• September 13, 2020

Lesson: Letter of Credit (“LOC”) versus a Cash Security Deposit

Lesson: Letter of Credit (“LOC”) versus a Cash Security Deposit

Next on our list is comparing letters of credit (“LOC”) versus cash security deposits. As a consequence of the bankruptcy laws, one can make an argument that all landlords should require their tenants to have their security deposits in the form of a LOC over cash. However, most landlords don’t require it. Generally stated, if you have a cash security deposit and the tenant files for bankruptcy, the landlords have to take that cash security deposit, deposit it into bankruptcy court, and they will stand side by side with the other creditors of the tenant as it relates to that tenant’s funds. Conversely, if you have a LOC, because the LOC is a contract between the bank and the landlord as to the funds that have been segregated of the tenant, if the tenant files for bankruptcy, simply put, the landlord does not lose the right to the security deposit.

From the tenant’s perspective, when it comes to a cash security deposit, if you lock up a large amount of cash, you’re potentially restricting yourself by not having that cash at your disposal, and you’re receiving a de minimis rate of return on it. As a result, all tenants should explore the annual administrative cost that a bank will charge you for having a LOC. Administrative costs generally range somewhere around 1.5% to 2% of the security deposit per year. The other side of the coin is, if you’re given the option as a tenant between the landlord holding your money or a bank holding your money – not that you particularly love either one – but in my world, I’m going to choose the bank over the landlord, as it is a safer, more secure option.

It doesn’t pay for a landlord to put the cash from the security deposit into an interest-bearing account when the interest rate is low (e.g., 1% or less). I can tell you, as a landlord, if I’m holding on to the tenant’s money and putting it into an interest-bearing account, I’m going to charge a 1% administrative fee for doing so. Since the 1% administrative fee will exceed the amount of the interest being earned, it just doesn’t make sense to invest.

From the perspective of a landlord that is small in nature and dealing with large upfront costs – carrying cost on their mortgage, paying their real estate taxes, and, in addition, they’re not going to be receiving any rent during the free rent period – such landlords want the cash security deposit for cash flow purposes (to help pay the brokerage commission and get through the time when the monies aren’t coming in), even if the tenant is a bankruptcy risk. As a consequence, they’re not going to accept a LOC, and further, they’re going to look to co-mingle that particular amount of security deposit.

As it relates to subleases, as a subtenant, you are not in privity with the landlord (i.e., you have no contractual relationship with the landlord). There’s the landlord, there’s the tenant who turns into your sublandlord, and then you as the subtenant. In the event that your master lease gets terminated because the sublandlord is in default of the lease beyond the expiration of any applicable notice and cure period, your subtenancy is at risk and the landlord, in general terms, can cancel your sublease. The acid on the wound would be, if that situation arises, that your cash security deposit given to the sublandlord is at risk and very well might be lost. To prevent against this, you can either: (1) have the sublandlord’s attorney hold your security deposit in escrow, or (2) put up the security deposit in the form of a LOC. It will definitively help you out dramatically.

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