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Security Deposit Concerns for the Thoughtful Tenant

Introduction

A tenant derives no particular benefit from posting a security deposit other than its use as a means to conclude lease negotiations. A security deposit is merely part of that package of rights and duties we call a lease. Every single term and condition of a lease is economic in nature, and it takes no giant intellectual step to recognize that security deposits are merely a matter of dollars and cents. For a landlord—it is dollars; for a tenant—it makes no sense.

Being a “landlord” issue, security deposit clauses in leases are almost always drafted by the landlord, in its favor. Like most other lease provisions prepared for a landlord’s benefit, the proposed language may be only a starting point for a fair and balanced outcome. Knowledge being power, the following exploration of security deposit issues should serve as useful armament for a tenant willing and able to do battle with a landlord over this often ignored area.

Why Post a Deposit Anyway?

What are the economics for a tenant? A security deposit equal to two months’ rent is 16-2/3% of the annual fixed rent. If today’s borrowing rate is ten percent, the carrying cost to a tenant of posting such a deposit is 1-2/3% of the rent per year, each and every year. So, $15.00 per square foot is really $15.25 per square foot. If the tenant’s opportunity cost, what it earns annually on its assets, is 30%, a $15.00 per square foot rent is really $15.75 per square foot. If the security deposit is calculated as six months’ rent, with an opportunity cost of 30%, a tenant’s fixed rent cost is increased by fifteen percent. In our $15.00 example, the real rent becomes $17.25 per square foot.

Wow! Simple economics is why strong tenants refuse to post security deposits. And they prevail. Just as in almost every other aspect of a lease, the terms of the security deposit provision, and, indeed, the presence of such a provision itself, are functions of the bargaining powers of the parties. As an ironic result, the tenant that is least able to post a security deposit is the one most often required to do so.

Bargaining power is not measured merely by looking at the respective balance sheets of landlord and tenant. Weakness or strength of the marketplace is a significant factor in the negotiating equation. Given identical parties, landlord and tenant, but two different properties, it would shock no one to see different lease terms. Security deposit provisions are not immune from such factors. Moreover, the posturing of the parties during negotiations significantly influences the outcome. Tenants, be aware that your reaction to a landlord’s security deposit proposal will always shape the terms of the resulting lease.

What Does a Security Deposit Secure?

What is left to discuss once it is agreed that a deposit will be posted? Even setting aside any question of dollar amount, the answer is “plenty.” Not all security deposits are created equal. To begin the analysis, a tenant should ask—“what is the deposit intended to secure?” While the initial landlord response is—“all of the terms, covenants, and conditions of the lease,” this is merely an opening position. Alternative possibilities include: monetary terms only; damage to the premises only; post termination claims only; or a blend of one or more of the approaches. The simpler the standard, the easier it will be to resolve disputes down the road.

If, as is most favorable to a tenant, the deposit secures only defaults in the payment of basic rent, the arena for disputes is limited. Although there can be some exceptions, tenant and landlord generally agree as to whether the rent has been paid. Extending the net to cover items of additional rent is only slightly more problematical. To the extent that the lease already includes a means to resolve disputes over the calculation of items of additional rent, the landlord’s right to draw upon the security deposit should be available only after the underlying dispute has been resolved. Otherwise, if a landlord can apply the security deposit upon its own allegation that an event of default has occurred, the tenant will fall victim to its landlord’s “self-help” remedy. Consequently, a tenant believing that if it holds a tight checkbook, the landlord will be forced to come to the table, is in for a surprise.

For similar reasons, tenants should be careful to see that an appropriate set of post-termination restoration standards are included in the lease. Otherwise, its landlord will have free rein to spend the security deposit on repairs and have immediate funds available to do so. If a tenant is unable to resist its landlord’s insistence that the security deposit cover alleged breaches of non-monetary obligations, the tenant would be wise to counter that the amount claimed by the landlord first be adjudicated by a dispute resolution method or forum. It doesn’t take a great deal of understanding on the part of a tenant to know that the less the deposit covers, the smaller will be its exposure to loss.

Amount of Security Deposit

The rule previously expressed, that is, the tenant least able to afford posting a security deposit is the one most likely to be asked to do so, is no more apparent than when negotiating how much deposit is to be posted. No rule regulates the amount of a security deposit. Although frequently phrased as “X” months’ fixed rent, there is no logic to such a formulation. In fact, to the extent that the basic rationale for a security deposit is to provide restoration funds after the natural or unnatural termination of the lease, calculating such a deposit as a function of the rental amount makes little sense. At least, if the landlord wants the security deposit primarily to assure that there is no gap in rent receipts between the early termination of one tenant’s lease and the beginning of a replacement tenant’s lease, then the landlord should be honest enough to denominate the security deposit as advance rent. That way, a tenant may be able to treat the outlay as a tax expense. Of course, the landlord may not be pleased to treat such a payment as current income. Landlords are quite happy to enjoy the benefits of using the tenant’s security deposit while merely treating it as a balance sheet item.

When it comes to negotiating the amount of the security deposit to be posted, landlords frequently make the first proposal. For obvious reasons, they ask for large amounts when a tenant’s credit is weak. It is less obvious, however, that landlords ask for greater deposits where their up front investment in the premises is high. The point of this discussion is only to reveal that the amount of the security deposit is almost exclusively related to the relative bargaining powers of the parties and the common rationales expressed by the landlord may be pretext or subterfuge. If that is the case, the tenant must recognize that if the landlord’s true rationale is based on its apprehension about the tenant’s ability to perform, then there are other ways in which a suitable compromise can be reached.

At the outset of the lease, the landlord and tenant generally do not know each other very well. Over the course of time, however, the tenant is able to demonstrate its willingness and ability to meet its obligations under the lease. If and when a tenant has proved itself, whatever that means, it is entirely appropriate for a portion or all of the security deposit to be returned. Commonly described as a “burn down,” such an approach is premised upon the tenant performing without default for a period of time. In the alternative, a meeting of pre-established financial standards can trigger return of part or all of the security deposit.

Interest or Earnings on Deposit

A tenant incurs a number of costs by posting a security deposit. The tenant loses liquidity because it is unable to utilize the funds, without restriction, as its cash flow needs dictate. Also, the funds constitute what would otherwise be an investment opportunity for the tenant. One should not make the mistake of thinking that furnishing a substitute for a cash security deposit avoids any of these issues. Posting any other asset, such as a negotiable security, restricts use of that asset in the same way that posting a cash deposit restricts use of the cash. Posting a letter of credit in lieu of cash security reduces the amount of credit otherwise available to the tenant to fund other business purposes.

Once a security deposit is posted, liquidity is lost and use of the funds is restricted to lease purposes. However, a tenant has no reason to acquiesce in allowing the interest or earnings on a security deposit to suffer the same fate. The tenant is in a position to successfully negotiate the payment of interest on a security deposit and should insist that the interest be periodically paid to the tenant or be credited against the tenant’s monetary obligations under the lease.

Sometimes, but not as frequently as tenants would like, landlords agree that earnings or interest on the deposit are to be applied for the benefit of the tenant. When such a deal is struck, a tenant should not assume that the interest earned is necessarily dependent on the amount paid on a passbook account or that it is dependent on where the funds are actually deposited. There is no fixed relationship between how the funds are used or invested and the interest rate that should be payable to a tenant. If a tenant were not required to pay a security deposit, it would have its choice of investment possibilities. It could choose to earn interest at a bank rate, a treasury bill rate, or to use it in its own business. If the latter measure is employed, then the rate earned by the tenant would appropriately be set at the internal return rate for that tenant’s business. Fortunately or unfortunately, once the parties agree as to where the funds are to be invested, discussion as to earning rate is often closed. Psychologically, landlord has bargained for the security deposit purely as security and not as a source of income to the landlord, and the tenant has, in effect, agreed that the security deposit is to be invested at a relatively low risk, in a vehicle that provides high liquidity. This equation usually results in a relatively low earnings rate, but at least the earnings inure to the benefit of the tenant.

A more serious negotiation should ensue if the funds are not to be banked, but are, instead, to be commingled with the landlord’s funds and thereby used for the landlord’s business purposes. It is no secret that landlords, as often as not, press for the posted security deposit, not primarily for the purposes of “security,” but often to provide a source of funds to be used for tenant improvements, payment of broker’s fees, and other such expenses. In effect, the landlord is seeking low-cost financing from the tenant. This being the case, the “fair” economic deal would result in a landlord paying its tenant at something approaching a borrower’s rate for an unsecured loan. Perhaps, a reasonable starting point is to demand interest on the security deposit at the default rate stated within the lease.

Where are the Funds Kept?

If it is agreed that the security deposit is not to be commingled with the landlord’s funds, then the tenant may wish to limit the investment vehicles through which the funds are held. Whether or not the lease is silent as to which bears the risk of a depository failure, landlord or tenant, it is in the tenant’s interest that the funds be securely invested. Prudence dictates that funds in excess of FDIC limits should be apportioned among insured banking institutions. Another safe vehicle is the purchase of United States debt instruments or slightly less safe, highly-rated commercial paper. Broker money market accounts are commonly insured by the SPIC and this system has thus far provided adequate protection to investors. Regardless of the vehicle used, a tenant would be wise to insist that the lease designate the security deposit as being held in trust for the benefit of the tenant until properly applied by the landlord. Lastly, if the deposit is a significant sum, tenant may want the lease to include a provision requiring a landlord to periodically “prove” that the funds are intact.

In some cases, such as where the property owner is a trust, the legal landlord may not be synonymous with the beneficial landlord. When this is the case, the tenant has the right to know the identity of the person or entity actually holding the security deposit. As a practical matter, the tenant will find itself dealing with the beneficiary or an agent of the beneficiary and not with the trustee. Therefore, it should come as no surprise to such a tenant that the beneficiary and not the trustee will actually possess the deposit. A prudent tenant will protect itself by seeking a separate (personal) guaranty from the beneficiary or an escrow agreement with an independent agent to assure timely return of any unapplied deposit monies.

Cure of Default

In almost all cases, a landlord’s right to invade the security deposit is triggered by an event that also constitutes a default under the lease. But does application of some or all of the security deposit also serve to cure the default? Obviously, express language within the lease may provide a direct answer. In the absence of such language, however, a tenant may maintain the position that a default no longer exists and therefore the landlord’s right to terminate the lease or exercise some other remedy may be lost. Depending on the lease language itself, the argument may be directly posed or, in other cases, may be a part of a tenant’s position that landlord has made an election of remedy.

In negotiating the remedies provision of the lease, a tenant should keep in mind the future possibility of raising these two arguments: (a) that the landlord has cured the default by application of the security deposit, and (b) the landlord has already elected its remedy. A carefully crafted remedies provision can hinder a landlord seeking to terminate a lease or evict a tenant, especially where the cognizant courts readily apply principles of equity or are pragmatic in their application of law.

Where does this leave a tenant that has agreed to the common lease clause requiring replenishment of any deficit in its security deposit account? Fortunately, not in a particularly disadvantageous position. It does not necessarily mean that a tenant has jumped from the “default” frying pan into the “default” fire. Typically, a lease will provide a cure period allowing the tenant time to remedy any alleged breach. Therefore, it is quite conceivable that once a landlord has taken the “self-help” remedy of applying the security deposit, the tenant then gains an additional ten or more days (depending on the lease itself) to cure what has now become a secondary default. Even if the tenant is unable to finesse the lease language to avoid a replenishment provision, the tenant may still be able to structure an extended grace and cure period, avoiding application of drastic remedies by the landlord in those circumstances where the landlord has applied the deposit to cure what would otherwise have been a default.

A related, but distinctively separate approach that can be taken by a tenant is to negotiate a provision requiring landlord to first move against the deposit before placing the tenant in “default” by reason of breach of a lease provision that money alone can cure. In the course of negotiating security deposit provisions, the tenant should never forget that the deposit itself is an asset of the tenant and a liability of the landlord. With this in mind, the tenant should endeavor to utilize this asset to maximum advantage. Logically, if the tenant retained control over the security deposit, i.e. had the money in its own bank, the tenant would be able to cure a potential monetary default merely by writing a check. That is what people do with their cash assets. They use them to pay their expenses. In the landlord/tenant context, it is reasonable to think of the security deposit as a restricted bank account, owned by the tenant, but controlled by the landlord. Landlord and tenant have agreed to restrict the use of this particular asset of the tenant for the sole purpose of meeting the tenant’s lease obligations. Accordingly, it is entirely reasonable for a tenant to insist that its landlord release this asset for exactly the purposes intended. If the tenant can’t retain control of the funds, it still should be able to use them to cure a monetary default and avoid the drastic consequences that tenants face when they don’t pay rent or additional rent on time. Therefore, tenants would be wise to take the position that a landlord is first obligated to apply the security deposit toward delinquent rent and additional rent before landlord may elect any other remedy.

Release of Security Deposit

At some point in the landlord/tenant relationship, the tenant expects return of its security deposit. If there is no lease provision directing an early return of the deposit, this transaction will take place at termination of the lease. However, a comprehensive landlord-prepared lease may erect other barriers to be crossed before the deposit is returned. In such cases, the tenant can expect to see one or more of the following conditions precedent: termination of the lease; removal of tenant’s property from the premises; surrender of the premises; vacating of the premises; and a requirement that all rent adjustments first be calculated and paid. What a tenant usually will not find is a requirement imposed on the landlord to return the deposit within a certain number of days after the conditions precedent have been met. Even less likely to be found is contractual penalization of the landlord for delayed release of the tenant’s funds. This distinction between what a landlord drafts into its proposed lease and what is omitted from that draft is instructive. Not only must the tenant be in a position to bargain over the conditions precedent, but a tenant must also be aware that unless it brings the issue to the table, return of the security deposit is solely within the “reasonable” control of the landlord.

Except in the rare and probably imaginary situation in which a landlord has agreed to pay interest on a security deposit at a rate in excess of what a tenant is otherwise able to earn, it is always to the tenant’s advantage that the security deposit be returned sooner rather than later. Once the parties have agreed on the principle that the deposit is to be returned before the lease is terminated, the negotiating equation becomes rather complex. The tenant’s objective is simple—get the funds, securities or letter of credit back as quickly as possible. Landlords, however, have two separate considerations—risk and basic economics. A landlord’s concern about risk is not very much different at this point than it was at the time of lease formation: what is the tenant’s willingness and ability to honor its commitments under the lease, including its covenant to return the premises in the agreed-upon condition? Certainly, landlords differ on their degrees of risk aversiveness and landlords interpret financial statements and credit reports in different ways. In this regard, it is usually a tenant’s burden to persuade a particular landlord that the meeting of stated financial standards at some point in the future will adequately address that landlord’s concerns. In the alternative, the tenant’s challenge is to persuade a landlord that the mere passage of time, without a material default on the part of tenant, is sufficient demonstration of the tenant’s soundness. There is no magic formula that can be applied to every combination of property, tenant’s persuasiveness, and landlord’s psyche.

A more difficult task, however, is convincing a landlord that even when the tenant has defaulted under the lease or has vacated the premises or has left the premises in poor condition, the tenant is still going to be willing to write the appropriate size check to its landlord. This is why landlords take great comfort in having control of the funds. Everyone knows that it is better to be a “chase-ee” than a “chase-or.” Consequently, once the tenant has determined, for itself, the importance of obtaining an early release of the security deposit, it can only rely on the strength of its bargaining power to achieve that end.

If agreement on early return is reached, the amount of the security deposit can be reduced over time, whether in periodic steps or in a lump sum at the end of a predetermined period. For obvious reasons, tenants should avoid agreeing to requirements other than the mere passage of time. If a landlord prevails in insisting that a given period pass without default on the part of tenant, then the tenant should endeavor to limit the default to monetary items alone, and certainly only to those items which would constitute a default after appropriate notice and exhaustion of cure periods.

One last concern that should not affect the negotiating equation, but frequently does, is the landlord’s financial resources. Recognizing that most leases will allow the commingling of the security deposit with the landlord’s funds and recognizing that landlords frequently use security deposits to enhance their own cash flow, return of the deposit can impose a financial burden on the landlord. Not only is this situation often the root of a landlord’s desire to delay release of a deposit, or to release it in steps, i.e. “burn down” that deposit, but it also affects the way in which the deposit will be returned. In bargaining for an early return of the security deposit, a tenant should be prepared to allow the deposit to be credited against future installments of rent and additional rent, or even only against future installments of additional rent. It is probably least painful for a landlord to allow a credit against installments of additional rent because these are generally reimbursement payments from a tenant. Therefore, a landlord will already have paid the underlying expenses and there is no further need for a landlord to write its own check to the tenant for return of the deposit. When all that is required is return of negotiable securities or release of a letter of credit, the landlord’s financial condition should not influence landlord’s desire to stretch out the burn down period.

What Triggers Application of Security Funds?

If no restrictions were imposed within the lease, a tenant’s security deposit constitutes the ultimate self-help remedy. Without standards governing when and why the landlord may use the funds, a tenant may find that the landlord has spent the tenant’s money without tenant’s consent and perhaps without its knowledge. Commonly, leases provide agreed-upon notice provisions and opportunity to cure provisions before the happening of an “event of default.” Tenants should be cautious not to leave the rear door open by allowing landlord’s resort to the security deposit before applicable notice and grace periods have lapsed. Also, it is not a “given” that a landlord may apply the security deposit automatically and without notice. Even if prior notice is not given, a tenant should insist that notice of the application of the funds be given within a relatively short period of time after the action has taken place. This gives the tenant an opportunity to seek immediate redress, in the courts if needed. A related issue is tenant’s interest in limiting application of the proceeds to cover narrowly specified purposes only. Frequently, landlords will advance the position that their primary interest in holding a security deposit is to assure that the funds are available when needed, rather than to shift the burden from landlord to tenant wherein a tenant must chase its landlord for return of the monies. If the true purpose of the deposit is “security,” then a landlord should be willing to agree that the money would not become available until after a judgment or arbitration award is obtained in its favor. After all, this would serve the purpose of “securing” a ready source of tenant’s funds to pay what would in effect be an undisputed debt.

Who Gets the Deposit Back?

Although primarily an issue of concern to landlord, the tenant should look to see if the lease governs the landlord’s obligation to return the security deposit to the original, named tenant, or to the last assignee of whom the landlord has notice. There is another side to the equation, however. To protect a tenant, the lease must provide that a landlord’s successor be deemed to have received the security deposit and also bear the burden of returning the unused portion to the tenant at the agreed-upon time. Further, a tenant should not rely solely on case law or statute, but should require that a foreclosed-upon landlord transfer the security deposit to its lender and give notice of such transfer to that tenant. All leases should declare that until a landlord is entitled to draw upon the deposit, all funds and other forms of security are held in trust for the tenant and not as an asset of the landlord. As a final protection, no tenant should release a departing landlord from its obligation to return the security deposit until and unless the successor landlord assumes the obligation, in writing.

Security Deposits Other Than Cash

While cash may be king, it is not the only currency that landlord will accept. Without doubt, cash has the attraction of being simple because it is fungible. Nonetheless, for those tenants most likely to be subject to the requirement of posting a security deposit in the first place, cash is frequently a rare or expensive commodity. Where this is the case, a tenant will frequently offer a letter of credit, negotiable securities, security interests in defined collateral, personal guaranties, and sometimes even key owner insurance as a substitute, in whole or in part, for a cash security deposit. Letters of credit, as the most frequently tendered substitute, are the subject of a later, more extensive, discussion. Nonetheless, at this point a tenant must recognize that obtaining and delivering a letter of credit is not without cost. First, the tenant must have an available credit facility. If it does not, it must be in a position to tender one of the other substitute security vehicles anyway. Without a creditworthy applicant, issuers of letters of credit want collateral such as negotiable securities or a security interest in otherwise acceptable collateral. In addition, the issuer may accept, either as sole collateral or as supplementary collateral, the very same personal guaranties and key owner insurance that a tenant might offer to its landlord in the first place.

Therefore, if the issuer of a letter of credit insists on collateral, the tenant may prefer to offer the same collateral directly to its landlord. This is because the tenant who delivers a standby letter of credit can expect to pay an annual charge of from one-half of one percent to two percent of its face amount. Because all letters of credit reduce the amount of credit otherwise available to the applicant, if a tenant is able to obtain a letter of credit, collateralized or not, it should also be able to borrow cash. Cash is an inherently more flexible vehicle and if posting a letter of credit as a security deposit reduces the tenant’s ability to obtain cash from the lending community, the tenant has not helped itself beyond the interest rate differential. The lesson is that tenants should not immediately jump to the conclusion that tendering a letter of credit is always more desirable than posting a cash security deposit. A tenant should weigh the economic costs of a letter of credit, and not just look at the difference between marketplace interest rates and standby charges.

A negotiable financial instrument may be used as a security device, but seldom is. Whether the collateral be in the form of readily-tradable stocks or bonds, with or without coupons, the landlord can have the underlying instrument as security and the tenant can receive the investment income, in the form of interest or dividends. With the ability to substitute equivalent quality collateral, the tenant or the tenant’s principal may have the ability to manage an investment portfolio, while using part of that portfolio to collateralize the security deposit.

An entity tenant often is not sufficiently capitalized to be able to readily post a security deposit. In some cases, however, one or more principals of that entity have the personal financial strength to step in for the tenant. Although generally unwilling to assume unlimited responsibility for all lease obligations by giving a full personal guaranty, such principals may be willing and able to personally guaranty an amount equal to what would otherwise be the security deposit. In such a case, there should be no reason to give a security deposit. Acceptance of a personal guaranty in the amount of, and in lieu of, the security deposit, should be an attractive option to a landlord seeking “security” rather than financing. Tenants are frequently single purpose entities with liability exposure limited to the owner’s equity in the tenant. If a landlord restricts a part of that equity by insisting upon a cash security deposit, the economic viability of a tenant is reduced. On the other hand, acceptance of a solid personal guaranty in the amount of the security deposit should make sense to a landlord. Accepting such a guaranty yields a financially stronger tenant. Cash on the tenant’s balance sheet is a much more useful balance sheet asset than a security deposit.

In some circumstances a landlord may be concerned that the economic viability of the tenant is too dependent upon the personal involvement of one or more of the tenant’s principals. While relatively comfortable that the tenant will be able to perform on the lease as long as the principals are living, a landlord may be willing to forego insisting upon a security deposit if the key owners obtain an insurance policy with an appropriately sized collateral assignment in favor of the landlord. This is an alternative of limited usefulness and, as with every other alternative, the tenant must look at the relative economic cost of such an approach.

Use of Letters of Credit
The most common substitute for a cash security deposit is a letter of credit. Although simple in concept, the terms of a letter of credit security deposit clause can be quite complex. Landlord and tenant must agree upon the type of letter of credit to be used, the conditions under which a full or partial draw may be made, the strength of the issuing bank, renewal conditions, transfer rights, allocation of bank fees, and more. In addition, all of the concerns regarding the conditions under which the landlord may have access to the security deposit are equally applicable to letters of credit and cash. Nonetheless, for financial reasons, some tenants prefer to deposit a letter of credit with their landlord and many landlords, especially larger ones, are willing to accept such instruments as security under a lease.

A letter of credit is an undertaking of payment by a bank upon the satisfaction of preestablished conditions. Always in writing, it is a promise by the issuing bank to the beneficiary (landlord) at the request, and on the instructions, of the applicant (tenant) to pay no more than a stated amount of money, before a given date, and against stipulated documents. As a conditional undertaking, the landlord has the right to demand payment only if it meets all of the requirements described in the letter of credit.

Common terms used in leases to describe letters of credit include: “unconditional,” “clean,” “irrevocable,” and “transferable.” An unconditional or clean letter of credit requires only presentation of a draft or demand of payment, and no other documents. Therefore, it is the type most frequently requested by landlords. In the banking trade, another name for a clean letter of credit, appropriately selected, is a “suicide” or “guillotine” letter of credit. The prudent tenant should not agree to deliver an unconditional or clean letter of credit. At a minimum, a tenant should insist that its landlord deliver an affidavit of default as part of the draw documents.

In contrast to a revocable letter of credit that may be amended or cancelled by the issuing bank without prior notice to landlord, an irrevocable letter of credit can neither be amended nor cancelled without the agreement of the issuing bank and the landlord. For this reason, a landlord properly can insist that the tenant’s letter of credit be irrevocable. A transferable letter of credit is one under which the landlord may transfer the rights to draw drafts or make demands for payment under the credit. Lastly, the type of instrument that is commonly used to satisfy a lease’s security deposit requirement is called a “Standby Letter of Credit.” This term is used to distinguish it from a “Commercial Letter of Credit,” and is generally issued to pay the beneficiary (landlord) if the applicant (tenant) fails to perform under the lease and usually requires presentation of only a draft or demand for payment.

The dilemma tenants face is that if they are unqualified to obtain a loan, they are also unqualified to obtain a letter of credit. To the banking community, a letter of credit is an unconditional promise to make a loan, up to a given amount and at any time before the expiration date of the instrument. In return for making such a promise, a bank extracts a fee for making the “standby” loan available to its customer. Such fees are negotiable, but the neediest firms can expect to pay the highest charges, often two percent of the maximum available credit under the letter of credit. If the tenant has a general credit facility at a lending institution, the letter of credit will “tie up” a portion of that facility. If the tenant does not have such a relationship with its bank, it can expect the bank to require that some form of collateral or acceptable personal guaranties be tendered in support of the credit being issued. Personal guaranties have the lowest cost to the tenant. On the other hand, cash deposits must usually be in the full amount of the credit and therefore offer little initial advantage over depositing the cash directly with the landlord. Of course, if the tenant’s credit improves, its bank may allow the tenant to withdraw some or all of the cash deposit, while still maintaining the letter of credit. This is an attractive alternative when faced with a landlord that will not allow early return of a cash security deposit. Nonetheless, tenants should be aware that monies deposited at banks often yield much lower returns than the same amount of money invested elsewhere or used within a tenant’s own business. This reduced investment yield increases the tenant’s effective cost for a letter of credit. Fortunately, it is very common for banks to accept negotiable securities, of acceptable quality, in support of the letter of credit. This offers a number of advantages to a tenant, especially because the securities continue as an investment vehicle for the tenant or for the tenant’s principal, if he or she is the true owner of the collateral.

Cautious landlords are concerned about the strength of the financial institution issuing the letter of credit. A typical requirement is that the issuer be a United States bank or that it be a “money center” bank. Landlords may also state this requirement in terms of a minimum deposit base at the issuing bank. What this means is that tenants who use small banks or who use foreign banks unfamiliar to the landlord may face the necessity of arranging for the issuance of a letter of credit from their own bank that, in turn, must be confirmed by an acceptable, larger U.S. or world bank.

As previously noted, letters of credit are issued upon the payment of fees. In addition, issuing banks frequently charge fees on the transfer of a letter of credit. A tenant should always insist that the landlord pay transfer fees which are frequently stated as a small percentage (say 1/2%) of the face amount of the instrument or a minimum fee of perhaps, $500.00. If the tenant has the energy to do so, it may want to negotiate with its landlord to get the landlord to pay some or all of the issuing fee. Letter of credit issuance fees are paid each time a letter of credit is renewed. It would not be inappropriate for a tenant to insist that its landlord begin paying the issuance fee after the second or third year of the lease because, by that time, the landlord should feel secure enough to release the letter of credit entirely.

Other Letter of Credit Considerations

In addition to the basic considerations described above, the agreement between landlord and tenant with respect to a letter of credit should address at least the following issues. The lease must describe the specific conditions under which a draw may be made. If the landlord is entitled, indeed limited, to apply for partial drawings, the lease must expressly require the letter of credit to contain such a condition. In addition, the lease must describe the conditions under which partial draws may be made and provide a reasonable period of time for the tenant to replenish the amount of the letter of credit to its original face value. A tenant should require that its landlord furnish a certification to both the tenant and the issuing bank that the monies are due and owing. It would be to the tenant’s advantage that such a certification be signed by a responsible officer, general partner or managing member of the landlord to assure review by a high official within the landlord’s organization prior to a demand for payment. A tenant should insist that, under any circumstances, notice of the draw be given by the landlord directly to the tenant, even if that notice is simultaneous with the draw request itself.

Letters of credit bear expiration dates. The procedure for renewing letters of credit should assure that the tenant need not furnish overlapping letters of credit because during a period of overlap, the tenant must satisfy an issuer with respect to twice the amount of credit that is required in the first place. As such, it is probably beneficial to all concerned that a tenant obtain an “evergreen” letter of credit, if one is available to the tenant. This type of letter of credit renews automatically unless the issuing bank advises the parties otherwise.
In negotiating with the landlord to accept a letter of credit in lieu of a cash security deposit, the tenant should not lose sight that its own future needs may make it attractive for a tenant to reverse the transaction, i.e. replace the letter of credit with a cash security deposit. Therefore, tenants should insist on such a conversion provision in the lease.

In its haste to conclude a lease negotiation, a tenant should not overlook some other details that come into play when a letter of credit is used as a security deposit. For example, at the end of a lease term or when the landlord is no longer entitled to hold the letter of credit, the lease should provide that the instrument be surrendered to the tenant together with a letter from the landlord to the issuing bank advising the bank that the tenant has the right to surrender the letter of credit. Also, the lease should provide that when there is less than one year in the remaining term of the lease, the expiration date of the letter of credit will coincide with the lease termination or bear a date that is one or two months after the lease termination. A landlord should not be permitted to pledge, hypothecate or otherwise collaterally assign the letter of credit except to its first mortgagee or a trustee under a first deed of trust. It should never be able to use it as collateral for its own loans other than a part of the mortgage or deed of trust covering the premises. Recognizing that a landlord, upon sale of its property, will need to transfer the letter of credit, the tenant should agree to cooperate with the landlord in such transfer, but the landlord or its buyer should pay all charges related to that cooperation as well as all of the tenant’s reasonable costs and expenses in connection with an actual transfer.

The tenant must have recourse if the letter of credit is improperly liquidated. In almost all cases, the letter of credit used as security deposit will be “clean.” Therefore, the threshold at which the issuing bank will disburse funds to the landlord is extremely low. Once the letter of credit has been honored, the issuing bank will seek reimbursement from the tenant, either by liquidating the underlying collateral, enforcing the personal guaranties, or converting the standby letter of credit to a loan account and beginning to charge interest on that loan to the tenant. Because of these dangers, the tenant should have some recourse against the landlord if the landlord improperly draws against the letter of credit. Certainly, the lease should provide an indemnification for the tenant’s cost and expenses, including attorney’s fees, should the tenant prevail. The tenant may wish to submit such disputes to arbitration and upon the issuance of an award in favor of tenant, the tenant should have the immediate right of offset. This should not be offensive to the landlord or its lender because the landlord has already collected cash. The trap to be avoided by the tenant is a situation where the landlord has wrongfully drawn against the letter of credit and then seeks to evict the tenant because the tenant failed to restore the security deposit. In those jurisdictions where summary proceedings preclude a full airing of the dispute, a tenant may find itself forced to replenish the security deposit and then file a separate action to achieve its remedies against the landlord.

A final major consideration is establishing the law, rules, and jurisdiction that will govern the letter of credit. Article 5 of the Uniform Commercial Code concerning letters of credit has existed since the 1950s, but is now being replaced with a 1995 revision. Most commercial transactions, however, incorporate the terms of the Uniform Customs and Practice which has also existed since the 1950s, with the current version having become effective in 1994 as “UCP 500.” The 1995 revisions to the Uniform Commercial Code are coordinated with the Uniform Customs and Practice and the parties to a letter of credit transaction are strongly advised to incorporate the terms of each into the lease and, by extension, into the letter of credit itself. Tenants also should be aware that there are other letter of credit guidelines, the most commonly accepted ones being those issued by the International Chamber of Commerce. Tenants concerned with the differences between and among each of these laws and standards are advised to turn to the ample body of literature that focuses on them.

Waiver of Protective Laws

Legislatures, in their wisdom and to protect the public good, frequently adopt laws restricting the manner in which landlords may deal with security deposits. Only general principles can be discussed here. Nonetheless, in all jurisdictions, tenants should be cautious when acceding to the sometimes boilerplate clauses that result in tenants waiving the benefit of laws designed to protect them against overreaching by landlords. Such laws, when present, frequently establish that the security deposit is property of the tenant, essentially being held in trust by the landlord. By way of example, California law states: “[t]he claim of a tenant to the payment or deposit shall be prior to the claim of any creditor of the landlord, except a trustee in bankruptcy.” Other states are more explicit about stating the trust relationship, but the principal intent is the same. Why should a tenant readily agree to waive protections of law so that a third party will have a greater claim on the tenant’s money than the tenant itself does? State law also may limit the purposes for which this deposit may be applied. In many cases, states establish a time period within which unapplied deposits must be returned to a tenant; in other cases, there is a penalty for landlord’s failure to comply with such time limits. Certainly, no tenant should knowingly waive a provision of law that requires the landlord to transfer the security deposit to an assignee, to a receiver or in connection with a foreclosure.

Tenants often negotiate leases for premises located in jurisdictions whose laws are unfamiliar to the them. The landlord, however, as an owner of real property in that jurisdiction, is usually more knowledgeable about those laws. There is no reason for this inequality of knowledge, other than the pressure of time or the tenant’s laziness. The conclusion is obvious. Tenants should never negotiate a lease without at least an overview of the commercial tenancy laws of the jurisdiction in which a property is located. Only then can a tenant knowingly waive rights that the state legislature thought to be appropriate in this type of commercial transaction.

Conclusion

The conclusion is that there is no conclusion. There are only agreements to be reached and in reaching those agreements, compromises to be made. Astute and concerned tenants will realize that compromises must be made by both landlord and tenant. The material presented here intentionally presents very little in absolute terms. Instead, its goal is to provoke thought in the community of landlords and tenants and to provide groundwork for drafting, indeed crafting, appropriate and fair security deposit clauses.


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