Since we do not live in an ideal world where each and every tenant has a perfect credit history and pays all amounts that are due under its lease, landlords must fortify leases with certain security-enhancing measures that protect against the possibility of a tenant default. Such measures may also discourage a tenant from willfully defaulting under the lease. A savvy landlord will consider its exposure when entering into a lease and will determine each tenant’s credit-worthiness before determining which security measures to insert into the lease. There are many forms of security that a landlord can use. This article will discuss the mechanics and the general pros and cons of the following lease security enhancements: (i) security deposits, (ii) guaranties, (iii) security interests (liens), and (iv) standby letters of credit.

Damages to Consider When Calculating Sufficient Security

The first step in the process is for the landlord to determine its potential exposure upon a lease default, which is not merely limited to lost rent. The landlord may have granted the tenant a free rent period or an allowance, may have undertaken improvements to the premises, and will probably have incurred transaction costs in connection with the execution of the lease including leasing commissions and legal fees. All of these costs decrease the landlord’s bottom line and were likely incorporated into the calculations for determining the amount of base rent that the landlord was willing to accept. These amounts should be considered when determining what types of security measures the landlord will accept and whether the security is sufficient. The landlord’s lease should also make it clear that the unamortized amounts of these costs can be recouped if the tenant defaults and the lease is terminated earlier than the scheduled expiration of the term.

Security Deposits

Cash is king. The more cash that a landlord has on hand, the better off that landlord will be in connection with a tenant default. No other security method compares to a security deposit as the landlord does not need to seek remedies through a court proceeding, make a demand on the provider of a letter of credit, or hold a sale of the tenant’s personal property. The landlord can simply apply the cash to the amount that the landlord is owed under the lease. The issue with this form of security is that most tenants do not have substantial cash reserves that they can hold in an account. Most tenants will also balk at tying up a significant cash balance as it may hinder the growth of their business. A landlord will likely not be able to obtain a security balance exceeding the equivalent of a couple of months of rent obligations under the lease for these reasons and due to market standards. The approach that the landlord should take is to obtain as high of a security deposit that it can obtain, but fill the gaps with other forms of security.

Guaranties

A guaranty is an essential form of security from a landlord’s perspective in that it creates a situation where the owner of the tenant cannot walk away from a bad business. Absent a guaranty, the owner of a corporate tenant will not be personally liable for the debts of the tenant as the corporate structure of the tenant creates a liability shield between the tenant and the tenant’s owners. Due to this situation a prudent landlord will always obligate the principals of the tenant to sign a guaranty unless the tenant’s balance sheet is incredibly strong.

Actually enforcing a lease guaranty is not simple. The guarantor is unlikely to pay upon demand. Instead, the more likely scenario is that the landlord is forced to sue upon the guaranty and the guarantor will fight the landlord in court. The landlord would not see any cash until either a settlement is reached at a fraction of the amount that is due, or the issue is litigated to judgment, which could be difficult to collect upon. In either case the landlord has incurred legal fees that may exceed the amount that the tenant owes (although a landlord can reduce the latter exposure by including language in the guaranty that the landlord is entitled to legal fees and costs in connection with any enforcement action). Another possible nightmare for the landlord is that the guarantor no longer has assets that can be applied to the tenant’s debt. The tenant’s business and the guarantor’s financial health are likely tied to each other so a tenant that is defaulting is usually a good sign that both the tenant and the guarantor are on the verge of bankruptcy. Simply put, exercising rights under a guaranty is an uphill battle for the landlord and a landlord should not solely rely on this form of security.

One additional issue that a landlord should take into consideration when requiring a guaranty is whether to include the guarantor’s spouse on the guaranty. Minnesota is not a community property state so one spouse may not have any ownership interest in the assets of the other spouse. A landlord will not know how spousal assets are treated or how the assets are transferred between the spouses. A careful landlord will have both the owner of the tenant and the owner’s spouse sign the guaranty.

Security Interests in the Tenant’s Property

Of the lease security measures discussed in this article, the least used and the one that is least recommended by the authors is a security interest in the tenant’s property. Some landlords require that each tenant grant to the landlord a security interest (or a lien) in the tenant’s personal property that is located in the premises, such as inventory, equipment, and furniture. Tenants usually fight such clauses in the lease negotiation process. As such, security interest clauses in leases are uncommon. However, when in place and perfected, the security interest allows the landlord a mechanism to acquire ownership of the tenant’s personal property upon a default under the lease. The remedy process is complex and is rarely fully acted upon.

A security interest in a lease is only enforceable if the landlord takes the next step to “perfect” the security interest, and it is only collectible if other superior lien holders (such as the tenant’s lender) do not apply proceeds from the sale of the tenant’s assets to their debts. To perfect a security interest in tangible goods, the landlord must file a UCC-1 financing statement. For tenant entities formed in Minnesota, the UCC-1 must be filed with the Minnesota Secretary of State’s filing office. Many landlords ignore, or are unaware of, this crucial second step of perfecting the security interest by filing the UCC-1, which renders the grant of security interest meaningless. UCC filings lapse after five years unless the filing is properly and timely renewed.

There is a place in the lease where security interests are highly recommended. Landlords should add a provision in the security deposit section of the lease that grants to the landlord a security interest (or a lien) in the tenant’s security deposit. Since the deposit is cash that is delivered to the landlord, the security interest in the deposit is perfected simply by mere possession (no UCC filing is needed). The reason for obtaining a lien on the security deposit is in case the tenant files bankruptcy and the bankruptcy trustee demands the return of the security deposit as cash that should be a part of the bankrupt’s estate. In such a case the landlord can resist such a demand under the argument that there is a perfected lien on the security deposit that renders it as the landlord’s cash collateral. Thus the landlord ought to be deemed a secured creditor that is entitled to adequate protection of its collateral (which is the security deposit).

Standby Letters of Credit

A standby letter of credit (LOC), where the tenant’s bank agrees to deliver funds to the landlord if the tenant defaults under the lease, is a solid form of lease security due to something called the “independence principle”. This means that the letter of credit is an independent agreement and payment under it will be made if the tenant defaults under the lease even if the tenant files for bankruptcy. However, at least one court in California has held that the automatic stay from a tenant’s bankruptcy prevented the landlord from drawing on the LOC, and another held that the draw on the LOC creates a cash security deposit that is the property of the estate. Thus, the benefit afforded by the independence principle is no longer clear in at least one other state and could be eroded by other courts.

The key to a good standby LOC is to be very careful about the actual language on the face of the instrument. It must be clear that the landlord can draw on the LOC whenever there is a default. Avoid any further steps, such as statements that require the landlord to first give written notice and the opportunity to cure before drawing upon the LOC.

Ultimately, no form of security is perfect and all forms have certain benefits and costs. A diligent landlord will determine the financial strength of the tenant and fit the form of security for the applicable tenant.

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.