Michigan and Unilever, adding additional rights and, more importantly, obligations to Pars Michigan that were not included at the time Traywick signed the personal guaranty.
Without Traywick’s acknowledgment, these changes constitute a significant alteration of the underlying agreement to which the personal guaranty applied and serve to discharge Traywick’s obligations under the personal guaranty.
Pars Ice Cream Co, Inc v Conopco, Inc, No. 12-15598, 2015 WL 4724734, at *4 (ED Mich August 10, 2015).
A similar argument could be made to preclude the enforcement of personal guaranties to future amendments using the doctrine of unconscionability. In order for a contract or contract provision to be considered unconscionable, both procedural and substantive unconscionability must be present. Northwest Acceptance Corp v Almont Gravel, Inc, 162 Mich App 294, 302, 412 NW2d 719 (1987). Procedural unconscionability exists where the weaker party had no realistic alternative to acceptance of the term. Allen v Michigan Bell Tel Co, 18 Mich App 632, 637, 171 N.W.2d 689 (1969). If, under a fair appraisal of the circumstances, the weaker party was free to accept or reject the term, there was no procedural unconscionability. Id. Substantive unconscionability exists where the challenged term is not substantively reasonable. Id. Clark v DaimlerChrysler Corp, 268 Mich App 138, 143–44; 706 NW2d 471, 474–75. To avoid any potential issues down the line, the landlord should demand an acknowledgement by the guarantor as a condition to any amendment or re-negotiation to a commercial lease.
Regardless of whether you are a landlord, tenant, or a guarantor involved in a commercial lease transaction, the personal guaranty should be reviewed, negotiated and/or eliminated altogether. It is imperative for landlords and business owners alike to be aware of the importance and ramifications of personal guaranties in such transactions.
Brandan Hallaq is an attorney with the law firm of Cummings, McClorey, Davis & Acho, P.L.C., in the firm’s Livonia, MI office where he focuses his practice in the areas of business and real estate law. He practices in state and federal courts handling a wide scope of real estate and business/commercial litigation matters. He also has experience preparing the necessary documents for business formation, purchases/sales of businesses, as well as negotiating and drafting contracts. Mr. Hallaq obtained his Juris Doctor degree cum laude from Wayne State University Law School and his B.A. degree cum laude in Political Science from Wayne State University.