Leasing Lessons From 2009

Tenant defaults and bankruptcies have been all too common this year.  More than ever, expectations of landlords, tenants, and lenders have been shattered by lease defaults, evictions, and bankruptcy.
 
Every cycle in the market makes lease documents longer and more complicated as the parties try to learn from difficult experiences. Some of this is unnecessary - an "as is" clause should not run three pages - but here are a couple of practical items that we are using to improve our leases for the next cycle.
 
1. If the security deposit is a Letter of Credit ("LC"), the LC should not require a default to permit a draw by the landlord 

A letter of credit used as a security deposit typically required two items to be presented to the issuer to draw on the LC: (1) a "sight draft" which looks like a typical check, but drawn on the LC rather than a checking account, and (2) a certification from the landlord, as the beneficiary of the LC, that an event has occurred to permit the draw.
 
The required certification from the landlord is frequently that the tenant is in default under the lease. However, under most leases, for a landlord to certify that a tenant is "in default" or that an "event of default" has occurred, the landlord must first give the tenant a notice of default and then wait for a grace period to expire. If the tenant has already filed for bankruptcy, the automatic stay imposed by the Bankruptcy Code on any creditor actions will prevent the landlord from giving the default notice.
 
When that occurs, the landlord cannot draw on the LC, and that is a poor result for the landlord. One reason that landlords prefer an LC as a security deposit is that the LC can generally be drawn even though the tenant is in bankruptcy, since the LC is an obligation of the issuing bank, not the tenant.
 
The LC should require only a certificate that "the tenant has not timely performed its obligations under the lease," as opposed to a certification of default. While there are still many hurdles for the landlord if the tenant is in bankruptcy, including possible rejection of the lease and a cap on the landlord's damage claim, one step - conversion of the LC to cash in the landlord's control - will have been eased.
 
Our experience is that issuing banks and tenants are open to negotiation and fine-tuning the form of the LC in connection with negotiating the lease, so inclusion of this language, especially if presented as a requested form to the issuing bank, should not be contentious.
 
2. Require a large "springing security deposit" if the lease is assigned 

Even if the initial tenant is creditworthy, and the landlord has not required a security deposit or has required only an amount equal to a month or two of rent, the assignment clause should specifically permit the landlord to require a larger security deposit, possibly six (6) months' rent, from an assignee. While this does not impact the initial tenant, it can serve as a helpful benchmark of conditions that the landlord may require if the tenant later proposes an assignment to a new tenant with questionable credit or no real track record. 
 
A "springing security deposit" may also be helpful in bankruptcy. If a tenant has assumed the lease for its own use or to assign it for consideration, Section 365 of the Bankruptcy Code permits the Bankruptcy Court to require the proposed assignee to provide "adequate assurance" of its future performance. While not binding on the Bankruptcy Court, the "springing security deposit" provides the court with a guide as to what the parties considered would be adequate assurance to the landlord if the lease were to be assigned. We have suggested six (6) months' rent as reasonable in most circumstances. The amount could be higher, but if it is too high, the landlord runs the risk that the Bankruptcy Court will think it unreasonable and simply ignore the provision altogether.
 
If you would like to learn more about any of the information presented here or have questions about Prince Lobel's real estate or leasing practice, please contact Robert Schlein at rschlein@PrinceLobel.com or 617 456 8098 or Craig Tateronis at ctateronis@PrinceLobel.com or 617 456 8021.