Tuesday, July 28, 2009

Alternatives to Lease Guaranties

You’re a landlord who is about to sign a lease with a tenant that is a corporation or limited liability company with no long-term operating history or few assets, and you want to be able to reach the principal of the tenant in the event of a default. The easiest way is to ask for a Lease Guaranty.

But if you’re the principal being asked to give the Lease Guaranty you don’t want to subject your personal assets to the risks associated with the possible failure of your business so you are reluctant to give the Landlord the Lease Guaranty. A failed business venture – especially in these times – should not necessarily result in a significant reduction of your lifestyle or possible loss of your house or other significant assets.

How do you resolve these conflicting interests in a manner that provides security for the landlord and is a reasonable but not life-changing risk to the tenant?

There are several alternatives to the Lease Guaranty. The simplest is for the tenant to provide more than the customary one month security deposit and one month advance rent. Looking at the local rental market, the landlord should “guestimate” how long it would take to relet the premises following a termination of the lease for default. If, for example, the landlord thinks it will take six months, then the landlord should ask for a security deposit equal to six – or maybe even seven – months’ basic rent. If the tenant defaults and the landlord relets the premises in less than the six (or seven) month time frame it will earn an unexpected windfall; if it takes longer, then the landlord can chalk that up to the typical risk of doing business.

Another alternative to a Lease Guaranty is a letter of credit in an amount equal to a prescribed number of months of rent. But, given that there are fees associated with the issuance of a letter of credit and that most issuers will require a significant amount of collateral to back up the letter of credit, this may not be as attractive to the tenant as posting the cash with the landlord.

Whether cash or a letter of credit is used, the landlord could also agree that after an agreed default-free period, a portion of the security will be released. For example, if the term of the lease is five years, then after two years the landlord could agree to reduce the security deposit by an amount equal to one month’s rent; after three years, the security deposit could be further reduced by an amount equal to two months’ rent leaving the landlord with a security deposit equal to two months of rent. In a ten-year lease the reduction might be one month after two years, one month after three years, one month after four years and two months after five years.

If the security deposit is paid in cash and it is a significant amount (e.g., equal to four months basic rent), the tenant should insist – and the landlord should agree – that the security deposit be held in a separate interest bearing escrow account. For small amounts, it is not typical that the security deposit will be segregated or bear interest but, in such cases, the landlord should be obligated to transfer the security deposit to any subsequent owner of the property and should not be released from liability until that occurs.

These are some examples of how we work with parties to address legitimate but sometimes competing interests. We are skilled in working with clients – in this example, landlords and tenants – to solve legal problems and balance the needs of all parties to a transaction.

Keywords: small business, loan, financing, small business loan, lease, commercial lease, commercial real estate, lease guarantee, guarantee

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