Who is your tenant? This should be the first question asked by any landlord that is about to commence negotiating a letter of intent for a commercial lease. The value of any lease is dependent on the credit of the tenant and any guarantors, and the tenant’s financial ability to pay the rent that is owed during the entire term of the lease. Many companies operate under numerous entities, some of which are formed only to be the tenant under a specific lease. If a default occurs, the landlord will only be able to sue the entity that executes the lease as a tenant and any guarantor of the tenant’s obligations, unless the landlord is able to “pierce the corporate veil”, which is a difficult task as discussed below.
The landlord should request audited financial statements for the entity that is proposed to be the tenant on the lease, and should check the applicable state records to confirm that the entity is formed and in good standing. The financial statements should be for the exact entity at issue, and not a parent, subsidiary or other affiliate. These affiliates will not be liable for any default under the lease, so such financial statements are not relevant to the financial strength of the tenant and, as a result, the value of the lease.
If there is a tenant default, the landlord can attempt to sue the owner or parent entity of the tenant through “piercing the corporate veil”; however, this is not an easy task. Although each state has different legal requirements, many states have a strong presumption against piercing the corporate veil. Factors that are sometimes considered in this evaluation are failing to adhere to corporate formalities, undercapitalizing the entity, substantially intermingling personal affairs with the entity, and using the entity to perpetrate a fraud. A landlord should not enter into a lease with the assumption that it will be able to sue a parent entity or owner for a tenant’s default.
If a tenant is insisting on using an entity that does not have sufficient financial strength, the landlord can require an owner or other entity to guaranty the tenant’s obligations under the lease. The same evaluation process for the tenant’s financials should be performed in evaluating the guarantor’s financials.
In the event a tenant or guarantor will be an individual, the applicable state laws should be reviewed to determine what assets will be subject to a judgment in the event a landlord is successful in obtaining a monetary judgment as a result of tenant default. Some states require that both the husband and the wife must be the tenant or guarantor in order to execute against any assets that are owned jointly by both individuals (for example, a residence or joint bank account).
The financial evaluation of a tenant and any guarantors at the commencement of lease negotiations is a critical step in negotiating a lease, and each landlord must clearly understand who will be liable for any tenant default.