Letters of Credit versus Cash Security Deposits

Commercial Tenants often request that Landlords accept a Letter of Credit in lieu of a cash security deposit. This blog examines the benefits and burdens of each from both the commercial Landlord and Tenant perspectives.

Cash Security Deposit:

First of all this represents cash out of Tenant’s pocket. Generally a cash security deposit is mingled with Landlord’s funds. Tenant’s security may be subject to the financial soundness of Landlord and the bank in which Landlord deposits its funds.

The only true negative for the Landlord is that the funds are Tenant’s funds and a petition in bankruptcy by Tenant is likely to freeze the security for disposition by the Bankruptcy Trustee.

Letter of Credit:

A Letter of Credit is the obligation of the Bank that issues the Letter of Credit and bankruptcy of Tenant will not impede Landlord’s ability to reach the proceeds of the Letter of Credit.

The Letter of Credit should be carefully drafted to permit the Landlord the right to draw down the proceeds (all or a portion) upon presentation to the Bank of a demand for payment in the amount to draw on, together with a certification by Landlord that it is entitled to draw on the Letter of Credit pursuant to the Lease.  The Letter of Credit should also provide that it is renewable for consecutive annual periods; and that upon notice of nonrenewal at least thirty (30) days prior to expiration date of the Letter of Credit, Landlord may draw on the Letter of Credit.  The Letter of Credit should expire no earlier than thirty (30) days after the expiration of the lease term.

The Letter of Credit and the Lease should each provide that the amount drawn down be replenished by the Tenant with a replacement Letter of Credit for the full amount.  The Lease and Letter of Credit should expressly provide that its application is not a limitation on Landlord’s damages, or liquidated damages, or rent for the last month of the term of the lease.

The Letter of Credit should permit transfer to Landlord’s transferees.  Landlord should also have the right to cause Tenant to replace the Letter of Credit with a Letter of Credit from another bank acceptable to Landlord in the event that Landlord becomes concerned about the stability of the Issuing Bank.

Complexity is the only true negative of the Letter of Credit.  The Letter of Credit benefits Tenant who may still earn interest on the funds subject to the Letter of Credit.

Here is an example lease provision providing for a Letter of Credit.