Use of guaranty as credit enhancement is gaining in popularity in many deals.

Use of the guaranty as a credit enhancement in leasing transactions has recently become a matter of heightened interest, as the use of limited liability companies and other sophisticated techniques for reducing recourse liability becomes widespread.

It is startling how many leasing transactions get derailed well into the drafting stage when the attorney becomes the first on the landlord's side to learn that the tenant has vanished in favor of a special purpose vehicle. The landlord, being familiar with the tenant and its principals, and having waived balance sheet and other financial due diligence, is now faced with an unknown, no doubt judgment-proof entity on the eve of the closing. The law in this state is clear that, absent fraud, knowledge of an entity's net worth as well as of the internal arrangements of its constituents to eliminate, reallocate or limit personal liability is imputed to a party dealing with the entity.

Where the landlord has priced the lease in reliance upon the credit of the tenant, the ready compromise is to insist upon a guaranty of a credit-worthy party, while oftentimes not focusing on the added risks and costs. Taking care to insure that the guaranty will be enforceable to the extent of the landlord's expectations is the purpose of this article.

Our law is well enough established to at least point to the problems, if not the solutions, relating to the enforcement of lease guaranties, The most frequent type of problems arises in a bankruptcy affecting the tenant or the guarantor. The guarantor will argue that since the muniment of its obligations arises through the tenant, it is entitled to bootstrap the protections afforded the tenant under the Bankruptcy Code. While some courts have held the guarantor liable for the full performance of the tenant's covenants under the lease as originally written (not the lease as re-written in the bankruptcy court), other bankruptcy cases have held that the Code limitations on the amount of rent and the length of time a tenant can be held liable limit the obligations of the guarantor as well.

Fortunately for landlords, there is a recent case which holds that a guarantor in bankruptcy cannot avail itself of such Bankruptcy Code protections, since these are expressly restricted to tenants. In any case, the document preparer should include language making clear the primacy of the guaranty in the underlying pricing of the transaction in order to best position the landlord should a tenant file for bankruptcy protection.

As would be expected, the preponderance of guaranties are issued by persons or entities related to the tenant. A frequent defense raised by related guarantors is lack of adequate consideration for the guaranty, or that absence of board approval or adherence to corporate formalities vitiates the guaranty. (New York statutes such as the UCC, which give effect to a recital of consideration in the documents even though consideration itself is lacking, do not apply to real estate transactions.)

However flimsy are these defenses, at very least they will shift to the landlord the burden of establishing that the guaranty is enforceable. Counsel should require complete underlying documentation fully reciting the level and nature of the consideration, and verifying proper board approval of the guaranty and authorizing its execution and delivery. In larger transactions, due diligence steps beyond the face of the papers should also be considered.

The law underlying guarantor liability rests on the bedrock concept that the guarantor stands as surety for the principal when called upon by the beneficiary to perform. Sounds good, but pitfalls abound. Defenses arise whenever any of the principals obligations are altered, however slightly. Not only is the guarantor in such a case able to open the door to admitting parole evidence undercutting the clear language of the guaranty waiving such a defense, the guarantor may be discharged entirely under the guaranty.

These concerns are heightened where the guaranty covers performance as well as payment.

Take as an example premises being constructed or upfitted for the tenant. Courts in this case are likely to sympathize with a guarantor who, while called upon to complete the work, is not permitted to mitigate their losses. Questions the court may ask are, is the guarantor emitted under the documents to take possession of the leased premises? Is it clear from the lease that loan proceeds will be available to the guarantor in order to complete the work, free of liens and on time as most leases require? Will subcontractors be obligated to perform for the benefit of the guarantor? Many courts take the view that these rights are personal to the tenant, and therefore deny injunctive relief against the guarantor, limiting the landlord to damages.

Unfortunately, damages may be insufficient to compensate the landlord or may be impossible to compute within the framework of the litigation. Indeed, the court, on similar equitable grounds, may rule that the whole picture has changed so greatly that it would be unjustifiable to hold the guarantor to the guarantee, fully discharging him from the liability.

In summary, it is imperative that the papers be tailored to the particulars of the transaction. While most guaranty forms attempt to speak to the problems, blind trust most often is too little, too late, leaving the landlord without meaningful recourse.

Mark Schwarz, Attorney-at-Law, Law Offices of Mark Schwarz