Will Your New Tenant Bail Out?

What About Credit?

Of equal importance, the landlord should assure itself that the tenant is credit-worthy and has the ability to pay the rent. Since many entities are formed for single purposes, the mere corporate existence of the entity adds little protection if the tenant defaults under the lease and has no assets. How is this problem to be solved? The simplest and most common solution is to require a security deposit. The landlord should make sure that it can use the security deposit, at the landlord's sole discretion, to remedy any default. Once applied, the remainder of the security deposit must be replenished to the full amount. Often, a security deposit is based on one or two months' base rent, so consideration should be given to increasing the security deposit as rent increases. This may be difficult to administer, and many leases do not escalate the security deposit.

Recently, many landlords have elected to require letters of credit instead of cash security deposits. Landlords fear that they will be barred from applying cash deposits against tenant defaults if the tenant files for bankruptcy before the landlord attempts to apply the cash deposit. Moreover, the cash deposit is considered the property of the tenant, and, therefore, may well be considered part of the bankruptcy estate; consequently, the landlord might lose the benefit of all or most of the deposit. A letter of credit, on the other hand, is not considered property of the debtor, since it represents the contractual obligation of a third party (the issuing bank). Accordingly, the bankruptcy of the tenant should not bar the landlord from drawing on the letter of credit, and the letter of credit itself would not become part of the bankruptcy estate. This policy is currently being re-evaluated because there is a risk that the bank issuing the letter of credit may itself fail, and the letter of credit may be worthless. The FDIC recently announced that it might not honor letters of credit issued by banks that have been placed in receivership by the FDIC. Landlords must, therefore, monitor these letters of credit more closely and demand replacement letters of credit if the issuing bank files for bankruptcy or otherwise becomes unsatisfactory.

The other obvious solution to a tenant's lack of creditworthiness is to require a guaranty from either an established entity (such as the parent of a single purpose tenant), or a principal of the tenant. Financials should be carefully reviewed and periodically checked and a substantial decrease in net worth of the guarantor (or the tenant itself) should trigger a lease default.

Guaranties

All too often, landlords do not ask for guaranties from well-established tenants, only to realize too late that the actual tenant signing the lease has no assets other than the leasehold estate, and the entity the landlord thought to be obligated on the lease denies liability. When leases are signed by franchisees, the franchisor should be required to sign the guaranty. Although a full payment and performance guaranty, which is absolute and unconditional, is the best type of guaranty to get, often national tenants will resist, and the landlord may have to settle for a payment-only guaranty or one limited to payment of base rent only. The guaranty should state that it is a guaranty of payment and not of collection, and should cover payments required under the lease if such payments accrue before, during or after the expiration or earlier termination of the lease. Less common is the performance-only guaranty, which is often limited in scope to a particular performance and situation.

Less valuable guaranties may be limited scope guaranties (for a particular purpose, such as repayment of tenant finish work) or limited time guaranties (or the reverse, a springing guaranty) which only remain in effect for a portion of the lease term. Finally, there are decreasing value guaranties which burn off after a certain time period. Landlords may be willing to accept these lesser guaranties over the initial period of the lease term until the tenant can establish itself at the location in the shopping center.

Construction Allowance

In new construction or store remodeling situations, landlords often agree to provide a substantial construction allowance for work performed by the tenant. In such a situation, payment of the allowance should be delayed until after the tenant delivers final lien waivers, sworn contractors' and owners' statements and a certificate of occupancy. The tenant must also open for business and begin paying rent. Consideration should be given to further delay payment over a period of time, so that a portion of the allowance is available when the above conditions are satisfied, with annual (or monthly) payments continuing until paid in full. Many landlords are discovering that some tenants open for business, receive the construction allowance, and then immediately shut down operations. In no event should any portion of the allowance be paid until the tenant has deposited the required security deposit and pre-paid rent, if any, and has delivered any required guaranties. Should there be a default, the unamortized amount of the allowance should be repaid and any guaranty should cover this repayment.

If there are serious concerns that a start-up tenant may not have the wherewithal to install necessary fixtures or fully stock the store with inventory, the landlord may consider requiring the tenant to deposit funds with the landlord (or landlord's lender) or into escrow, to pay for anticipated Furniture, Fixtures and Equipment (FF&E), pursuant to an approved budget. The landlord will disburse funds or allow withdrawal upon satisfactory evidence (invoices, etc.) being deposited with the landlord, confirming the use of the funds for FF&E.

Liens

A lease may also provide for the tenant to grant the landlord a lien on and security interest in personal property of the tenant, now or later, placed in or upon the premises. This property remains subject to the lien and security interest of the landlord for payment of all rent and other amounts agreed to be paid by the tenant. While the landlord would generally subordinate this lien to liens from the tenants' lenders for the acquisition of the property in question, it should be superior to all other liens. The problem with this provision is that in many states, the landlord must file a UCC financing statement to perfect the lien, and most landlords do not do so. Unless perfected, the lien remains subordinate to other perfected liens.

In Case of Bankruptcy

Finally, many leases contain provisions stating that if any petition in bankruptcy or insolvency or for reorganization or the appointment of a receiver is filed, then the lease is automatically cancelled and terminated and neither the tenant, nor anyone taking by, through or under the tenant shall be entitled to possession of the premises. The landlord is thereafter allowed to retake possession of the premises and discontinue all services. Unfortunately, under the Bankruptcy Code these so-called ipso facto clauses are not enforceable. Often, the landlord will also provide that notwithstanding the earlier language, if the lease is rejected in any bankruptcy proceeding (i.e., cancelled, which a tenant in bankruptcy typically has the right to do), and the effective date of rejection is on or after the date upon which rent is due and owing, then rent for the entire month in which such rejection occurs shall be due and payable in full and shall not be prorated. Bankruptcy courts cannot be relied upon to enforce the requirements of such lease provisions, but landlords should nevertheless consider adding such sections in the lease in case they are held to be valid and enforceable.

Conclusion

While the economic downturn continues to plague retail landlords and other property owners, cautious behavior and added safeguards in leases can provide some protection for these landlords as they struggle to lease their shopping centers.

Ira Fierstein, a member of this newsletter's Board of Editors, is a partner in the Chicago office of Seyfarth & Shaw, LLP. He has more than 30 years of experience counseling national developers, shopping center owners, limited liability companies, partnerships and other clients regarding significant investments in office, retail, industrial, telecommunications, residential and mixed-use properties throughout the United States, Canada and in several European countries.

With so many vacancies popping up in shopping centers around the country, landlords are willing to entertain creative solutions to placing tenants in these empty spaces. However, before signing the leases and dropping off the keys, landlords should make certain they follow some very simple procedures and perform routine due diligence so that they are protected in case these new tenants follow the footsteps of their predecessors and shut down operations and bail out before expiration of the lease terms.

Is the Tenant Real'?

First, the landlord should make sure the tenant is a “real” entity. If it is an LLC or corporation, is it in good standing and qualified to do business in the state in which the shopping center is located? A quick check with the secretary of state can confirm valid formation and good standing.

What About Credit?

Of equal importance, the landlord should assure itself that the tenant is credit-worthy and has the ability to pay the rent. Since many entities are formed for single purposes, the mere corporate existence of the entity adds little protection if the tenant defaults under the lease and has no assets. How is this problem to be solved? The simplest and most common solution is to require a security deposit. The landlord should make sure that it can use the security deposit, at the landlord's sole discretion, to remedy any default. Once applied, the remainder of the security deposit must be replenished to the full amount. Often, a security deposit is based on one or two months' base rent, so consideration should be given to increasing the security deposit as rent increases. This may be difficult to administer, and many leases do not escalate the security deposit.

Recently, many landlords have elected to require letters of credit instead of cash security deposits. Landlords fear that they will be barred from applying cash deposits against tenant defaults if the tenant files for bankruptcy before the landlord attempts to apply the cash deposit. Moreover, the cash deposit is considered the property of the tenant, and, therefore, may well be considered part of the bankruptcy estate; consequently, the landlord might lose the benefit of all or most of the deposit. A letter of credit, on the other hand, is not considered property of the debtor, since it represents the contractual obligation of a third party (the issuing bank). Accordingly, the bankruptcy of the tenant should not bar the landlord from drawing on the letter of credit, and the letter of credit itself would not become part of the bankruptcy estate. This policy is currently being re-evaluated because there is a risk that the bank issuing the letter of credit may itself fail, and the letter of credit may be worthless. The FDIC recently announced that it might not honor letters of credit issued by banks that have been placed in receivership by the FDIC. Landlords must, therefore, monitor these letters of credit more closely and demand replacement letters of credit if the issuing bank files for bankruptcy or otherwise becomes unsatisfactory.

The other obvious solution to a tenant's lack of creditworthiness is to require a guaranty from either an established entity (such as the parent of a single purpose tenant), or a principal of the tenant. Financials should be carefully reviewed and periodically checked and a substantial decrease in net worth of the guarantor (or the tenant itself) should trigger a lease default.

Guaranties

All too often, landlords do not ask for guaranties from well-established tenants, only to realize too late that the actual tenant signing the lease has no assets other than the leasehold estate, and the entity the landlord thought to be obligated on the lease denies liability. When leases are signed by franchisees, the franchisor should be required to sign the guaranty. Although a full payment and performance guaranty, which is absolute and unconditional, is the best type of guaranty to get, often national tenants will resist, and the landlord may have to settle for a payment-only guaranty or one limited to payment of base rent only. The guaranty should state that it is a guaranty of payment and not of collection, and should cover payments required under the lease if such payments accrue before, during or after the expiration or earlier termination of the lease. Less common is the performance-only guaranty, which is often limited in scope to a particular performance and situation.

Less valuable guaranties may be limited scope guaranties (for a particular purpose, such as repayment of tenant finish work) or limited time guaranties (or the reverse, a springing guaranty) which only remain in effect for a portion of the lease term. Finally, there are decreasing value guaranties which burn off after a certain time period. Landlords may be willing to accept these lesser guaranties over the initial period of the lease term until the tenant can establish itself at the location in the shopping center.

Construction Allowance

In new construction or store remodeling situations, landlords often agree to provide a substantial construction allowance for work performed by the tenant. In such a situation, payment of the allowance should be delayed until after the tenant delivers final lien waivers, sworn contractors' and owners' statements and a certificate of occupancy. The tenant must also open for business and begin paying rent. Consideration should be given to further delay payment over a period of time, so that a portion of the allowance is available when the above conditions are satisfied, with annual (or monthly) payments continuing until paid in full. Many landlords are discovering that some tenants open for business, receive the construction allowance, and then immediately shut down operations. In no event should any portion of the allowance be paid until the tenant has deposited the required security deposit and pre-paid rent, if any, and has delivered any required guaranties. Should there be a default, the unamortized amount of the allowance should be repaid and any guaranty should cover this repayment.

If there are serious concerns that a start-up tenant may not have the wherewithal to install necessary fixtures or fully stock the store with inventory, the landlord may consider requiring the tenant to deposit funds with the landlord (or landlord's lender) or into escrow, to pay for anticipated Furniture, Fixtures and Equipment (FF&E), pursuant to an approved budget. The landlord will disburse funds or allow withdrawal upon satisfactory evidence (invoices, etc.) being deposited with the landlord, confirming the use of the funds for FF&E.

Liens

A lease may also provide for the tenant to grant the landlord a lien on and security interest in personal property of the tenant, now or later, placed in or upon the premises. This property remains subject to the lien and security interest of the landlord for payment of all rent and other amounts agreed to be paid by the tenant. While the landlord would generally subordinate this lien to liens from the tenants' lenders for the acquisition of the property in question, it should be superior to all other liens. The problem with this provision is that in many states, the landlord must file a UCC financing statement to perfect the lien, and most landlords do not do so. Unless perfected, the lien remains subordinate to other perfected liens.

In Case of Bankruptcy

Finally, many leases contain provisions stating that if any petition in bankruptcy or insolvency or for reorganization or the appointment of a receiver is filed, then the lease is automatically cancelled and terminated and neither the tenant, nor anyone taking by, through or under the tenant shall be entitled to possession of the premises. The landlord is thereafter allowed to retake possession of the premises and discontinue all services. Unfortunately, under the Bankruptcy Code these so-called ipso facto clauses are not enforceable. Often, the landlord will also provide that notwithstanding the earlier language, if the lease is rejected in any bankruptcy proceeding (i.e., cancelled, which a tenant in bankruptcy typically has the right to do), and the effective date of rejection is on or after the date upon which rent is due and owing, then rent for the entire month in which such rejection occurs shall be due and payable in full and shall not be prorated. Bankruptcy courts cannot be relied upon to enforce the requirements of such lease provisions, but landlords should nevertheless consider adding such sections in the lease in case they are held to be valid and enforceable.

Conclusion

While the economic downturn continues to plague retail landlords and other property owners, cautious behavior and added safeguards in leases can provide some protection for these landlords as they struggle to lease their shopping centers.

Ira Fierstein, a member of this newsletter's Board of Editors, is a partner in the Chicago office of Seyfarth & Shaw, LLP. He has more than 30 years of experience counseling national developers, shopping center owners, limited liability companies, partnerships and other clients regarding significant investments in office, retail, industrial, telecommunications, residential and mixed-use properties throughout the United States, Canada and in several European countries.