Recommendations for Commercial Landlords
An important consideration for commercial landlords when negotiating a lease with a prospective tenant is the “strength of the tenant’s covenant”, or, in other words, an assessment of the prospective tenant’s ability to comply with and perform the terms and covenants under the lease. Some prospective tenants may be well-established businesses with a long track record of success.
- But what about prospective tenants that do not have a history of profitability, for example, those that have been newly incorporated?
- What if the market or industry of the prospective tenant is in a downturn?
In circumstances where covenant strength is a concern, landlords can negotiate the requirement that a third party pledge to honour the tenant’s lease covenants in the event that the tenant defaults in performing the same. This pledge is typically provided through an indemnity and/or a guarantee.
Key Differences between Guarantees and Indemnities
An indemnity is a contractual promise by an indemnifier to accept liability for loss sustained by another party. In the context of commercial leasing, a third party can agree to indemnify the landlord in the event the landlord sustains losses or incurs costs of any kind, even if the tenant has not defaulted in performance of its obligations under the lease. An indemnity is considered a primary obligation because it requires payment even if the underlying lease (or any part thereof) becomes void or unenforceable, meaning that the indemnifier remains “on the hook” for any losses sustained or costs incurred by the landlord even if the tenant is no longer bound by the terms of the lease.
A guarantee is a contractual promise by a guarantor to meet the tenant’s obligations under the lease if the tenant fails to do so. A guarantee is known as a secondary obligation because a guarantor’s liability will never be greater than that of the tenant’s under the lease. If the tenant’s liability is reduced or extinguished, the guarantor’s liability can be correspondingly reduced or extinguished. If the underlying obligation is amended, the guarantee may be lost altogether.
Which to Choose and When?
At first glance, the indemnity would appear to be the most protective choice, given the direct contractual connection between the indemnifier and the landlord independent of the tenant. Pre-2004, the leading decision on this issue led many landlords to choose indemnities over guarantees, as it held that when a lease was disclaimed under bankruptcy proceedings, it also had the effect of terminating the guarantor’s obligations to honour the tenant’s covenants under the lease. There was suggestion that landlords should seek indemnities or joint covenants so that landlords had a “primary debt” against the tenant and the indemnifier.
However, in 2004, a Supreme Court of Canada overruled that decision by finding that lease repudiation only benefits the insolvent tenant and does not protect third parties, such as assignors and guarantors, who will remain liable for performing the tenant’s covenants under the lease. This decision provided welcome reassurance to landlords as to the enforceability of guarantees in the context of tenant bankruptcies.
Indemnities and guarantees are not mutually exclusive and can be combined with additional security, such as security deposits or letters of credit, to ensure the landlord is best protected if issues with the tenant arise. To this end, we recommend that landlords secure tenants’ covenants-particularly financial ones-through guarantees, as there is extensive caselaw supporting the enforcement of guarantees even in the context of a tenant’s bankruptcy. Indemnities, on the other hand, are better used for covering the performance of non-financial obligations (e.g. environmental indemnities).
Though there are commonly known defences to the enforceability of guarantees (e.g. the landlord has conducted itself in a way which has the effect at law of releasing the guarantor), extensive and well-drafted guarantees can effectively remove these defences and position the guarantor as the primary obligee-essentially making the guarantor a co-debtor of the tenant.
A final point to consider is the importance of compliance with Alberta’s Guarantees Acknowledgment Act (the “GAA”) when obtaining a personal guarantee from a tenant’s principal to secure the lease, or when obtaining certain indemnities from the tenant’s principal which are, in substance, personal guarantees. Alberta is the only jurisdiction in Canada which legislatively requires that guarantees provided by people (not corporations) which are executed, delivered, or which may need to be enforced in Alberta, must be properly acknowledged by the guarantor in front of a lawyer. If this requirement is missed, the guarantee is not legally enforceable. Thus, when considering what security to obtain from a third party individual which is not a corporation, it is of the utmost importance that commercial landlords turn their minds to the requirements under the GAA.
Conclusion and Takeaway Points
Commercial leases are highly customized contracts and the recommended type of security to be obtained from the tenant in each instance will depend on numerous factors.
For citing references, guidance on what security to require in which instances, and assistance with drafting guarantees that best protect your interests while ensuring compliance with Alberta’s Guarantees Acknowledgment Act, if applicable, please contact Jenaye Lewis. Click here to learn more about Swainson Miki Peskett LLP’s Real Estate and Lending Team.
Material in this article is available for information purposes only and is a high level summary of the subject matter. It is not, and is not intended to be, legal advice. You should first obtain professional legal advice prior to taking any action on the basis of any information contained in this article. This article is copyrighted. For permission to reproduce this article, please email Swainson Miki Peskett LLP.