Require Letter of Credit, Not Bond, to Protect Against Tenant's Alterations

If a tenant will be performing alterations in its space, you'll want some security that they'll be performed properly and that no mechanic's liens will be filed against your property. To achieve this end, many owners require the tenant to provide bonds before performing alterations. But bonds can be a problem for both you and the tenant, warns New York City attorney Jeffrey A. Moerdler.

To avoid these problems, require the tenant to give you a letter of credit (L/C) as security for its alterations instead of a bond, says Moerdler. An L/C is easier to get and use, and more reliable than a bond, notes Moerdler.

We'll explain why an L/C is better than a bond and tell you how to spell out the L/C requirement in your lease. Plus, there's a Model Lease Clause on p. 3 that you can adapt and use for this purpose.

Why L/C Is Better than Bond

A bond could take various forms—such as a “performance” bond to guarantee that the tenant's contractors will perform their work, or a “mechanic's lien” bond to guard against mechanic's lien filings against your building or center if the tenant doesn't pay its contractors. But regardless of whether you require either or both bonds, you could have difficulty enforcing a bond if you need to, Moerdler explains. Many owners find that when they try to enforce a bond, the bonding company responds with a variety of reasons why it isn't required to pay. If that happens to you, you may have to ask a court to force the bonding company to pay you.

And bonds can be expensive for tenants. Although the tenant's contractor applies for the bond, the contractor will pass through the cost of the bond to the tenant. Typically, a contractor pays a fee for the bond and is also required to provide security to the bonding company in the form of a cash security deposit, L/C, stocks, or negotiable bonds—which could leave the contractor strapped for cash.

An L/C sidesteps these problems. You can easily draw down on a properly drafted L/C—without having to run to court—if the tenant or its contractor doesn't properly perform its alterations, Moerdler explains. There's no need to fight a bonding company to get paid. And an L/C is typically less expensive to get than a bond.

Set Seven Requirements

If you'll require the tenant to give you an L/C before it performs alterations, add an L/C clause to your lease where it discusses alterations. Like our Model Lease Clause, your L/C clause should require the following:

L/C must be irrevocable. Require the tenant to give you an L/C that's irrevocable, unconditional, transferable, and negotiable, advises Moerdler [Clause, par. a]. It's important that the L/C be “irrevocable,” so that the bank that issues it can't cancel it without your consent, he explains.

Amount must be sufficient to protect you. Set an amount for the L/C that's high enough to cover the cost of completing or tearing down the alterations—if the tenant's contractor doesn't complete or construct them properly. It should also cover reconstructing them properly. The amount should equal at least 125 percent of the cost of the tenant's alterations (as you determine that cost), Moerdler suggests [Clause, par. a].

L/C must be issued by stable bank with a local office. Require that the L/C be issued by a bank or trust company—known as the “issuer” or the “issuing bank”—that's reputable, says Moerdler. He recommends that the lease require the issuing bank to be a member of the Clearing House Association (formerly known as the New York Clearinghouse Association, which includes the biggest banks in the country) or a commercial bank or trust company that's satisfactory to you. Also require the bank to be financially stable—that is, have a substantial net worth of, say, not less than $1 billion, says Moerdler. And say that the bank should have an office located in the same city as your building, center, or office where L/Cs can be presented for payment, since they aren't generally accepted at any branch, he adds. You don't want to have to travel a long distance to get paid [Clause, par. a].

L/C must be acceptable to you. Say in the lease that the form and content of the L/C must be acceptable to you, says Moerdler. This way, you can better control what it says, he explains [Clause, par. a]. Alternatively, you can attach a form of L/C as a lease exhibit, but most banks prefer to use their own L/C form, he notes.

Tenant must renew L/C. If the tenant's alterations will last more than one year, the issuing bank is unlikely to issue one L/C to cover the whole time. It's likely to issue an L/C for one year. In that case, you'll want to require the tenant to renew the L/C without any gaps between the expiration of the old L/C and start of the new L/C.

To achieve this, say in the lease that the tenant must renew or replace the L/C at least a 30 days before it's set to expire and keep renewing it until the work is completed, says Moerdler. And say that the tenant's failure to do so will be tantamount to a “material” violation of the lease and that you'll be allowed to draw down on the current L/C. You can then hold the money as a cash security deposit instead, he says [Clause, par. b].

Practical Pointer: Even if the project looks as if it will take less than a year to finish, Moerdler suggests that the tenant still give you an L/C that lasts one year and must be renewed. There's always the chance that delays could cause the project to last much longer than expected, he explains. If the project is completed in less than a year, you'll return the L/C to the tenant at that time, rather than waiting until the year is up, he says.

You get draw right. Get the right to draw down on the L/C if, in your determination, the tenant doesn't properly perform, complete, or fully pay its workers for the alterations, says Moerdler. Give yourself the right to draw down on the L/C to the extent you deem necessary in connection with the tenant's alterations, to protect the space or your building (or center), or to pay any necessary costs or damages, he says [Clause, par. c].

Tenant must meet conditions to get L/C back. Agree that you'll return the L/C (and/or the remaining cash security, if you've drawn on it) to the tenant only after it:

• Completes its alterations as required by the lease; and

• Provides proof that it has paid its contractors (so you won't have to worry about mechanic's liens being filed against your building or center), says Moerdler [Clause, par. d].

Practical Pointer: You may not need to add all of these requirements to your lease's alterations clause if your lease already has a separate, detailed L/C clause, says Moerdler. There may be such a clause because you're requiring the tenant to give you a separate L/C as a regular security deposit. Then your alterations clause could simply refer to the requirements set out in the L/C clause, instead of repeating them, he says.

CLLI Source

Jeffrey A. Moerdler, Esq.: Partner, Mintz, Levin, Cohn, Ferris, Glovsky & Popeo, PC, 666 3rd Ave., New York, NY 10017; (212) 692-6700; jamoerdler@mintz.com.

Sidebar

Letter of Credit Basics

Here's how a letter of credit works: Typically, a tenant applies to its bank for a letter of credit (L/C), says New York City attorney Jeffrey A. Moerdler. If the bank agrees to issue an L/C, it's known as the “issuer” or “issuing bank.” The tenant is known as the “applicant.” The person or entity to which the L/C is paid—that is, you—is known as the “beneficiary.”

If the tenant fails to properly perform, complete, or fully pay for its alterations, as required by the lease, you would go to the bank to get paid by “drawing down” on the L/C. To do this, you would present the L/C and a “sight draft”—that's a letter directing the bank to pay you without the need for any explanations, Moerdler explains. After the bank pays you, you can then use that money to repair, replace, or complete the alterations or pay the subcontractors.