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COVID-19: Handling Monetary Defaults and Security Deposits under Commercial Leases

April 21, 2020

As commercial tenants of all kinds face economic hardship resulting from the COVID-19 pandemic and an uncertain timeline for a return to business as usual, reports of tenants missing rent payments, seeking rent relief, or otherwise anticipating an eventual default are growing in number.  Landlords and tenants alike are now re-reading their leases to determine whether a monetary default is deemed to have occurred and what action the landlord can take, including with respect to any security deposit being held.

Monetary Default
Commercial leases typically require tenants to pay monthly installments of fixed rent plus other variable charges, such as a pro-rata share of a building’s operating expenses and real estate taxes in the case of multi-tenant buildings.  For some retail tenants, percentage rent based on revenues from the leased premises may also be due and payable.  If a tenant fails to make one of these payments when due or within an applicable grace period, the tenant is considered to be in “monetary default” under the lease, permitting the landlord to exercise its remedies, usually after sending a written default notice to the tenant. 

As a practical matter, a landlord may choose not to default a tenant after the first missed rent payment but may instead reach an agreement with the tenant that would temporarily reduce or defer the rent or implement alternative payment arrangements.  In these circumstances, the landlord should make clear that it is not waiving its right to declare a default if the tenant fails to comply with the terms of any restructuring agreement or fails to pay rent again in the future.  It is also important for a landlord to consider whether granting accommodations under a lease would require the consent of its lender under its mortgage loan documents (see our prior alert on Lease Modification Considerations for Landlords).  During negotiations, a tenant may try to argue that it is excused from paying rent because of its landlord’s failure to perform under the lease; however, in many states, the tenant’s duty to pay rent is independent from the landlord’s obligations, and rent must still be paid notwithstanding a landlord default. 

Where a tenant remains in monetary default, the landlord is often permitted to terminate the lease, seek unpaid rent through the date of lease termination, and evict the tenant through summary process proceedings if necessary.  In addition, if a landlord elects to terminate, the lease may permit the landlord to accelerate the rent that would have been due for the remainder of the lease term, which will be either reduced by the fair market value of the premises for that period or offset by amounts actually received from re-letting the premises to another tenant.  A landlord may also be able to recoup unamortized portions of tenant improvement allowances. 

Practically speaking, if a defaulting tenant is in dire financial straits, the landlord may have enough trouble recovering past-due rent, let alone collecting damages.  Furthermore, applicable law--or the terms of a lease itself--may require a landlord to use commercially reasonable efforts to mitigate damages following a tenant default.  Landlords will often list examples of what constitutes “commercially reasonable efforts” in the lease, such as using the same efforts to market the premises that they would use for other properties.  In the current economic situation, the pool of replacement tenants may be limited, and market rents for a given property type may decrease due to lower demand and greater availability caused by tenants being evicted or downsizing.  Consequently, defaulting tenants may not have the benefit of a robust market to help offset potential damages where the landlord accelerates rent.

In any case, whether a landlord charges late fees on past-due rent, accelerates the rent, or applies a tenant’s security deposit to unpaid rent, landlords must bear in mind that these amounts could be considered liquidated damages.  As a general principle, the amount of liquidated damages must bear a reasonable relationship to the damages anticipated to be suffered, and the actual amount of damages must be difficult to ascertain at the time of contract or hard to prove.   Liquidated damages will not be enforceable if they are greatly disproportionate to the actual damages suffered, thereby operating as a penalty. 

Any evaluation of monetary defaults should also include a review of any lease guaranties and the availability of landlord liens on a tenant’s personal property, to the extent they have not been waived. 

Security Deposits
Due to the COVID-19 crisis, many courts’ functions have been significantly reduced, and some state governments have issued moratoria on evictions.  As a result, the remedies discussed above, which require lawsuits to be filed against a defaulting tenant, may be difficult to obtain or altogether unavailable.  In these circumstances, a security deposit is a readily available remedy that may provide a stopgap until the courts fully reopen and moratoria are lifted.

Commercial landlords typically require a security deposit from a tenant as a means to secure the tenant’s performance of its obligations under the lease.  When a tenant doesn’t pay rent, the terms of the lease may permit the landlord to draw on the tenant’s security deposit and apply these funds to the unpaid rent or to other defaults.  A security deposit usually takes one of two forms:  cash or a letter of credit issued by a financial institution. 

Cash is the most palatable form of security deposit for tenants with weaker credit.  There is no bank underwriting involved and no issuance fees to be paid, unlike with letters of credit.  The landlord must return the deposit to the tenant upon termination of the lease if the tenant has satisfactorily fulfilled all of its obligations.  It is important to note, however, that a cash security deposit is an asset of a bankrupt tenant’s estate, so if a tenant stops paying rent and the landlord applies the cash deposit, and the tenant files for bankruptcy protection soon thereafter, the landlord may have to disgorge the security deposit as a “preferential transfer” under bankruptcy law.  This makes cash security deposits less attractive to landlords.

Letters of credit, on the other hand, are more desirable for landlords but more burdensome for tenants.  A letter of credit is a commitment by a bank to give a beneficiary (here, the landlord) a specified sum when the landlord presents the letter to the bank following the failure of the applicant (here, the tenant) to fulfill contractual obligations.  One subset of letters of credit, known as irrevocable letters of credit, cannot be changed without the written agreement of the issuing bank, the beneficiary, and the applicant, and cannot be cancelled during the stated term (here, the term of the lease).  Because a letter of credit involves an extension of credit by the bank on behalf of the tenant, the bank may require the tenant to keep an amount on deposit equal to the face amount of the letter of credit; some banks may instead loan the tenant the face amount of the letter of credit. Consequently, less creditworthy tenants may not be willing or able to obtain a letter of credit as a security deposit.

Importantly for landlords, because letters of credit are a contractual obligation of the issuing bank to pay the landlord/beneficiary, instead of cash that remains the property of the tenant despite being held by the landlord, a letter of credit is not part of the tenant’s estate in bankruptcy and is not subject to the automatic stay.  As such, a landlord could draw on a letter of credit without being subject to disgorgement if the tenant files for bankruptcy.

Depending on the lease, there may be a wrinkle with letters of credit or cash used as security deposits: the “burn-down” clause.  In some commercial leases, a tenant may be permitted to reduce the amount of the deposit if certain milestones are met without a tenant default.  In these cases, if a tenant defaults far into the lease term, a landlord may have a significantly lower amount available to draw upon as a security deposit.  Presumably, though, the landlord weighed that risk in agreeing to the burn-down clause.

Shipman & Goodwin attorneys are available to assist landlords and tenants navigate leases, including issues involving monetary defaults and the exercise of remedies, with functional and pragmatic solutions during these uncertain times. We will endeavor to analyze and explain the relevant law in these areas and related considerations, and update our Coronavirus Resource Center (specifically, the Real Estate Leasing page) periodically to include relevant Connecticut, New York, federal and local laws, rules and regulations that are enacted during this crisis, as well as court filings and relevant precedent or other topical information, which are being circulated on these matters.

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