When a landlord and tenant are negotiating the type of security that will be given to support the tenant’s lease obligations, the options are usually either a cash security deposit or a letter of credit. How do letters of credit work? And why would landlords and tenants prefer a letter of credit as security for a lease rather than a cash security deposit?

What is a Letter of Credit?

A letter of credit is an instrument issued by a bank that allows the holder (in this case, the landlord) the right to draw up to the face amount of the letter of credit if specified conditions set forth in the letter of credit have occurred; typically, an uncured default under the lease allows the landlord to make a draw.

In order to make a draw, the landlord has to present the original letter of credit to the issuing bank, identify the amount of the draw that the landlord seeks, and provide a statement that an uncured default has occurred under the lease. The issuing bank is then required to fund the draw without the need to first obtain the tenant’s consent. This is because the letter of credit is between the issuing bank and the landlord, and is independent of the relationship between the landlord and the tenant under the lease.

The landlord is allowed to make partial draws, so if the face amount of the letter of credit is three months of base rent and the tenant misses a payment, the landlord can draw one month of base rent and then draw the balance later if another lease default occurs. However, the lease probably requires the tenant to restore the letter of credit to the full face amount shortly after a draw is made, just as a landlord would require a tenant to restore a cash security deposit to the full amount if the landlord applied part of the cash security deposit to cure a lease default.

The letter of credit is typically issued for a one year term but renews automatically for successive one year terms until an outside expiration date (which is usually the end of the lease term). If the letter of credit is not renewed at the end of any one year term, the landlord has the right to draw the entire amount and hold the proceeds in the same way as it would with a cash security deposit.

Getting a Letter of Credit

A tenant has to apply for a letter of credit from an issuing bank that is acceptable to the landlord. In evaluating an issuing bank, the landlord generally focuses on its financial strength and whether it has offices where the property is located in order to make it easier for the landlord to make a draw. The landlord may also want the right to require a replacement issuing bank if it believes that the financial strength of the current issuing bank is deteriorating. When Silicon Valley Bank (which was the preferred bank for many tech companies and had issued many letters of credit to support those companies’ leases) collapsed recently, this caused some landlords to demand that the tenants find a new issuing bank due to the uncertainty about whether Silicon Valley Bank would honor a draw request under a letter of credit. Ultimately, First Citizens Bank (which took over Silicon Valley Bank) agreed to honor all letters of credit that were issued by Silicon Valley Bank, so landlords were protected as to those letters of credit.

Benefits to the Tenant

Using a letter of credit may help a tenant with its cash management. If the tenant posts a cash security deposit, it completely loses the use of those funds. In the case of a letter of credit, the issuing bank will often require the tenant to keep a compensating balance with the bank that is at least equal to the face amount of the letter of credit. However, if the tenant typically has a minimum cash balance in its operating and/or investment accounts that is well in excess of the amount of the compensating balance, then it is really not losing the use of those funds in the same way as if it had to provide the landlord with a cash security deposit. Note that the issuing bank will also charge an annual fee for the letter of credit, which is typically one percent of the face amount of the letter of credit.

Benefits to the Landlord

If a tenant is in financial trouble and ends up in bankruptcy, then a landlord is in a better position if holds a letter of credit rather than a cash security deposit. In a bankruptcy, a cash security deposit is considered part of the tenant’s bankruptcy estate and cannot be applied by the landlord without court approval, which can take time and with an uncertain outcome. However, most (but not all) courts have held that a letter of credit is an independent obligation of the issuing bank and the tenant’s bankruptcy does not impact the landlord’s ability to draw on the letter of credit.

A tenant’s bankruptcy also raises another potential issue for a landlord, whether it holds a cash security deposit or a letter of credit. If the lease is rejected in bankruptcy, the landlord’s claim for lease rejection damages is limited to the greater of one year of rent or 15% of the rent due for the remaining lease term (capped at three years). So if the lease has 36 months remaining and the total rent due (base rent and pass throughs) is $10,000 a month, then the landlord’s claim for lease rejection damages will be capped at $120,000 (one year’s worth of rent). This cap applies when the landlord holds a cash security deposit, but it might not apply to the proceeds from a draw under a letter of credit (the court decisions are inconsistent on this point, but at least there is the possibility that a landlord could prevail). Note that this cap on lease rejection damages only applies if the amount of the cash security deposit or letter of credit exceeds one year of rent, which is not that common.

Other Issues

If the amount of the security deposit is relatively small, then landlords and tenants often just proceed with a cash security deposit rather than deal with the expense and administrative issues associated with a letter of credit. $50,000 or $100,000 are common thresholds below which the parties might just agree to a cash security deposit but this amount can vary depending on the preferences of the landlord and/or the tenant.

If a tenant negotiates for a reduction of the letter of credit amount during the term of the lease, this can be handled by either having the issuing bank issue an amendment to the original letter of credit or by having the issuing bank issue a replacement letter of credit in the reduced amount. If the issuing bank issues a replacement letter of credit, the landlord should return the original letter of credit to the issuing bank for cancellation.

Sometimes a landlord will ask for a guaranty in addition to, or in lieu of, the security deposit or letter of credit. If the guaranty is provided by an independent party (that is, a person or entity that is legally distinct from the tenant), then the bankruptcy cap on lease rejection damages will not apply and the landlord can enforce the guaranty even if the tenant is in bankruptcy. However, a landlord would need to sue under the guaranty in order to enforce it, which can take time (months or years, depending on how crowded the local courts are) and can result in significant legal fees (which the landlord can eventually recover if it wins the lawsuit and the guaranty contains an attorneys’ fee clause). So the landlord may need to balance the delay and costs associated with a lawsuit against a guarantor versus negotiating a settlement with the guarantor for a lesser amount.

Summary

Providing a letter of credit to support lease obligations can benefit both the landlord and the tenant. The landlord will probably be able to draw on the letter of credit even if the tenant files for bankruptcy, while the tenant may be able to avoid tying up its cash in the same way as it would with a cash security deposit. If the amount is large enough to justify the cost and effort, both the landlord and the tenant should consider using a letter of credit to support the tenant’s lease obligations.

For more information, please contact Leon Tuan.