When negotiating a lease, a landlord may require that the tenant provide security for the performance of the tenant’s obligations under the lease. Such security will typically be in the form of a cash deposit, a letter of credit, a guarantee or indemnity from a third party, or a combination of the foregoing. This article will address lease indemnity agreements and why landlords prefer them over lease guarantee agreements, and some minimum requirements to ensure that an indemnity agreement is drafted so that it is legally effective.
The principal reason that landlords prefer lease indemnity agreements over lease guarantees stems from the difference in liability between an indemnifier and a guarantor. An indemnifier assumes a primary liability, independent of the tenant, whereas a guarantor assumes only a secondary liability. The following explanation taken from an often-cited Canadian case1 succinctly describes this difference.
“In its widest sense a contract of indemnity includes a contract of guarantee. But, in the more precise sense…a contract of indemnity differs from a guarantee. An indemnity is a contract by one party to keep the other harmless against loss, but a contract of guarantee is a contract to answer for the debt, default or miscarriage of another who is primarily liable to the promisee.”
Therefore, a landlord may pursue an action against an indemnifier immediately upon default by the tenant, but must first pursue an action against the tenant before seeking recourse against a guarantor.
A secondary explanation for the preference for indemnities can be found in Canadian jurisprudence related to the effect of the bankruptcy of a tenant upon the obligations of a guarantor or an indemnifier. Until a 2004 decision of the Supreme Court of Canada2, it was generally accepted law that upon the bankruptcy of a tenant, all of the tenant’s rights and obligations under the lease, including its obligation to pay rent, passed to the trustee in bankruptcy. Accordingly, there were no lease covenants which the tenant was liable to perform and therefore a guarantor’s guarantee of the due performance by the tenant of its covenants under the lease became inoperative. While the Supreme Court of Canada decision is understood to have reversed the previous law and provides reassurance as to the enforceability of guarantees in bankruptcy situations, indemnities are still generally regarded as preferable security by most landlords.
In order to ensure that a lease indemnity agreement will be enforceable, several legal requirements must be met. Firstly, and perhaps most importantly, there must be “consideration”. Consideration is “some right, interest, profit or benefit accruing to the one party, or some forbearance, detriment, loss or responsibility given, suffered or undertaken by the other.”3 Many lease indemnity agreements provide that the consideration given by the landlord to the indemnifier for the indemnity is the landlord’s entering into the lease with the tenant. However, it would be advisable for the landlord not to rely solely upon such consideration, but to provide as a minimum, some minimal monetary consideration. If consideration cannot be shown to have passed from the landlord to the indemnifier, the indemnity agreement may not be enforceable.
Certain other clauses should be contained in every lease indemnity agreement. These would include:
- a promise by the indemnifier to perform the obligations of the tenant under the lease, regardless of tenant compliance with or default of its covenants contained in the lease
- confirmation that the obligations of the indemnifier include both the obligation to make all payments of rent and the obligation to perform all other covenants of the tenant under the lease
- a covenant that the indemnifier and the tenant shall be jointly and severally liable under the lease
- an acknowledgement that the indemnifier will be liable for all losses, costs or damages resulting from the tenant’s default or the disclaimer of the lease under any statute (e.g. bankruptcy laws)
- a covenant by the indemnifier that if the lease is terminated due to the tenant’s default, or disclaimed as a result of the tenant’s bankruptcy or other insolvency, the indemnifier may be required to enter into a new lease with the landlord on the same terms as the lease with the tenant for what would have been the balance of the lease term remaining, but for the tenant’s default or such disclaimer
Many additional clauses are typically found in lease indemnity agreements, and should be carefully considered when drafting the agreement. While perhaps not strictly required for the agreement to be effective, such clauses often clarify or expand the scope of the indemnity, or waive potential defenses which the indemnifier may seek to assert if called upon to honour its obligations under the indemnity.
There are pitfalls which may result in a lease indemnity agreement being found by a court to be unenforceable. While it is beyond the scope of this article to canvass all of them, an example would be a material amendment to the lease agreement agreed to by the tenant and the landlord which, if not consented to by the indemnifier, may result in the release of the indemnifier from its obligations despite language in the indemnity agreement to the contrary.
Another potential pitfall is the limitation period for seeking recovery on an indemnity agreement. Under the Limitations Act, 2002 (Ontario), no proceeding can be commenced in respect of a claim except within a period of two years after the claim is discovered4. Accordingly, a landlord may find itself unable to enforce a claim against an indemnifier under a lease indemnity if it does not commence an action in court to assert such claim within two years after the landlord “discovered” (i.e. became aware, or should have become aware) that it had a claim against the indemnifier.
A lease indemnity agreement can constitute valuable security for a landlord to ensure that a tenant will perform its obligations under a lease. Care must be taken in the drafting of such agreements, and in their enforcement, so that they will be effective to provide the landlord with the security it requires.