Understanding Your Commercial Lease: Security Deposit, Letter of Credit, and Personal Guarantee
When negotiating a commercial lease, you will almost always encounter one or more lease clauses (and many times entire lease exhibits) that deal with what landlords often call “credit enhancement.” The major types of credit enhancement found in a commercial lease are security deposits, letters of credit, and personal guarantees. Often you may deal with more than one type in a single commercial lease. These provisions are designed to give the landlord more certainty that the tenant will be able to meet its obligations under the lease. And security deposits, letters of credit, and personal guarantees are particularly important to the landlord when the landlord is extending some type of credit, such as a tenant improvement allowance. They are also generally required to ensure that the landlord will not have to “chase” the tenant to pay for damages to the space after the tenant leaves. This post in our Understanding Your Commercial Lease series will explain the three major types of credit enhancement you may encounter in your commercial lease:
Most of us are familiar with security deposits, because security deposits are generally required in residential leases. The security deposit is money that belongs to the tenant but is held by the landlord to satisfy the obligations of the tenant under the lease. In a residential lease, the funds are a form of trust money that is heavily regulated by state law. In a commercial lease, security deposits are much less sacred and are regulated by the terms of the lease. But the purpose in both situations is the same: to give the landlord access to tenant funds to cure a tenant’s breach of the agreement (particularly damage) if the tenant refuses or is unable to do so. We generally see a security deposit requirement in almost every lease, with the only exceptions being in situations when the tenant pays for all tenant improvements to an otherwise empty or “shell” space or the landlord decides to gamble.
Security deposit clauses in leases are not generally heavily negotiated. But both parties will want to ensure that they understand:
- under what circumstances the landlord can access the deposit;
- how the deposit will be held (and where the interest will go);
- what events will trigger a requirement that the tenant replenish the deposit;
- when the funds will be returned to the tenant after the lease ends; and
- what happens to the deposit if the building is purchased or the landlord goes bankrupt.
Tenants may also want to negotiate for a reduction in deposit (A) after a specified period of time or (B) if the tenant is remodeling the space or otherwise unlikely to cause any damage the landlord might have to deal with when the tenant leaves. Security deposits can be a major burden on tenants, particularly startup tenants who may not have access to cash they can give to the landlord to hold for a long period of time. When it is impractical (or impossible) to give the landlord enough security with just a security deposit, the parties will often consider a letter of credit to either supplement or replace a security deposit.
Letter of Credit
A letter of credit is a third party guarantee that the tenant will pay according to the terms of the lease. In essence, it is a security deposit in the form of credit advanced by a third party institution (generally a bank). Letters of credit come in two major types, commercial and standby. For purposes of commercial leasing, we are talking only about the standby letter of credit.
The way the letter of credit works is that the tenant will go to its banker and ask for a letter of credit in favor of the landlord. The bank may have enough information about the tenant to know whether the tenant is creditworthy (if they have an established relationship) or the bank will ask for information to determine creditworthiness. If the bank decides the tenant is creditworthy, then the bank will provide a letter of credit vouching for the tenant. The letter of credit is usually literally a letter signed by the bank that says the bank will provide a certain amount of money to the landlord if the landlord contacts the bank and certifies that the tenant is in default. In exchange, the tenant pays the bank a fee for the letter of credit (and pays interest on any funds actually dispersed).
Letters of credit are often negotiated, both between the landlord and tenant and between the tenant and the bank. One of the major issues is whether the landlord will have to provide any evidence of actual lease default before the bank is required to pay on the letter of credit. The landlord wants to be able to get access to the funds first and have the bank ask questions later. And the tenant would prefer the bank ask questions before handing over the money. You should understand what your landlord has to do in order to gain access to the letter of credit, including whether the landlord must first seek payment from other sources. Also, because a letter of credit can be expensive (usually a few percent of the balance per year just to keep the letter in force), the tenant will want to consider replacing the letter of credit as soon as the landlord is willing to let it go. Good reasons for the landlord to let the letter of credit go are that the letter of credit is replaced with some other security or the risk the letter of credit is covering is diminished or gone (for instance, if enough time has passed or if the tenant meets certain financial thresholds).
A letter of credit can be a very useful tool for landlords and tenants to compromise regarding creditworthiness, and they are used often, particularly in larger transactions where the cost of the letter of credit is more easily absorbed. You should understand whether a letter of credit will benefit you, what other options might be available, and the specific terms of the letter of credit, before agreeing to provide one. As part of the early stage leasing process, you may want to seek pre-approval from your bank, so you know what credit enhancement you can offer along with your security deposit.
A personal guarantee (alternatively written as “personal guaranty”) is another common type of credit enhancement. It is a guarantee by one or more individuals that a third party tenant (usually the limited liability entity through which the individuals are transacting business) will pay according to the terms of the lease. By signing a personal guarantee, you are putting your personal assets on the line and agreeing to pay at risk of losing those personal assets. A personal guarantee can be a powerful form of credit enhancement and is another tool used to supplement (but generally not replace) a security deposit. Personal guarantees are common when the tenant is a limited liability entity, such as an LLC, without an established operating history and without substantial assets. These entities are often “judgment proof” in the sense that getting a judgment against an entity for breach of the lease is worthless if the entity has no assets from which to pay the judgment. Because of this, landlords will often require that limited liability entity owners personally guarantee the lease obligations. The personal guarantee is similar to the letter of credit in that it gives the landlord more certainty of being paid in the event the tenant is unable or unwilling to put up a large enough security deposit to make the landlord comfortable.
Personal guarantees are often negotiated heavily in the early stages of the lease process, and your broker should inform you as to whether the personal guarantee is likely to be required in your lease. The terms of a personal guarantee often differ, and the more heavily negotiated terms surround whether the landlord must first pursue the tenant before pursuing the personal guarantor. Often, the landlord wants the option to pursue the personal guarantor without having already pursued the tenant, where a personal guarantor wants the opposite. Landlords and tenants will also negotiate over whether the personal guarantee expires and whether the personal guarantee has a maximum amount. You should fully understand the personal guarantee before signing, as signing a personal guarantee significantly undermines the purpose of having a limited liability entity and exposes the personal guarantor to substantial personal risk.