The Illusory Guaranty - International Law Office

A recent ruling by a New York appellate court in Madison Avenue Leasehold, LLC v Madison Bentley Associates LLC(1) has called into question the validity of many guaranties and other forms of security currently supporting leases in New York State. If the court's decision is generally applied, many guaranties and other security of any lease on which a tenant regularly pays rent late may not be enforceable.

Background

Because many commercial tenants create separate limited liability entities for each space they rent, a landlord will often be confronted with a tenant without significant assets. When the lease fails, so has the obligor and so does any chance the landlord had of enforcing its right to collect unpaid rent. It is common practice, therefore, for landlords to require a guaranty of, or other form of security for, the lease from a parent company or individual with more assets than the tenant. Often, the landlord and the tenant will agree to limit the guaranty (or security) by providing that it will not last for the full term of the lease, but will expire after the first few years of the term, as long as the tenant has not been in default (whether or not the default has been cured) prior to the date on which the guaranty (or security) is due to terminate. If a default has occurred prior to such termination date, the guaranty will stay in effect for the full term of the lease.

Case

In Madison Bentley Associates the tenant, a dealer in luxury automobiles, rented retail space in New York City pursuant to a lease with a term of 10 years. The lease required payment of rent on the first of every month, but provided for a 20-day grace period allowing the tenant to "cur[e] such default" before the landlord was empowered to take legal action to evict the tenant. The lease was guaranteed by two individuals who were principals of the tenant. The guaranty provided that:

"in the event the tenant shall not have been in monetary default under the lease at any time during the first three years of the lease, this guaranty and guarantor's [sic] obligations thereunder shall cease and terminate upon the third anniversary of the commencement date."

Like many tenants, the tenant regularly paid the rent after the first of the month, but before the end of the grace period. The landlord never protested the late payments. On September 29 2003, three years and three months after the commencement date of the lease and three months after the guaranty was scheduled to expire if there had been no default, the tenant stopped paying the rent and abandoned the premises. Early in 2004, the landlord commenced an action against the tenant and the guarantors to compel payment of the rent for the remainder of the term, as the terms of the lease provided.

The landlord argued that each late payment of rent constituted a default under the lease and that therefore the guaranty was still in effect. The defendant argued, first, that because of an ambiguity between the provisions of the lease and the guaranty, a default would have occurred only after the expiration of the grace period, so no default had occurred to extend the term of the guaranty. In the alternative, the tenant argued that the landlord had waived all defaults by failing to register a protest and making preparations to take legal action against the tenant each time payment was not timely made and that, once waived, such defaults could not be 'revived' for the purpose of keeping the guaranty alive.

Both the trial court and the appellate court sided with the guarantors and dismissed the case on the grounds that the landlord had waived the defaults and established a course of dealing by regularly accepting the late payments without protest. The court deemed irrelevant a provision in the lease stating that the landlord did not waive defaults by accepting late payments.

Comment

Because the Madison Bentley Case was prepared on a pre-printed standard form lease that is used in tens of thousands of transactions in New York every year, this case has wide application. What makes the case significant is that many tenants regularly pay their rent late and it is generally far too much of an administrative burden for landlords to lodge a protest if the rent is paid a few days late. In most cases the tenant has already posted the delinquent rent cheque and the rent will be received by the landlord before a protest notice could be delivered to the tenant. After Madison Bentley, landlords may now be faced with a difficult choice: they can either lodge an immediate protest of late payment (which will not only be an administrative burden but certainly will not improve relations with their tenants) or lose the guaranty on a lease (or other credit support, such as security, which expires in the absence of a default) by letting late payments be made without protest.

What is curious about the Madison Bentley decision is that the courts were given the opportunity to reach the same result while making a far more limited ruling, but chose not to do so. Since legal doctrine provides for documents to be construed against the party which drafts them, it would have been a simple matter for the courts to have interpreted the ambiguity between the lease and the guaranty against the landlord. Because the guaranty was not a standard form document, but rather one that was tailored to the specific transaction, the decision would not have called into question the status of so many lease transactions.

The court's opinion would apply equally to any form of credit support for a lease if that support had a similar early termination provision. Whether the support took the form of a guaranty, security deposit, security interest or some other right granted to the landlord, if the landlord has not asserted his rights upon being tendered late payment, it will lose those rights.

One can only assume that the court intended to have had the wide-ranging effect its ruling creates. If a lease is supported by a guaranty, security or other right which expires early in the absence of a default and the tenant has paid its rent late, even by one day, the landlord should send a letter reminding the tenant that:

• payments must be made on the due date;
  
  
• any payment after the date constitutes a default;
  
  
• the landlord has not waived the default by accepting the late rent; and
  
  
• the late payment has resulted in an extension of such support.

What this does for landlord/tenant relationships is best left unmentioned.

For further information on this topic please contact Thomas F Berner at Katten Muchin Rosenman LLP by telephone (+1 312 902 5200) or by fax (+1 312 902 1061) or by email (thomas.berner@kattenlaw.com).

Endnotes

(1) 811 NYS 2d 47 (1st Dept, 2006).