Final Assessment: Security Deposits, Good Guy Guarantees, and Minimizing Short and Long Term Risks When Underwriting a Lease

In a commercial lease, security deposits and good guy guarantees are used by landlords to manage short-term and long-term financial risks.

As a tenant, you never have less leverage in the transaction than when negotiating the letter of intent (“LOI”).

As a landlord, you should keep your letters of intent as narrow as possible to get your tenant into the negotiation stage of the lease.

A tenant’s attorney or broker should include various exit strategies from the good guy guarantee within the letter of intent.

The longer the lease term, the greater the period for the landlord to be able to recoup its upfront costs.

The following factors will increase the amount of security deposit a landlord will require from the tenant: (i) the tenant being a shell corporation; (ii) the tenant putting little or no money into the space; and (iii) there being no guaranty.

Typically, the tenant performing all of the work to prepare the space will increase the amount of security deposit its landlord requests.

A healthy balance sheet and profit and loss statement of a prospective tenant will work to reduce the exorbitant amount of security deposit that a landlord might require.

Generally speaking, the greater the commissions, the greater the concessions, the greater the allowances given by the landlord, the shorter the term, and the worse the financials; the smaller the security deposit is going to be.

Landlords should try to base a tenant’s security deposit on the rent payable during the last year of the lease term.

A security deposit “burndown” is a provision wherein after a specific timeframe, if the tenant isn’t in default of the lease, the landlord will reduce the security deposit by refunding the money to the tenant or having it credited towards the rent.

The costs of securing the deposit and having money tied up are not factors a tenant needs to consider when negotiating the amount of security deposit with the landlord.

As a consequence of bankruptcy laws, it is beneficial for landlords to require tenants to have security deposits in the form of a letter of credit over cash.

A letter of credit is a contract between the bank and the landlord as to the funds of the tenant that have been segregated.

A letter of credit is considered part of a tenant’s estate in bankruptcy.

It is safer and more secure for a tenant to have its security deposit in the form of cash than a letter of credit.

Tenants should explore the annual administrative cost that a bank will charge you for having a letter of credit. Administrative costs generally range somewhere around 1.5% to 2% of the security deposit per year.

If you’re given the option as a tenant between a cash security deposit where the landlord is holding your money or a letter of credit where a bank is holding your money, the landlord holding the money is a safer, more secure option for the tenant than the bank.

Given the risk to a subtenant of losing its security deposit if the sublandlord defaults under the master lease and the subtenancy is terminated, subtenants should try and either (i) have the sublandlord’s attorney hold the security deposit in escrow, or (ii) have the security deposit in the form of a letter of credit.

From the perspective of a landlord that is small in nature and dealing with large upfront costs, even if the tenant is a bankruptcy risk, such landlords ordinarily prefer the cash security deposit for cash flow purposes.

When the principals of a tenant hesitate to give the landlord a basic good guy guarantee, it sends up a red flag often perceived as foreshadowing a breach of the most basic of covenants a tenant makes to a landlord; to pay rent.

When a tenant gives back its space early and the guarantor is released from the good guy guaranty, because the lease is still in effect, the tenant will lose its security deposit.

If a tenant gives back its space early (e.g., in year six (6) of a twelve (12) year lease), not only is the guarantor let off the hook of a good guy guarantee (“GGG”) (assuming the conditions in the GGG are met), but the tenant is let off the hook as well.

If a tenant gives back its space early and releases the guarantor from the good guy guarantee, the tenant’s lease is terminated as well.

If you are a tenant or guarantor thereof, you should attempt to have the good guy guarantee be a guarantee of monetary and non-monetary obligations.

It is very important for landlords to be mindful of the tenants’ obligation to give notice under the good guy guarantee as to when they’re vacating the space.

The lesser the amount of advance notice required of tenant to terminate its good guy guarantee, the better it is for the tenant/guarantor.

In addition to paying the rent through the date of surrender and delivering the space broom clean and vacant in order to terminate the good guy guarantee, tenant advocates need to be mindful that some good guy guarantees also require that the landlord must be reimbursed for its unamortized free rent concessions, tenant improvement allowances, brokerage commissions and its cost of landlord’s work.

As a condition to terminating the good guy guarantee (“GGG”), tenants and guarantors would prefer the GGG to require that the tenant give back the space “in the condition required under the lease” rather than “broom clean and vacant.”

If the good guy guarantee (“GGG”) requires the tenant to reimburse the landlord for its unamortized costs as a condition to terminate the GGG, a reasonable compromise the tenant can offer is to have the reimbursement of unamortized costs “sunset” (or go away) after the first 2-5 years of the lease term.

Given that almost all guarantees provide that the guarantor remains on the hook if the lease is assigned, it is very important for tenants and their guarantors to include provisions in the good guy guarantee that will allow for the release of the guarantor if a sale of the business or an assignment of the lease occurs, subject to having at least one or more of the principals of the assignee signing a good guy guarantee in similar form.

The assignment and subletting and good guy guarantee provisions go hand and hand, and if negotiated properly create a great deal of flexibility for a tenant.

A landlord should limit the definition of additional rent in a good guy guarantee to solely tenant’s payment of taxes, or if there is also an operating expense clause in the lease, to taxes and operating expenses.

It can be beneficial for a tenant to reinforce a landlord’s trust by committing to some of the terms in the good guy guarantee, as it can pay dividends for the tenant in the form of other items the landlord will agree to.

When representing a tenant with more than one principal signing the good guy guarantee (“GGG”), the tenant advocate should put into the GGG and the letter of intent that if one of those principals later withdraws from the corporate tenant, the obligations of the withdrawn member under the guaranty may be terminated unilaterally by that withdrawn party, provided that the remaining guarantors remain as guarantors.

In deciding the amount of security deposit to require from its tenant, a landlord will, among other things, evaluate its initial costs (such as how much landlord is paying for any tenant improvement allowance and brokerage fees) and review the tenant’s and its principal’s financial statement, historical track record and business plan.

A tenant’s financial standing is the sole factor a landlord will use when calculating the amount of security it will request and whether or not they will ultimately agree to a future reduction of a tenant’s security deposit.

Generally stated, the shorter the lease term, the greater the tenant concessions and the greater the risks uncovered during a landlord’s due diligence, the greater the amount of security deposit a landlord should demand.

A “burndown” clause essentially states that, so long as tenant is not in default of the lease at a particular point in time during the lease term, then tenant’s security deposit will be reduced (either by way of a return of such reduction or a rent credit).

A “burndown” clause is a useful vehicle for a tenant to negotiate when a landlord requires a security deposit, which is significantly larger than what the tenant anticipated or can afford to lock up for the full term of the lease.

In order to do a “burndown” of the security deposit in the form of a letter of credit, tenants will usually need to provide the landlord with the instruments and authorizations required by the issuer of the letter of credit.

Landlords should require as little security deposit from a tenant as possible to partially mitigate against its short and long term risks.

When negotiating a “burndown” clause when the security deposit is in the form of a letter of credit, it is essential for tenants to negotiate for language stating that upon receipt of the instruments and authorization from the issuing bank, landlord must promptly execute and deliver an amendment to the letter of credit reflecting the reduced security deposit amount.

Tenant advocates need to ensure that the security deposit burndown is applicable so long as tenant is not in default “beyond any applicable notice and cure period.”