Securing Tenants’ Obligations: Cash is King, Right?

Tenants often need to provide some financial assurance, commonly known as security, to ensure they fulfill their obligations under a commercial lease. Two widely used forms of security are the cash security deposit and the standby letter of credit.

Cash Security Deposit: The cash security deposit is a common way of securing a tenant’s obligations in a commercial lease. As anyone who has rented an apartment knows, with a cash security deposit, the tenant is required to make a lump sum payment to the landlord (often upon execution of the lease). This amount, held by the landlord, serves as a readily accessible pool of funds to be used by the landlord in the event of tenant default (e.g. not paying rent) or returned to tenant following expiration or sooner termination of the lease.

Standby Letter of Credit: Perhaps less familiar than a cash deposit, the standby letter of credit is another common form of security. Here, the tenant requests a letter of credit from a bank, which guarantees payment to the landlord in case of tenant default up to the face value of the letter of credit. To obtain this, the tenant usually needs to provide collateral in an amount equal to face value of the letter of credit.

Note re Tenant Bankruptcy: A crucial difference between a security deposit and a letter of credit comes into play when a tenant petitions a court for bankruptcy relief. Generally speaking, if a tenant files for bankruptcy, an automatic stay prevents the landlord from using a security deposit without the consent of the bankruptcy court (or trustee). In contrast, a well-drafted letter of credit is often considered outside the tenant’s bankruptcy estate, allowing the landlord to access the funds without participating in the bankruptcy proceeding.

Tenant Considerations: Tenants hesitant to make a substantial cash deposit to their prospective landlord (or sublandlord) should explore utilizing a letter of credit. A properly drafted letter of credit may limit the landlord’s access to funds by requiring documentation substantiating landlord’s claim that the tenant has defaulted before releasing the funds. This adds some layer of protection between the landlord and the funds (as opposed to the funds sitting in landlord’s account, accessible at-will). This may be especially a consideration in the subleasing context where the reason for subleasing the space might be a gloomy financial outlook for the sublandlord.

Other Considerations for Commercial Leases: Both landlords and tenants should consider various factors when negotiating the form of security to use in their next commercial lease, including:

• The bank’s fees for issuing a letter of credit.
• Legal fees associated with reviewing the letter of credit or preparing draw requests.
• The threshold required before the bank disburses funds through the letter of credit.
• Amount (or face value) of the security desired.
• Term of the lease.
• Creditworthiness of landlord, sublandlord, and tenant.

It should be noted that his blog post is merely a general discussion of potential legal issues and provided for educational purposes only. It should not be construed as the legal advice or recommendation of this author this blog, or the firm that you rely on the information contained herein. For questions about such topics and negotiating your commercial lease, reach out to the real estate team at Milgrom & Daskam.