Protecting Your Interests: How Landlords and Tenants Can Adjust to Troubled Economic Times

For he that gets hurt will be he who has stalled,
There's a battle outside and it is ragin',
It'll soon shake your windows and rattle your walls,
For the times they are a-changin'
– Bob Dylan

Those words are as true today as they were when Bob Dylan put them to music in 1963. It is no secret that the ongoing financial crisis is affecting virtually all aspects of the economy, not only in our country but throughout the world. Whether you are in the commercial, industrial, office, retail or restaurant sector of the real estate market, both landlords and tenants are understandably concerned about the ramifications of financial distress. As a result, the parties to a lease are, in many cases, looking at their traditional relationships through a new lens, and are revisiting their policies and procedures with the goal of protecting their interests as they try to operate in these troubled times.

Landlords: Proceed with Caution

Even though the duration of the economic downturn and the timing for a recovery are beyond anyone’s knowledge or control, landlords can take certain steps to prevent or minimize problems with tenants. Despite an obvious desire to attract and retain reliable, quality tenants, in these times it is critical for landlords to conduct greater due diligence and be even more proactive in evaluating their tenants’ financial wherewithal before entering into a new lease or renewing an existing lease. This may include (i) performing a more careful analysis of the tenant’s financial statements; (ii) asking a retail tenant to provide monthly and/or quarterly sales data for periods both prior to and during the lease term in order to determine the tenant’s financial condition and ability to perform its obligations under the lease; (iii) demanding larger security deposits and in the form of certified checks or wire transfers; (iv) requiring a third party to guarantee the tenant’s lease obligations and closely scrutinizing the existing obligations of the lease guarantor; and (v) mandating that tenants deposit funds in advance to secure their obligation to complete tenant improvement work and cover potential mechanic’s lien claims.

In dealing with security deposits, many landlords have historically preferred to hold letters of credit instead of cash. Why? If a tenant files for bankruptcy protection before the landlord applies a cash deposit, the cash may become an asset of the bankruptcy estate and thus be unavailable to the landlord. Moreover, since banks have generally been considered solvent and well capitalized, landlords have rarely had to worry about the creditworthiness of the bank issuing the letter of credit. However, the widespread financial difficulties that many banking institutions now face are causing some landlords to reconsider their preference for letters of credit. Amid a rash of bank failures and the related economic turbulence rocking the banking industry, the FDIC has stepped in and sent written notices to commercial landlords advising them that the FDIC will repudiate (i.e., refuse to honor) undrawn letters of credit issued by banks that have failed or been placed into receivership or conservatorship. Because a letter of credit is only as good as the issuing bank’s ability to honor it, and since no damages against the issuer will be available to the beneficiary of the letter of credit, landlords may be well advised to reevaluate their seemingly safe policy of accepting letters of credit to satisfy a security deposit.

What should landlords do to protect themselves from potential losses? First, lease provisions allowing letters of credit as an acceptable form of security deposit should be revised to provide that if the financial institution issuing the letter of credit is declared insolvent by the FDIC or is closed for any reason, then the tenant must immediately provide a substitute letter of credit from a financial institution approved by the landlord in the landlord’s sole discretion. For further protection, landlords could also insist on the right to approve the tenant’s bank that is issuing the initial letter of credit, and require the tenant to deliver a second letter of credit from an independent bank as additional security if the financial condition of the bank that issued the initial letter of credit becomes materially weaker during the lease term.

Second, if a letter of credit is to remain an approved means of satisfying the tenant’s security deposit, then landlords should consider adopting a policy stating that letters of credit will only be accepted from banks and/or financial institutions on the landlord’s approved list. Although the FDIC maintains a directory of troubled financial institutions commonly known as the "FDIC Bank Watch List," it is not published. Nonetheless, several private companies issue bank ratings that could serve as a valuable resource for concerned landlords. In addition, landlords would be well served by designating an employee to continually monitor the names of financial institutions that are placed into receivership or conservatorship or that are closed by the FDIC in case the landlord is holding a letter of credit issued by one of these institutions.

Tenants: Safeguard Your Position

From the tenant’s perspective, there may also be reason for concern about the landlord’s ability to meet its financial obligations in this challenging economy. Accordingly, before signing a lease, a tenant should consider requesting evidence demonstrating the landlord’s financial wherewithal to pay for construction and tenant improvements. If warranted, a tenant can also demand that its landlord post security in the form of cash, a letter of credit, a bond or a guaranty from a third party to ensure the timely completion of the landlord’s work and the availability of the funds needed for the buildout of the tenant’s space.

In addition to negotiating the typical rent abatements, tenant improvement allowances and other concessions with their landlords, tenants may want to insist that landlords advance cash to pay for tenant improvements before the lease commences, rather than offering free rent during the term of the lease. Tenants may also demand that any cash security deposit and/or tenant improvement allowance proceeds be held in escrow by a title company or a third-party escrowee so that they remain uncommingled, safe and available when needed.

Moreover, it is becoming increasingly critical for tenants to obtain non-disturbance agreements from their landlords’ mortgage lenders to ensure that the tenant will be able to remain in possession of its space (as long as the tenant is not in default) in the event the landlord encounters financial distress and defaults under its mortgage. Further, given the well-publicized economic challenges faced by General Growth Properties and other troubled landlords, tenants would be wise to investigate the financial condition of their prospective or current landlords to confirm that the premises they are contemplating leasing are not at risk of foreclosure, and that the landlord is unlikely to file for bankruptcy protection.

A Two-Way Street

The best landlord-tenant relationships are mutually beneficial. Each party can, in the best of times, contribute to the other’s success. In spite of current conditions, that goal can still be achieved—as long as both landlords and tenants recognize that they need each other and are willing to view their relationship through the realities of the new economy.