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As we live through these unique circumstances of the COVID-19 Pandemic, it is timely to reflect on personal guarantees in Commercial Leases.
In the current environment and more than ever, it is important to understand the seriousness and the risk that personal guarantees can have on businesses currently leasing or intending to enter into leases once the COVID-19 restrictions are eased and we return to some form of normality.
But before we look at personal guarantees during COVID-19, we need to understand what is a personal guarantee?
A personal guarantee is exactly that, a guarantee from directors and/or shareholders personally that undertake that the obligations of the lease will be fulfilled by the lessee for the entire period of the lease and in some circumstances beyond that. It is in fact common that in commercial leases (whether retail or industrial) where the lessee is a company or a corporate trustee, that the lessor may request the individual business owner or owners to guarantee the lessee’s obligations by way of that personal guarantee. A common guarantee clause in a lease may read “the guarantor will pay the lessor on demand any rent and all other moneys owed to the lessor at any time hereunder…” In the event of default by the lessee, personal guarantees would require the guarantors to pay the amount of any default to the lessor. Consequently, under such circumstances not only does the business fail (eg. the company is forced into liquidation) but now the guarantor personally also owes the remaining balance of the rent.
We all know that lessors do carry risk when they lease commercial space. Often they are required to do some work to the premises, provide a leasehold improvement allowance, and pay real estate commissions. Even in cases when they do not have much cash outlay, they still want to find credit-worthy lessees to lease their space and not have to worry about always marketing their vacant properties. They would love to have both the business and the director or shareholder personally on the lease.
So does a director or a shareholder of company or a corporate trust have to sign a personal guarantee? Not at all. This really just comes down to leverage. Securities for commercial leases can always be negotiated with the lessor at the start of the lease. When negotiating a lease it is important to offer an optional security such as a Bank Guarantee, a Cash Bond or any other form of commercially acceptable security. Negotiations may also include increasing the security deposit or bank guarantee or in worst case scenario reducing the person’s liability under the personal guarantee by agreeing to a certain amount.
A 2018 lessor v lessee case, illustrates the financial risk that company directors take when giving personal guarantees under a retail lease.
The company directors in the case NE2 Pty Ltd v P.T. Ltd gave unlimited personal guarantees, exposing themselves to potentially ruinous losses.
In this case, handed down in the Court of Appeal on 14 February 2018, a lessee entered into a lease for a fresh fruit and vegetable shop in the Westfield Centre, Miranda. The directors of the lessee guaranteed the lessee’s obligations under the lease. When the tenant defaulted on paying rent, the lessor terminated the lease and brought proceedings to recover damages from both the company and the directors. The lessee disputed the termination and damages claimed by the lessor alleging that the lessor had promised that their shop would be the only fresh fruit vegetable retained in the precinct of the shopping centre. The lessee claimed that this representation was ‘false and misleading’ as Franklins opened up next door selling fresh fruit and vegetables. On appeal, it was determined that the lessor did not make express or implied representations as claimed by the lessee. Further, it was held that the landlord had no duty to disclose that Franklins would soon also become a lessee of the shopping centre and would also retain fresh fruit and vegetables. The lessor was therefore entitled to retrieve arrears in rent up to the date of termination, lost rent from that date until 10 November 2015 (when a new lessee moved into the premises) and the cost of removing the lessee’s fixtures and fittings. These damages were approximately $3,900,000. PT Ltd subsequently pursued the directors for the debt personally and commenced bankruptcy proceedings in an attempt to recover the debt when the lessee company could not and did not pay.
Whilst many lessors view the personal guarantee as an added assurance of performance of those lease obligations, because the guarantor is personally committed (and potentially faces bankruptcy if they cannot honour the guarantee), lessors need to realise that, the “personal guarantee is only as valuable as the worth of the individual giving it”. Hence where that leverage is fundamental. In fact if the guarantor owns no assets of value, have assets that are not liquid or have assets that are heavily financed, the guarantee may not be worth enforcing. This may be even more the case as businesses and personal assets of the individual entrepreneur and guarantor are impacted heavily by the effects of COVID-19.
Despite the known fact that personal guarantees are a risky business as seen in many occasions similar to NE2 Pty Ltd v P.T. Ltd, and the old saying “A guarantor is nothing but a fool with a pen” continues to apply, it remains to be seen to what extent those personal guarantees will be enforced by lessors if those leases are defaulted upon in the next 6 months, and probably beyond, as COVID-19 restrictions linger.
On 7 April 2020 the Federal Government introduced a mandatory commercial tenancies code the “NATIONAL CABINET MANDATORY CODE OF CONDUCT – SME COMMERCIAL LEASING PRINCIPLES DURING COVID-19” (“the Code”).
This Code has been established to guide lessors and lessees through these difficult times and in the eventuality of disputes including that of unpaid rents or any essential lease terms. The question remains “What happens to a personal guarantee in case of default by the lessee?”
Amongst the 14 Leasing Principles established by the Code, there is principle no. 11 “Landlords must not draw on a tenant’s security for the non-payment of rent (be this a cash bond, bank guarantee or personal guarantee) during the period of the COVID-19 pandemic and/or a reasonable subsequent recovery period.” We would assume that those personal guarantees will not be called upon by the lessor for at least the next 6 months referred to in the Code. Nevertheless, those personal guarantees continue beyond that period, even if the lease was to expire during those 6 months, the guarantor remains responsible as it entered into a covenant with the lessor for the lessee’s compliance of all obligations. The lessor can at any time act upon those personal guarantees to enforce its rights pursuant to the default and guarantee provisions of the lease.
However, unlike a bank guarantee (in normal circumstances, unlikely during COVID-19), which can be called upon relatively simply by visiting a bank branch and making a request for a drawdown, a personal guarantee needs to be enforced. This may involve a process of issuing a statutory demand against the guarantor and then by bringing Court proceedings to pursue the guarantee as a debt. This will likely involve a time delay and an outlay of expenses (Court fees and legal costs) before any funds flow from the guarantor. This process now also needs to take in consideration the recent temporary changes to bankruptcy law made by the Australian Government on 25 March 2020 in which:
- Debt threshold for creditors to apply for a Bankruptcy Notice against a debtor will increase from $5,000 to $20,000.
- Timeframe for a debtor to respond to a Bankruptcy Notice before a creditor can commence bankruptcy proceedings will be increased from 21 days to up to six months.
- Temporary protection period procedure available for debtors to prevent recovery action by unsecured creditors will increase from 21 days to six months.
Those provisions to the bankruptcy law should not be used (or abused) as a safety net by a personal guarantor in commercial leases. One cannot simply say “the Lessor will not sue me and send me bankrupt for at least six months”, but rather need to be treated carefully and not be taken advantage of. Let’s be reminded that these are only temporary provisions to prevent the current COVID-19 affecting even further the business relationships and environment in which we live in. Further the Code states that its purpose is to “impose a set of good faith leasing principles for application to commercial tenancies”. Let’s not run into the risk of a false sense of security and abuse the extent of (or delay of) enforcement of those personal guarantees by lessors but always be mindful that no matter what and no matter when personal guarantees are a risky business.
You can refuse to provide a personal guarantee in your next commercial lease. However, the lessor may require and insist on one before you sign the lease. Companies and their directors are once more advised to obtain legal assistance before entering into a leasing arrangement and seek independent advice regarding the extent of their personal obligations under a guarantee.
SLF Lawyers can assist you with regards to commercial leases, personal guarantees, negotiating terms and giving you any necessary advice. Contact Fabio Orlando on 07 38398011 or by email at forlando@slflawyers.com.au
