Out-Law Guide 7 min. read
19 Dec 2011, 5:10 pm
A landlord is likely to consider the requirement for a guarantor as part of the proposed terms of a new lease. Where the tenant's financial strength is insufficient to convince a landlord that the tenant will be able to pay the rent and comply with repairing and other covenants throughout the term, a landlord may still decide to grant a lease to such a tenant, but on condition that the proposed tenant can provide a third party of sufficient financial strength to guarantee the tenant's obligations.
Parties rarely stop to consider whether they should be seeking a guarantee from the third party or a guarantee and an indemnity, or even realise there is a distinction between the nature of each obligation.
In fact, there are some significant differences between them and in particular differences in principle; how they are created; the effect of variations of the lease during the term; and the discharge of the obligations. This article deals with each of these matters, but does not cover the liability of guarantors following the assignment of a lease or the impact of the Landlord and Tenant (Covenants) Act 1995, or liability following forfeiture or expiry of the contractual term, which are outside its scope.
Why this matters
Where market conditions are poor, a landlord will want to have the benefit of the extra security given by having a guarantor of the tenant's obligations under a lease. In commercial leases, the guarantor will often be a parent company which may be able to offer a better covenant strength.
In general an indemnity creates a primary obligation and a guarantee creates a secondary obligation. But the importance of the distinction really only comes to the fore when a landlord is seeking to obtain payment from a guarantor once a tenant has defaulted.
At this point, a landlord may discover that a guarantor has a good defence to the claim on the basis there has been a substantial variation to the lease and it is therefore released from liability. However, if the guarantor also gave an express indemnity covenant, this would not be affected by a variation of the lease and would remain enforceable.
Care should therefore be taken when drafting a lease on behalf of a landlord to include a separate indemnity covenant as well as a guarantee, so that the landlord has the benefit of both and there is no difficulty of interpretation or argument as to the nature of the obligations created.
Practitioners should also check whether there is a guarantee before agreeing or documenting any variation of the lease on behalf of the landlord and, if so, obtain the written and signed consent of the guarantor to the variation.
In practice, solicitors acting for tenants also negotiate and advise on the terms of a guarantee on behalf of the guarantor, because the tenant and guarantor are frequently related companies. In this situation, solicitors should consider whether there is any conflict of interest and whether they need to advise the guarantor to obtain separate representation.
When advising a guarantor, it would clearly be appropriate to seek to exclude any indemnity covenants and to oblige the landlord to notify the guarantor of any default, so that the guarantor can bring pressure to bear on the tenant at an early stage.
Basic distinction between an indemnity and a guarantee
Modern leases tend to include two separate covenants, one a covenant to guarantee and a second indemnity covenant. This benefits the landlord because it makes it more difficult for the party giving the guarantee and indemnity to argue that the obligation created is just a guarantee. However, disputes could still arise as to the nature of the obligation created and the distinction is one of substance, which will not be decided on the language alone.
An indemnity is a primary obligation. It is an express obligation to compensate someone for loss or damage and is independent of the obligations of the party whose covenants are being reinforced by the provision of the indemnity.
A guarantee is a secondary obligation. A guarantor will only be liable on a guarantee if the party whose obligations have been guaranteed has failed to perform its primary obligations.
An indemnity has advantages over a guarantee because of the primary nature of the obligation which will become clear below.
Creation of indemnities and guarantees
In order for a guarantee to be valid it must meet certain requirements.
A guarantee must be:-
There are no formal requirements for creating a valid indemnity, so it could be oral, or in writing but not signed. However, an indemnity would still have to meet the requirements for a valid contract as it (in common with a guarantee) is only enforceable as a contractual obligation. Therefore, there must be offer and acceptance, and consideration. In addition, the parties must have intended to enter into a legal relationship with each other.
Because the agreement by the guarantor/indemnifier in relation to a lease is generally contained in the lease itself and commercial leases are executed as deeds, problems about whether or not a guarantee and/or indemnity has been validly created rarely arise in practice.
In a recent case between Trustees of Beardsley Theobalds Retirement Benefit Scheme and Joshua Yardley, though, the court found that even if the lease was unenforceable as a deed, it would still have been enforceable as a contract in writing, so long as the landlord could show that that contract was supported by consideration. The consideration was the landlord granting the lease, which was the detriment moving from them, on terms that the lessee procured a guarantor of the rent who was a director of the lessee company, which is the benefit moving from both the lessee and the guarantor.
Similarly the question of whether the guarantee or indemnity complies with the basic contractual requirements is answered by their being created by deed.
Consequently, the issue of whether or not there is a valid guarantee is more likely to arise in the context of a commercial landlord/tenant situation where a tenant is in occupation without having executed a lease - for example, where a landlord has allowed a tenant into occupation before a lease has been executed possibly with heads of terms in writing or correspondence between the landlord and tenant, including reference to a guarantor. It is unlikely that the guarantor will have signed the heads of terms, with the result that the landlord will not have the benefit of a valid guarantee. Equally, it is very unlikely that an indemnity would have been given orally by a third party directly to the landlord and, even if it had, the landlord would face the evidential problem of proving that the conversation took place. It would also have to prove the basic contractual requirements mentioned above.
Variations to the terms of a lease
A guarantor's liability is linked with the underlying obligations of the tenant. This means that care must be taken where the terms of the lease are varied. A guarantee will be discharged if there has been any substantial variation in the terms of the lease without the consent of the guarantor. Therefore, consent in writing should always be obtained.
This principle does not apply to an indemnity since this is a primary liability. The variation of a lease will not discharge the obligations of the person that has given the indemnity. Nevertheless it would be prudent to obtain the consent of the indemnifier to the variation. In practice, where the guarantor of a tenant's obligations has also given an indemnity covenant and has consented in writing to the variation, no further agreement is required.
Guarantors have been released from liability under guarantees in the following circumstances:-
If a landlord allows a tenant to pay rent late without obtaining written and signed consent from the guarantor, this may be seen as 'giving time' to the tenant which may operate to discharge the guarantee (although the position may be different if the lease states that the guarantee will not be affected by any time given by the landlord to the tenant to make payments).
However, a variation which is not substantial (ie one which does not affect the terms of the principal obligations and is self-evidently beneficial to the guarantor) will not affect the guarantor's secondary contract. This was established in a case between Metropolitan Properties Co Regis Ltd and Bartholomew in 1995.
From a litigator's point of view, variation of the terms of a lease is one of the first things considered when advising a landlord or guarantor in relation to the guarantor's liability because this can provide a good defence to a guarantor. However, if the guarantor also gave an indemnity, it will not have a defence to a claim under the indemnity on the grounds of variation. The importance of the indemnity is clear in this situation.
Discharge of obligations of guarantor and indemnifier
In general terms, if the tenant is discharged from performance of its covenants by the landlord the liability of the guarantor will also be discharged. This is not the case with an indemnity.
The situation on the tenant's insolvency is of particular interest in the current economic climate. To summarise the position, neither the bankruptcy of a tenant who is an individual nor the liquidation of a tenant company will release a guarantor.
However, if a liquidator disclaims the lease (on the basis it is 'onerous property'), the House of Lords has confirmed in a case of between Hindcastle Ltd and Barbara Attenborough Associates Ltd in 1997 that a disclaimer operates only in relation to the liability of the company to which it relates, i.e. the tenant, and does not affect the liability of any third party such as a guarantor.
Therefore a guarantor will remain liable following disclaimer, as will an indemnifier.
For the reasons set out above, the inclusion of an express indemnity covenant in a lease will have 'teeth' in certain situations and guarantors should be advised of the implications of giving a guarantee and indemnity. Landlords should also be warned not to agree variations of lease terms without obtaining the written and signed consents from guarantors.
This guide is based on an article which first appeared in Estates Gazette in December 2011