on August 1, 2016
When negotiating the security deposit for a commercial lease, the parties often simply focus on the dollar amount required. While this is important, and can vary wildly depending on several factors, the language of the security deposit provision is often overlooked. This seemingly standard language, however, is important for both landlords and tenants. Unlike residential landlord/tenant law, commercial security deposits are not governed by statute. Thus, it is up to the parties to negotiate specific terms dictating the amount and process for using the security deposit.
Security Deposit Amount
Security deposit requirements in the greater Boston area are sometimes as low as one month’s rent and as high as a full year’s rent. Typically, the amount of the security deposit is based upon (1) the creditworthiness of the tenant; (2) the type of space being rented (a high-end laboratory will command a higher security deposit than a warehouse space); and (3) whether the lease is personally guaranteed. Once the amount is determined, the parties next need to determine how the security deposit may be used, whether the security deposit may be reduced at a certain point, and whether the parties wish to use something in addition to, or in lieu of, the security deposit (e.g. letter of credit or Uniform Commercial Code lien).
How the Security Deposit can be Used
Landlords often seek language stating that the security deposit can be upon any breach of the lease. Written broadly, this would include the tenant’s failure to pay rent/utilities, damage to the leased premises, failure to open for business and, in some instances, penalties, costs and attorney fees. Tenants usually push back on such provisions and look to limit the use of a security deposit for material breaches of the lease (e.g. failure to pay rent). As a corollary, the landlord will also want language requiring the tenant to replenish any portion of the security deposit used by the landlord for the tenant’s default. Regardless of the perspective, both tenants and landlords should also include language stating what happens to the security deposit at the end of the lease: tenants obviously want the security deposit back as quickly as possible (typically within 30 days of the termination of the lease) and landlords want to make sure there is language allowing the landlord to hold onto the security deposit until any and all remaining obligations have been fulfilled.
With larger security deposits, landlords will sometimes agree that after a certain period of time – say one year – the security deposit will decrease so long as the tenant is not in default. While this can be helpful for a tenant’s cash flow, it is also usually dependent on whether a tenant has an uncured material default. Thus, the tenant needs to ensure that a “default” under the terms of the lease is not so broad as to preclude a drop-down for a de minimis violation. Although there is no set rule, security deposit burndown provisions usually allow for a reduction in the security deposit halfway through a lease (e.g. a ten-year lease may allow a burndown after five years of the lease).
Uniform Commercial Code: An Alternative to a Security Deposit
As a bargaining option for both landlords and tenants, landlords may be willing to decrease or eliminate the security deposit amount, or change the burndown provision, if the tenant gives the landlord a Uniform Commercial Code (“UCC”) lien against the tenant’s property. A UCC lien works much like a mortgage: the landlord effectively has a lien against the tenant’s personal property. In office settings, this is often of little use to the landlord. After all, desks, chairs and the like generally do not have large commercial value. In higher-end uses, like restaurants, factories and laboratories, the onsite personal property likely has significant commercial value. If the tenant defaults, the landlord can seek court-intervention to obtain and potentially sell the tenant’s property. From a tenant’s perspective, this may help cash-flow by lowering the security deposit or incentivizing the landlord to provide a burndown provision. One pitfall, however, is that, like a mortgage, a UCC lien acts as an encumbrance on the tenant’s property. Meaning, it may be difficult to sell the equipment and/or use the equipment to obtain a loan from another source. If the tenant is comfortable with this, the tenant can agree to a UCC lien but should ensure that the lease contains language requiring the landlord to remove the lien upon the termination of the lease. This is simply an administrative process, but is critical for the tenant going forward.
Letter of Credit: An Alternative to a Security Deposit
A letter of credit is typically only used when the security deposit is a large dollar figure. Instead of the tenant giving the landlord a cash security deposit, the tenant obtains a letter of credit from a financial institution that essentially says the institution promises to pay the security deposit in the event of a default. Like a loan or line of credit, the issuer will charge a fee, which is often a percentage of the dollar amount of the line of credit. From the tenant’s perspective, this would free up cash flow; from a landlord’s perspective, if the letter of credit is issued by a reputable institution (e.g. a large bank), the landlord has a deep pocket from which to collect funds if need-be. The problem for landlords, however, is that letters of credit and security deposits are treated differently in bankruptcy. Meaning, if a tenant files for bankruptcy protection during the lease, courts will treat letters of credit and security deposits differently and thus a landlord may lose its protection. The implications of bankruptcy in the commercial lease context is quite complex and really deserves its own article. This article provides a great summary explaining the potential implications..
The above is a simplified summary of different approaches to security deposits and letters of credit for a commercial lease. Each situation is different, and often different locations will have differing “standards” for how leases are structure. For example, in the Boston area, the standard provisions for commercial leases in Cambridge often differ from those in the City of Boston. In fact, the standards in different neighborhoods in Cambridge (e.g., Kendall Square) often deviate from other neighborhoods (e.g., Harvard Square). As such, it is critical that both landlords and tenants speak with a commercial real estate lawyer before executing a commercial lease.