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Lease Guaranties and Other Security - The Tenant's Perspective

The view of the tenant in connection with security measures required under a lease is quite different from that of the landlord. Many tenants are entrepreneurs and all tenants want to reduce or eliminate any liability associated with a failing business. The obligations under the tenant’s lease are one of the largest risks. A tenant will therefore want to minimize its exposure as much as possible, or even eliminate it altogether. Successfully reducing or eliminating the lease security measures is the best way to accomplish this goal.

Security Deposits

The most commonly used form of lease security is the security deposit. It is omnipresent and very familiar to tenants. Most landlords require one month’s rent along with an obligation that the tenant replenish any amount of the security deposit that is applied to a tenant default. The upside to a security deposit is that it may provide sufficient comfort to a landlord so that the landlord does not require another form of security so the exposure of the owner of the tenant will be capped. The downside is that the landlord controls the tenant’s money so the tenant will likely not see any of the security deposit if the relationship goes south, the return that the tenant will make on the security is minimal, and the tenant’s funds are tied up for the length of the lease. Of the types of security measures employed by landlords, security deposits are the most innocuous and should be favored by tenants.

Letters of Credit

Standby letters of credit (“LOC”) are a benefit to landlords as the landlord does not need to look to the tenant to be made whole. The landlord can simply draw on the LOC whenever the tenant defaults so the landlord is guaranteed a repayment source. LOCs are not, however, a benefit for tenants and should be avoided. A tenant will have to pay both an issuance fee and an annual fee for the entire term of the LOC (which costs can be substantial), and the tenant will lose the ability to control any dispute with the landlord as the letter of credit will provide that the lender must permit the landlord to draw on the letter of credit if specific preconditions are satisfied. There is very little upside for a letter of credit from a tenant’s perspective so a tenant should eliminate any language requiring one if possible.

If the landlord continues to insist on a letter of credit, a tenant may be able to mitigate its risk by carefully drafting the conditions that the landlord needs to satisfy in order to make a draw on the letter of credit. The standards should be objective and should give the tenant the ability to prevent a draw if the tenant disputes the landlord’s claim to damages. A tenant could also request that the LOC requirement be terminated after a couple of years so long as the tenant has not committed any event of default. It may be difficult to convince a landlord to accept such language. If all attempts at reducing its exposure fails and the landlord is still requesting a LOC, a tenant should consider whether it wants to enter into a lease with such a landlord.

Guaranties

An individual does not want to be personally liable for the debts of the individual’s business. That is why an individual will form an entity to cut off any such lability. Entering into a guaranty will essentially eliminate all of the benefits of creating a corporate liability shield. For many small tenants, the cumulative amounts owed for the remaining term of the lease are enough to force the individual in bankruptcy. Such a risk would make most individuals wary of entering into any new business venture as the individual could lose everything he or she owns. Due to the substantial personal risk associated with guaranties, a tenant must limit or eliminate any guaranty if possible. A tenant’s initial approach with the landlord should be to refuse any guaranty requirement. Most landlords will not accept this. The tenant’s second approach should be to require that the guaranty be capped at a set amount, and that the cap burn off over time so long as the tenant does not commit an event of default (e.g. 25% for each year of the term until the guaranty is terminated). As the landlord’s risk is reduced over time, the tenant’s risk should also be reduced.

Granting a Security Interest

An increasing number of landlords are asking their tenants to grant a security interest (i.e. a lien) in the tenant’s assets, particularly the assets located at the tenant’s premises. If a tenant does not anticipate needing a loan at any time during the term of the lease, granting such a security interest would not be that detrimental as the landlord would ultimately have the right to go after the tenant’s assets once it receives a judgment against the tenant following a tenant default. If a tenant does anticipate needing a loan, or if the tenant is unsure of its future financing needs, a tenant should avoid granting a security interest as most lenders will not accept being in a second position behind the landlord. A landlord holding a lien on the tenant’s property will likely preclude the tenant from obtaining any such loan. One possible compromise would be to include language in the security interest provision that states that the lien held by the landlord is subordinated to the lien of any future lender of the tenant together with language stating that the landlord must execute any document reasonably requested by the lender and that subordinates the landlord’s interest. The tenant should be successful in arguing that a landlord should want to assist the tenant in obtaining financing as such a line of credit will improve the financial health of the tenant.

Lease Remedy Provisions

If a tenant is unable to successfully negotiate the elimination of the security measures that are required by the landlord, or if the landlord is demanding security measures that the tenant does not want to give, a tenant could attempt to indirectly reduce its risk under a lease by drafting the landlord remedy provisions in a way that favor the tenant. Improved remedy provisions will reduce the tenant’s exposure upon a default so any security measures would also be limited to the amount of such damages. The most effective way to accomplish this is to eliminate any rent acceleration provision in the lease. Without such a clause the landlord’s damages would be limited to the rent and other costs due and owing as of the termination date of the lease. Any eviction of the tenant will effectively terminate the lease despite contrary language in the lease so a tenant’s exposure will be mixed as of that date. The difference could be owing a couple thousand dollars instead of owing a couple hundred thousand dollars. And, many landlords do not understand the ramifications of eliminating such a provision so such a reduction in damages can be a very useful tool of the tenant.

Incorporating to Minimize Risk

Regardless of the types of security measures that a landlord requires, a tenant needs to run its business through a corporation or a limited liability company, and must further maintain the necessary corporate formalities needed to preserve the liability shield created by a separate legal entity. If done properly, running a tenant’s business through a separate legal entity together with eliminating any personal guaranty will prevent the landlord from going after the personal assets of the tenant. A tenant should engage a good corporate attorney that can assist it with correctly establishing such an entity.

The ultimate goal of the tenant should be to be able to walk away from a failing business without having to declare bankruptcy in the process. There are many ways to accomplish this goal. A tenant should consider these risks when entering into a lease.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.


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