Strategies for Securing Against Tenant Defaults

Early Warning Signals

Care must be taken to confirm that the lease contains covenants binding the tenant to various obligations running from the monetary, such as paying rent, real estate taxes, utility charges and insurance premiums, to the non-monetary, such as keeping the property secured and properly maintained. Careful lease administration includes the constant monitoring of the tenant's performance to determine whether the tenant is keeping up its end of the bargain. It is not uncommon that a tenant will begin to fall behind in its maintenance obligations when it is experiencing economic hard times. Similarly, the tenant will fall behind in the timely payment of expenses that are to be paid directly by the tenant to third parties, such as the utility charges, insurance premiums and real estate taxes (if the premises are separately assessed). These types of defaults may be a precursor to the tenant's default in the payment of rent and other monies to the landlord.

Leases will typically require the tenant to provide the landlord with evidence that the real estate taxes and insurance premiums have in fact been paid when due. In net leases where the tenant occupies only part of the building or complex of which the premises are a part, the tenant will pay its proportionate share of those expenses in monthly installments so that the monies collected from all of the tenants of the property provide a fund of adequate size to allow the real estate taxes and insurance premiums to be paid by the landlord when due. In gross leases, the landlord is responsible for the payment of the taxes and insurance premiums, having theoretically collected the amount needed to make this payment from the tenants as part of their rent payments. The landlord's lease administration department should make sure that the tenant is honoring its obligations and making required payments. Lease provisions that allow the landlord to know that the tenant may be in financial difficulty sooner rather than later may give the landlord an advantage. Merely knowing of an impending default situation earlier rather than later may enable the landlord to react to market opportunities, have more time to secure a replacement tenant, and stop making additional investments in the existing tenant by allowing lease extensions or premises expansion. In the best of circumstances, early warning of impending problems may allow the landlord to take collateral to secure the tenant's performance or seek other protection.

The additional time will also allow the landlord to determine whether the tenant's business is in a slump that results from the depressed state of the economy and that there is a reasonable expectation that the tenant's business will improve when the economy improves, or that there is a fundamental and irreversible problem with the tenant's business. The type of response that is warranted in one situation will not be appropriate in the other situation.

Security For Tenant's Obligations

There are several types of security that the landlord may take to protect itself from the economic effect of the tenant's failure to perform its obligations in a timely fashion. While it is rare that these security devices will totally protect the landlord from the full economic impact of a default by the tenant under all of its monetary and non-monetary obligations, these devices will often provide the landlord with substantial protection against a tenant default. Security measures include:

• a guaranty from a creditworthy party,
• a security deposit – whether in the form of a cash deposit, the receipt of liquid collateral in lieu of cash, or a letter of credit,
• a security interest in the tenant's property,
• a landlord's lien, and
• a bond from an insurance company.

From the landlord's perspective the operative concept is the availability of liquid collateral. The landlord wants cash, or something that can be quickly converted into cash to satisfy the tenant's obligations. For this reason, cash security deposits, letters of credit and marketable securities are the favored form of the tenant's credit enhancement. Landlords do not favor time consuming and expensive procedures to obtain cash, such as claims against insurance companies, the need to resort to foreclosure or UCC sale procedures to obtain cash in replacement of the posted security, or worse yet, litigation.

Guaranty. The guaranty is a familiar security device. Obviously, it is only as good as the creditworthiness of the guarantor. The guaranty is not without its shortcomings, however. Even if it is entirely valid and enforceable, unless the landlord is faced with the rare occurrence in which it presents an itemization of its losses to the guarantor and payment is immediately made, the landlord typically must resort to litigation to collect.

While the tenant's bankruptcy will not result in an automatic stay against the enforcement of the guaranty, it is often the case that the bankruptcy filing affects not only the tenant, but also the tenant's affiliates and related organizations. In the instance of a guaranty by a parent entity, it is often the very existence of intertwined financial relationships with subsidiaries and affiliates that causes the financial difficulty and resultant restructuring or liquidation that affects the entire family of related entities.

Once in litigation, the possibility of defenses to the enforcement of the guaranty presents itself. Could the guaranty be set aside as a fraudulent transfer? Are any of the defenses available in this fragile suretyship-like relationship available to frustrate the landlord? While the guarantor may have been creditworthy at the time the guaranty was made, will the guarantor continue to have the same financial strength at the time of the enforcement of the guaranty? Have any of the protections available to the guarantor under the guaranty, such as limited recourse provisions or burn-offs, made the guaranty less valuable at the time of the tenant's default under the lease?

Careful structuring and drafting, and careful administration of the lease prior to and after the tenant's default may avoid some of these dangers. While not much can prevent the delays caused by the judicial system, the inclusion in the guaranty of forum selection, jury trial waivers, and choice of law provisions helps. To prevent a fraudulent transfer issue, the guaranty should be made by a party that will receive tangible benefits from the making of the lease, eg, a parent corporation whose subsidiary tenant will use the space to produce products, provide services or sell merchandise intended to generate profits that will inure to the benefit of the parent entity.

Security can be given for the guarantor's obligations in appropriate circumstances. By taking a mortgage on, or security interest in, the guarantor's assets, the landlord may be able to secure itself against the nonpayment of the guaranteed obligations. Even if it is possible to negotiate the collateralization of the guaranty, it is difficult sometimes to find assets of the guarantor that are not already encumbered and are readily available to new secured creditors without the consent of existing creditors of the guarantor.

Guarantees, like letters of credit, offer some material benefits to the landlord in the event of the tenant's bankruptcy, as long as the guarantor itself is not also a debtor in a bankruptcy proceeding. The statutory ceiling on the amount of damages that a landlord may receive as a result of the rejection of a lease in bankruptcy does not apply to actions against the guarantor of the tenant's obligations.

This article will conclude with a discussion of the use of security deposits, prepaid rent, letters of credit and lease bonds to protect a landlord from a defaulting tenant.

This two-part article describes some of the strategies that a landlord might utilize to protect itself from the impact of a tenant default or bankruptcy as it structures leasing transactions. The realization that landlords have become more security conscious will cause tenants to prepare themselves better to structure a deal that will accommodate the landlord's needs with the least possible burden.

In the past, landlords and their lawyers did not focus on the need for protection from the effects of a tenant default where the tenant was financially strong and well established. The belief that they were dealing with high-credit tenants gave landlords comfort against the economic consequences of default. The fallout from the failures of the likes of Enron and Arthur Anderson caused landlords to exercise a renewed caution in their dealings with even the strongest of prospective tenants, and of course, the subsidiaries and affiliates of those entities.

The protection of the landlord's interest begins with the review of the lease provisions to measure the tenant's performance of its monetary and non-monetary obligations and moves on to the analysis of the lease's default provisions and economic security devices such as security deposits and letters of credit. The first part of this article will discuss the early warning signals and the use of guaranties to protect the landlord. The conclusion will describe several other devices available for the landlord's protection.

Early Warning Signals

Care must be taken to confirm that the lease contains covenants binding the tenant to various obligations running from the monetary, such as paying rent, real estate taxes, utility charges and insurance premiums, to the non-monetary, such as keeping the property secured and properly maintained. Careful lease administration includes the constant monitoring of the tenant's performance to determine whether the tenant is keeping up its end of the bargain. It is not uncommon that a tenant will begin to fall behind in its maintenance obligations when it is experiencing economic hard times. Similarly, the tenant will fall behind in the timely payment of expenses that are to be paid directly by the tenant to third parties, such as the utility charges, insurance premiums and real estate taxes (if the premises are separately assessed). These types of defaults may be a precursor to the tenant's default in the payment of rent and other monies to the landlord.

Leases will typically require the tenant to provide the landlord with evidence that the real estate taxes and insurance premiums have in fact been paid when due. In net leases where the tenant occupies only part of the building or complex of which the premises are a part, the tenant will pay its proportionate share of those expenses in monthly installments so that the monies collected from all of the tenants of the property provide a fund of adequate size to allow the real estate taxes and insurance premiums to be paid by the landlord when due. In gross leases, the landlord is responsible for the payment of the taxes and insurance premiums, having theoretically collected the amount needed to make this payment from the tenants as part of their rent payments. The landlord's lease administration department should make sure that the tenant is honoring its obligations and making required payments. Lease provisions that allow the landlord to know that the tenant may be in financial difficulty sooner rather than later may give the landlord an advantage. Merely knowing of an impending default situation earlier rather than later may enable the landlord to react to market opportunities, have more time to secure a replacement tenant, and stop making additional investments in the existing tenant by allowing lease extensions or premises expansion. In the best of circumstances, early warning of impending problems may allow the landlord to take collateral to secure the tenant's performance or seek other protection.

The additional time will also allow the landlord to determine whether the tenant's business is in a slump that results from the depressed state of the economy and that there is a reasonable expectation that the tenant's business will improve when the economy improves, or that there is a fundamental and irreversible problem with the tenant's business. The type of response that is warranted in one situation will not be appropriate in the other situation.

Security For Tenant's Obligations

There are several types of security that the landlord may take to protect itself from the economic effect of the tenant's failure to perform its obligations in a timely fashion. While it is rare that these security devices will totally protect the landlord from the full economic impact of a default by the tenant under all of its monetary and non-monetary obligations, these devices will often provide the landlord with substantial protection against a tenant default. Security measures include:

• a guaranty from a creditworthy party,
• a security deposit – whether in the form of a cash deposit, the receipt of liquid collateral in lieu of cash, or a letter of credit,
• a security interest in the tenant's property,
• a landlord's lien, and
• a bond from an insurance company.

From the landlord's perspective the operative concept is the availability of liquid collateral. The landlord wants cash, or something that can be quickly converted into cash to satisfy the tenant's obligations. For this reason, cash security deposits, letters of credit and marketable securities are the favored form of the tenant's credit enhancement. Landlords do not favor time consuming and expensive procedures to obtain cash, such as claims against insurance companies, the need to resort to foreclosure or UCC sale procedures to obtain cash in replacement of the posted security, or worse yet, litigation.

Guaranty. The guaranty is a familiar security device. Obviously, it is only as good as the creditworthiness of the guarantor. The guaranty is not without its shortcomings, however. Even if it is entirely valid and enforceable, unless the landlord is faced with the rare occurrence in which it presents an itemization of its losses to the guarantor and payment is immediately made, the landlord typically must resort to litigation to collect.

While the tenant's bankruptcy will not result in an automatic stay against the enforcement of the guaranty, it is often the case that the bankruptcy filing affects not only the tenant, but also the tenant's affiliates and related organizations. In the instance of a guaranty by a parent entity, it is often the very existence of intertwined financial relationships with subsidiaries and affiliates that causes the financial difficulty and resultant restructuring or liquidation that affects the entire family of related entities.

Once in litigation, the possibility of defenses to the enforcement of the guaranty presents itself. Could the guaranty be set aside as a fraudulent transfer? Are any of the defenses available in this fragile suretyship-like relationship available to frustrate the landlord? While the guarantor may have been creditworthy at the time the guaranty was made, will the guarantor continue to have the same financial strength at the time of the enforcement of the guaranty? Have any of the protections available to the guarantor under the guaranty, such as limited recourse provisions or burn-offs, made the guaranty less valuable at the time of the tenant's default under the lease?

Careful structuring and drafting, and careful administration of the lease prior to and after the tenant's default may avoid some of these dangers. While not much can prevent the delays caused by the judicial system, the inclusion in the guaranty of forum selection, jury trial waivers, and choice of law provisions helps. To prevent a fraudulent transfer issue, the guaranty should be made by a party that will receive tangible benefits from the making of the lease, eg, a parent corporation whose subsidiary tenant will use the space to produce products, provide services or sell merchandise intended to generate profits that will inure to the benefit of the parent entity.

Security can be given for the guarantor's obligations in appropriate circumstances. By taking a mortgage on, or security interest in, the guarantor's assets, the landlord may be able to secure itself against the nonpayment of the guaranteed obligations. Even if it is possible to negotiate the collateralization of the guaranty, it is difficult sometimes to find assets of the guarantor that are not already encumbered and are readily available to new secured creditors without the consent of existing creditors of the guarantor.

Guarantees, like letters of credit, offer some material benefits to the landlord in the event of the tenant's bankruptcy, as long as the guarantor itself is not also a debtor in a bankruptcy proceeding. The statutory ceiling on the amount of damages that a landlord may receive as a result of the rejection of a lease in bankruptcy does not apply to actions against the guarantor of the tenant's obligations.

This article will conclude with a discussion of the use of security deposits, prepaid rent, letters of credit and lease bonds to protect a landlord from a defaulting tenant.