Methods for Securing Against Tenant Defaults

If a security deposit is agreed upon, more is involved than the mere determination of its amount. Who will hold the security deposit? Landlords generally want to take the security deposit as general revenue and post a liability for its refund on their balance sheets. Sophisticated tenants do not like this arrangement. In its pure form, the security deposit is intended to protect against the tenant's default, and not provide cash flow to the landlord to be used to pay the costs of tenant improvements and the like, or to otherwise fund property operations.

In fact, well-counseled tenants want to protect against the risk of the landlord's bankruptcy. If the security deposit is commingled with the landlord's funds, the tenant is relegated to the level of a general creditor in seeking the return of the deposit. The tenant will want the deposit held in a third-party depository in trust for the benefit of the landlord and the tenant, payable only when and to the extent that conditions merit.

Arrangements for the payment of interest on the deposit may be made, with the tenant being entitled to interest as long as there is no tenant default, and the landlord being entitled to the interest only if a tenant default occurs. There is some justification for this approach in that the fund is not the landlord's, but is merely on deposit to protect the landlord against a future contingency. The tenant will want the interest to be paid to the tenant on a regular basis and not, in effect, increase the size of the security deposit by accumulating in the account, unless of course a tenant default has occurred.

Tenants frequently argue that the deposit should be reduced as time goes by and the tenant gains credibility with the landlord by avoiding defaults and timely discharging its obligations under the lease. If the tenant is successful in this aspect of the negotiations, the deposit will be reduced over time or “burn off,” assuming that the conditions for the return of part of the deposit are satisfied. The manner of the refund of portions of the deposit is often an issue. The partial refund could be made by direct payments by the landlord to the tenant, or by means of rent credits, the latter being more feasible if the deposit is held by the landlord and already commingled with general landlord revenues. If the deposit is held by an escrowee, the parties may agree to jointly direct the escrowee to refund the reduction amount to the tenant, or they may instruct the escrowee in advance to refund agreed-upon reduction amounts on predetermined dates – unless the escrowee receives notice from the landlord that the tenant has defaulted. The rent credit approach also gives the tenant some protections in the event of a landlord bankruptcy, but it is only practical if the security deposit is to be reduced over time, as opposed to being refunded at the end of the lease term.

In some instances, rather than reducing the size of the security deposit over time, the landlord may argue that the security deposit should increase over time if the lease provides that the rental obligations increase. The effect of this provision creates increasing cash flow demands on what may be an already financially weak tenant. Will the landlord's efforts to obtain more security effectively force the weak tenant into a default situation, or is the tenant's default otherwise inevitable?

Some deposits made by the tenant may be used or earmarked for special purposes. For example, the tenant may negotiate to earmark the deposit so that it can be used only to pay monetary or rental defaults, rather than a nonmonetary default by the tenant. Other deposits may be earmarked to pay for the repair of damages caused by the tenant's vacation of the premises, or the tenant's failure to timely vacate the premises and remove its property from the premises upon lease termination.

The strong tenant will negotiate to allow the landlord to take the deposit only after there has been a judicial determination that the tenant has in fact defaulted under its obligations, rather than when the landlord claims that a default has occurred. At a minimum, the landlord should give the tenant notice of default and the intent to take the security deposit if the default is not cured within the time periods allowed by the lease.

Tenants may wish to post security other than cash so as to reduce demands on their cash flow, and to continue at the expected rate of return on their invested funds. If this is to be done, the landlord will require that the assets be liquid, such as marketable securities, and that if the market value of the securities decreases, additional liquid assets be posted so the landlord protections remain level. If the landlord is to agree to hold collateral for the tenant's lease obligations, it must take care to ensure that a perfected security interest in the collateral is obtained. This may require that the landlord actually possess the collateral or that the collateral be held under a custodial arrangement that satisfies the requirements of the Uniform Commercial Code, as adopted in the applicable jurisdiction.

While of value, security deposits offer some distinct disadvantages to the landlord if the tenant becomes a debtor in a bankruptcy proceeding. The automatic stay imposed by Section 362 of the Bankruptcy Code prevents the landlord from taking the security deposit without the approval of the bankruptcy court. Moreover, the landlord's damages are limited by a statutorily imposed formula under Section 502(b)(6) of the Code, which prevents the landlord from keeping any of the security deposit that exceeds the statutory maximum.

Prepaid Rent. A somewhat dated but still occasionally used device is the requirement that the tenant prepay some of the rent due under the lease. Strategically, the landlord will want the lease to provide that the prepayments shall be applied to other than the initial rental payments, ie rent payments that are staggered throughout the lease term and perhaps skewed to the end of the term, or the last rent payments to be made, with the right to accelerate the payment of rent, including prepaid rents, if the tenant defaults under the lease. As with most landlord protective devices, there are dangers if the tenant becomes the subject of a bankruptcy proceeding. See In re Orangebrook Concessions, 47 Bankr. Reptr. 858 (S.D.Fla.,1985) that holds that prepaid rents must be surrendered to the debtor's estate.

Letters of Credit. An alternate device, that is typically well received by landlords, is the posting of a letter of credit as security for the performance of the tenant's obligations. This has the advantage of not being too taxing on the tenant's cash flow, while at the same time providing an independent means of protection to the landlord in case the tenant defaults. Many tenants have a line of credit loan that contains a formula that is used to determine the amount of funds available to the tenant. In many instances, the letter of credit will be issued by the line of credit lender who will charge the face amount of the letter of credit against the amounts available for draw under the line. The concept of independence of the letter of credit obligation makes the letter of credit a most desirable device for use by landlords to secure tenants' obligations.

Because the letter of credit is the independent obligation of the issuing bank, it is not subject to the tenant's defenses to the landlord's claim of default. The issuing bank must draw on the letter of credit, if the landlord presents to the issuer the documentation required under the terms of the letter of credit. The quality and quantity of the presentment documentation varies with the bargain of the parties and the requirements of the issuing bank. Ideally, from the landlord's perspective, the presentment documentation will only include a sight draft. The tenant will often object to this limited documentation and seek to require the landlord also to present to the issuing bank the landlord's certification (a) that the tenant has defaulted under the lease, (b) that all applicable cure periods have expired with the default not being cured, and (c) that all conditions of the lease for the enforcement of the landlord's remedies against the tenant have been satisfied.

The letter of credit should have a term that lasts a bit longer than the period for which the security is to be posted, whether that period runs until the end of the term of the lease or is shorter. This will allow the landlord time to make sure that the conditions for making a draw have or have not been satisfied during the security period. For example, the landlord will want to be protected if the tenant does not move out on time and becomes a holdover tenant, or does not remove its property or any tenant alterations or improvements that were to be removed upon the expiration of the term.

As an extra measure of protection for the landlord, the letter of credit should not expire until at least 90 days after the end of the lease term to guard against claims that payments made by the tenant to the landlord are preferential and thus should be returned upon the tenant's bankruptcy.

The landlord should pay appropriate attention to the renewal of the letter of credit so that the landlord is given adequate time to draw upon the letter of credit if it is not timely renewed. Of course, the failure to provide a renewal of the letter of credit should be an express basis for a draw by the landlord. If the security requirement is reduced over time, the amount of the letter of credit should automatically reduce as the time goes by or the letter of credit should be replaced from time to time as the security requirement stages downward.

The automatic stay imposed under the Bankruptcy Code upon the tenant's bankruptcy will not prevent a draw on the letter of credit. It should be noted, however, that the automatic stay will prevent the landlord from taking action such as giving notice of default to the tenant so as to begin the running of the cure periods spelled out in the lease. Depending upon the lease terms and the provisions of the certificate required to be given in connection with a draw on the letter of credit, the operation of the stay may prevent the occurrence of the preconditions to a draw on the letter of credit.

An additional benefit of the letter of credit is that the statutory cap on the damages recoverable against the bankrupt tenant as a result of a default under the lease will not be available to limit the extent of the draw upon the letter of credit.

Lease Bonds. If security must be posted, tenants may seek the alternative of obtaining a bond or surety- type agreement from an insurance company to pay the landlord if the tenant defaults in its obligations. Tenants like this alternative because the fee is about the same as that for a letter of credit, and the insurance company issuer may require that less security be posted to collateralize the tenant's obligations to the insurer in the event a payment must be made under the bond. While somewhat similar to letters of credit, these arrangements are not favored by landlords because the insurer is under no immediate obligation to pay the bonded amount upon the presentation of documentation by the landlord. By comparison, the issuer of a letter of credit must make the payment in a very short period of time if the documentation required by the letter of credit is presented. Further, the claim by the tenant that there is no default under the lease will not prevent the issuer from honoring the draw upon the letter of credit, if the required documentation is presented. Where the lease bond is used, the insurance company issuer may well withhold payment pending the resolution of the dispute between the landlord and tenant as to the existence or not of a tenant default.

Conclusion

As can be seen, there are several alternatives available for the landlord and tenant. Some are more practical than others, and each of them has advantages and disadvantages for the landlord or the tenant.

The first part of this article addressed the problem of the impact of tenant defaults and bankruptcies on landlords and suggested various methods for the landlord's protection. The conclusion will discuss several specific devices.

Security Deposits. Security deposits are an age-old form of security for the performance of the tenant's obligations under a lease. In the simplest of transactions, the tenant deposits a fund with the landlord to be used to protect the landlord against the economic consequences of a tenant's default. The amount of the fund is the product of negotiations and usually involves a multiple of the monthly rent payable under the lease. In more sophisticated commercial transactions with other than the most creditworthy of tenants, the landlord wants the tenant to deposit a substantial sum, perhaps a multiple of the yearly rent payable under the lease, especially if the landlord pays for substantial tenant improvements.

An alternate to the security deposit may be to have the tenant pay directly some of the costs that would normally be paid by the landlord, rather than having the landlord finance those costs. For example, the tenant, rather than the landlord, may bear the costs of pricey tenant improvements (TIs), adding to its monthly financial burden, the cost of the TIs together with an interest factor. If this is done, the tenant will pay only the pure rent that will not include financing the additional amounts. In reality, this transfer of economic responsibility merely shifts a part of the risk of the tenant's default to the tenant who will bear the loss if it cannot remain operating as a solvent rent-paying tenant for the full term. Even with the “reduced” rent, the landlord may still want a security deposit to protect itself from the loss of economic rent if the tenant should default.

If a security deposit is agreed upon, more is involved than the mere determination of its amount. Who will hold the security deposit? Landlords generally want to take the security deposit as general revenue and post a liability for its refund on their balance sheets. Sophisticated tenants do not like this arrangement. In its pure form, the security deposit is intended to protect against the tenant's default, and not provide cash flow to the landlord to be used to pay the costs of tenant improvements and the like, or to otherwise fund property operations.

In fact, well-counseled tenants want to protect against the risk of the landlord's bankruptcy. If the security deposit is commingled with the landlord's funds, the tenant is relegated to the level of a general creditor in seeking the return of the deposit. The tenant will want the deposit held in a third-party depository in trust for the benefit of the landlord and the tenant, payable only when and to the extent that conditions merit.

Arrangements for the payment of interest on the deposit may be made, with the tenant being entitled to interest as long as there is no tenant default, and the landlord being entitled to the interest only if a tenant default occurs. There is some justification for this approach in that the fund is not the landlord's, but is merely on deposit to protect the landlord against a future contingency. The tenant will want the interest to be paid to the tenant on a regular basis and not, in effect, increase the size of the security deposit by accumulating in the account, unless of course a tenant default has occurred.

Tenants frequently argue that the deposit should be reduced as time goes by and the tenant gains credibility with the landlord by avoiding defaults and timely discharging its obligations under the lease. If the tenant is successful in this aspect of the negotiations, the deposit will be reduced over time or “burn off,” assuming that the conditions for the return of part of the deposit are satisfied. The manner of the refund of portions of the deposit is often an issue. The partial refund could be made by direct payments by the landlord to the tenant, or by means of rent credits, the latter being more feasible if the deposit is held by the landlord and already commingled with general landlord revenues. If the deposit is held by an escrowee, the parties may agree to jointly direct the escrowee to refund the reduction amount to the tenant, or they may instruct the escrowee in advance to refund agreed-upon reduction amounts on predetermined dates – unless the escrowee receives notice from the landlord that the tenant has defaulted. The rent credit approach also gives the tenant some protections in the event of a landlord bankruptcy, but it is only practical if the security deposit is to be reduced over time, as opposed to being refunded at the end of the lease term.

In some instances, rather than reducing the size of the security deposit over time, the landlord may argue that the security deposit should increase over time if the lease provides that the rental obligations increase. The effect of this provision creates increasing cash flow demands on what may be an already financially weak tenant. Will the landlord's efforts to obtain more security effectively force the weak tenant into a default situation, or is the tenant's default otherwise inevitable?

Some deposits made by the tenant may be used or earmarked for special purposes. For example, the tenant may negotiate to earmark the deposit so that it can be used only to pay monetary or rental defaults, rather than a nonmonetary default by the tenant. Other deposits may be earmarked to pay for the repair of damages caused by the tenant's vacation of the premises, or the tenant's failure to timely vacate the premises and remove its property from the premises upon lease termination.

The strong tenant will negotiate to allow the landlord to take the deposit only after there has been a judicial determination that the tenant has in fact defaulted under its obligations, rather than when the landlord claims that a default has occurred. At a minimum, the landlord should give the tenant notice of default and the intent to take the security deposit if the default is not cured within the time periods allowed by the lease.

Tenants may wish to post security other than cash so as to reduce demands on their cash flow, and to continue at the expected rate of return on their invested funds. If this is to be done, the landlord will require that the assets be liquid, such as marketable securities, and that if the market value of the securities decreases, additional liquid assets be posted so the landlord protections remain level. If the landlord is to agree to hold collateral for the tenant's lease obligations, it must take care to ensure that a perfected security interest in the collateral is obtained. This may require that the landlord actually possess the collateral or that the collateral be held under a custodial arrangement that satisfies the requirements of the Uniform Commercial Code, as adopted in the applicable jurisdiction.

While of value, security deposits offer some distinct disadvantages to the landlord if the tenant becomes a debtor in a bankruptcy proceeding. The automatic stay imposed by Section 362 of the Bankruptcy Code prevents the landlord from taking the security deposit without the approval of the bankruptcy court. Moreover, the landlord's damages are limited by a statutorily imposed formula under Section 502(b)(6) of the Code, which prevents the landlord from keeping any of the security deposit that exceeds the statutory maximum.

Prepaid Rent. A somewhat dated but still occasionally used device is the requirement that the tenant prepay some of the rent due under the lease. Strategically, the landlord will want the lease to provide that the prepayments shall be applied to other than the initial rental payments, ie rent payments that are staggered throughout the lease term and perhaps skewed to the end of the term, or the last rent payments to be made, with the right to accelerate the payment of rent, including prepaid rents, if the tenant defaults under the lease. As with most landlord protective devices, there are dangers if the tenant becomes the subject of a bankruptcy proceeding. See In re Orangebrook Concessions, 47 Bankr. Reptr. 858 (S.D.Fla.,1985) that holds that prepaid rents must be surrendered to the debtor's estate.

Letters of Credit. An alternate device, that is typically well received by landlords, is the posting of a letter of credit as security for the performance of the tenant's obligations. This has the advantage of not being too taxing on the tenant's cash flow, while at the same time providing an independent means of protection to the landlord in case the tenant defaults. Many tenants have a line of credit loan that contains a formula that is used to determine the amount of funds available to the tenant. In many instances, the letter of credit will be issued by the line of credit lender who will charge the face amount of the letter of credit against the amounts available for draw under the line. The concept of independence of the letter of credit obligation makes the letter of credit a most desirable device for use by landlords to secure tenants' obligations.

Because the letter of credit is the independent obligation of the issuing bank, it is not subject to the tenant's defenses to the landlord's claim of default. The issuing bank must draw on the letter of credit, if the landlord presents to the issuer the documentation required under the terms of the letter of credit. The quality and quantity of the presentment documentation varies with the bargain of the parties and the requirements of the issuing bank. Ideally, from the landlord's perspective, the presentment documentation will only include a sight draft. The tenant will often object to this limited documentation and seek to require the landlord also to present to the issuing bank the landlord's certification (a) that the tenant has defaulted under the lease, (b) that all applicable cure periods have expired with the default not being cured, and (c) that all conditions of the lease for the enforcement of the landlord's remedies against the tenant have been satisfied.

The letter of credit should have a term that lasts a bit longer than the period for which the security is to be posted, whether that period runs until the end of the term of the lease or is shorter. This will allow the landlord time to make sure that the conditions for making a draw have or have not been satisfied during the security period. For example, the landlord will want to be protected if the tenant does not move out on time and becomes a holdover tenant, or does not remove its property or any tenant alterations or improvements that were to be removed upon the expiration of the term.

As an extra measure of protection for the landlord, the letter of credit should not expire until at least 90 days after the end of the lease term to guard against claims that payments made by the tenant to the landlord are preferential and thus should be returned upon the tenant's bankruptcy.

The landlord should pay appropriate attention to the renewal of the letter of credit so that the landlord is given adequate time to draw upon the letter of credit if it is not timely renewed. Of course, the failure to provide a renewal of the letter of credit should be an express basis for a draw by the landlord. If the security requirement is reduced over time, the amount of the letter of credit should automatically reduce as the time goes by or the letter of credit should be replaced from time to time as the security requirement stages downward.

The automatic stay imposed under the Bankruptcy Code upon the tenant's bankruptcy will not prevent a draw on the letter of credit. It should be noted, however, that the automatic stay will prevent the landlord from taking action such as giving notice of default to the tenant so as to begin the running of the cure periods spelled out in the lease. Depending upon the lease terms and the provisions of the certificate required to be given in connection with a draw on the letter of credit, the operation of the stay may prevent the occurrence of the preconditions to a draw on the letter of credit.

An additional benefit of the letter of credit is that the statutory cap on the damages recoverable against the bankrupt tenant as a result of a default under the lease will not be available to limit the extent of the draw upon the letter of credit.

Lease Bonds. If security must be posted, tenants may seek the alternative of obtaining a bond or surety- type agreement from an insurance company to pay the landlord if the tenant defaults in its obligations. Tenants like this alternative because the fee is about the same as that for a letter of credit, and the insurance company issuer may require that less security be posted to collateralize the tenant's obligations to the insurer in the event a payment must be made under the bond. While somewhat similar to letters of credit, these arrangements are not favored by landlords because the insurer is under no immediate obligation to pay the bonded amount upon the presentation of documentation by the landlord. By comparison, the issuer of a letter of credit must make the payment in a very short period of time if the documentation required by the letter of credit is presented. Further, the claim by the tenant that there is no default under the lease will not prevent the issuer from honoring the draw upon the letter of credit, if the required documentation is presented. Where the lease bond is used, the insurance company issuer may well withhold payment pending the resolution of the dispute between the landlord and tenant as to the existence or not of a tenant default.

Conclusion

As can be seen, there are several alternatives available for the landlord and tenant. Some are more practical than others, and each of them has advantages and disadvantages for the landlord or the tenant.