§ 4A.01 Introduction
| Jurisdiction | United States |
| Publication year | 2022 |
§ 4A.01 Introduction
[1]—General
The term "security" is a misnomer in lease transactions. Although a lender expects its loan to be fully secured by the collateral pledged to it as security, a landlord is never fully secured against a tenant's default for the simple reason that a lease creates a long-term monetary obligation for rent that will always exceed the amount of the security the landlord can, as a practical matter, obtain from the tenant. To recover all of its actual damages, the landlord must usually sue the tenant and/or any guarantors, which is problematic. Therefore, the true function of lease security is instead to provide the landlord with enough of an economic cushion to fund its eviction costs and give it time to obtain possession of the space and re-let the premises, as well as (possibly) to cover expenditures (such as construction allowances and brokerage commissions) either incurred by the landlord to initially lease the space or to re-let the space after a tenant default.
The amount of the security deposit is often a key economic point for the landlord because its default expenses are substantial and its practical ability to recover damages is limited. Security is, however, also a key economic point for the tenant, because security deposits tie up large amounts of cash that are otherwise needed to operate the tenant's business. Accordingly, the amount of the security deposit is a critical term of the lease that should be dealt with at the term sheet stage.
The most common form of lease security is cash. However, cash may be replaced with other forms of cash-like security (such as letters of credit). In addition, in the back and forth of negotiations between the landlord and tenant as to the appropriate amount of the security deposit, the landlord may request or be offered supplemental non-cash security, which is usually in the form of a guaranty.
Although surety bonds free up capital for the tenant, they can be harder to enforce than a security deposit or letter of credit. The determination of the appropriate amount of the security will be a function of many factors, but fundamentally, the decision is a credit decision that requires close examination of the tenant's precise identity and balance sheets.2 The tenant may be a small company with a solid track record or a Fortune 500 company, in which event the landlord is likely to be flexible about security, or an undercapitalized shell company or a startup company, in which event the landlord is likely to demand a significant security deposit. Further, it should not be subject to a prior act of the tenant. This will be especially important in the context of a tenant bankruptcy.3
The first rule of security deposits, however, is that the tenant's ability to post a security deposit generally bears an inverse relationship to the amount of security required.
The need for a substantial security deposit is not always immediately obvious to the landlord. For example, a landlord approached by a substantial national retailer or Fortune 500 company may initially feel that no security deposit is required. But if the landlord determines, upon subsequent inquiry, that the proposed tenant entity is not in fact the retailer or Fortune 500 company, but is instead an affiliated shell company (often with a name confusingly similar to that of the parent company) with no assets, the security deposit may suddenly become a significant issue.
Other factors considered in the determination of the appropriate amount of security include the tenant's reputation and stature, as well as the state of the leasing market and the tenant's leverage.
If the lease is to be guaranteed by a third party or if the landlord's security is dependent on the credit of a third party (such as the issuer of a letter of credit), the landlord also needs to consider the solvency and stability of the third party. Accordingly, the landlord should familiarize itself with the financial institution or individual backing the lease and carefully examine the financial strength of these parties based on all available information, not just the information offered.4
Due diligence is critical to both the landlord's decision as to whether to lease to a particular tenant and the appropriate security deposit. In performing its due diligence, the landlord should take the following steps, among others, to protect itself against the risks of entering into a long-term lease that involves a significant financial investment: (1) properly analyze the actual tenant's balance sheet; (2) if the proposed tenant entity is a shell entity, analyze the validity of the tenant's claimed need to have a single purpose entity or subsidiary act as the tenant; (3) consider the tenant's reputation and longevity; (4) consider whether a guaranty or letter of credit would be appropriate under the circumstances; and (5) pay attention to often overlooked lease provisions, such as those covering notice and transfer rights and obligations, and the impact transfer can have on the landlord's risk.5
[2]—Amount of Security
[a]—Security Initially Required
Although the custom may vary from market to market, tenants are generally required to post security in an amount equal to two or three months' rent if the landlord is not spending substantial amounts to fund a construction allowance, improvements, or other obligations. However, tenants are often surprised to learn, especially in their first foray into leasing commercial space, that a great deal more security may be required in some circumstances and that the landlord may also ask for a guaranty or other form of supplemental security.6
Various factors influence the landlord's decision as to the appropriate amount of security. Primarily, the landlord wants to be assured that that the tenant has sufficient financial wherewithal to pay the rent during the lease term. To determine the tenant's financial strength, the landlord will almost always request a copy of the tenant's financial statements to review and use as a guide in gauging the tenant's creditworthiness and deciding on an appropriate security deposit amount.7 The landlord will review the tenant's past cash flow, projected future cash flow, and net worth. The prudent landlord should also consider the certainty of the tenant's income stream when deciding whether or not to lease to a particular tenant.8 At one end of the financial spectrum are the poorly capitalized companies and startup companies (who may have significant net worth because of equity infusions, but no operating history), who are generally required to post large security deposits together with full guaranties or "good guy" guaranties9 from the company's principals. At the middle of the spectrum is the thirty-year old family-run business, with a healthy if modest balance sheet, which should be able to negotiate a relatively modest security deposit—perhaps between one and two months—and successfully to resist requests for a guaranty. At the far end of the spectrum are the Fortune 500 companies who often are not required to post any security deposit. Another category of tenant that can sometimes eliminate the security deposit is the long-term tenant who renews its lease and pays its rent on time.
Other factors that affect the amount of the security include local custom, the strength of the rental market, the landlord's leasing expenses, the risk inherent in the tenant's business, and the amount of construction the tenant plans to undertake. If the landlord is funding a substantial construction allowance, making significant improvements, giving the tenant a large rent concession, or incurring a special expenditure, it is likely to require a very substantial security deposit, unless the tenant is so well capitalized that the credit risk is minimal or nonexistent. The requested deposit will probably be sufficient to cover or almost cover the landlord's expected outlay and to provide an additional cushion of several months' rent. If the tenant plans to operate a high risk enterprise, such as a restaurant, the landlord is also likely to require more security; and if the tenant plans to invest a substantial amount in constructing the space (as, for example, a restaurant or child care facility), the landlord will, at a minimum, want enough security to cover its expenses if the tenant goes under during the course of construction (which expenses would include the cost of demolishing or...
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