Use Letter of Credit as Security for Tenant's Construction

When a tenant performs alterations in its space, there’s always the risk that they won’t be performed properly or that one or more mechanic’s liens will be filed against your property. Both of these issues can be costly and have long-lasting ramifications. Traditionally, many owners have tried to avoid those situations by requiring a tenant that plans to do construction to provide bonds before the work starts. But bonds can be a problem for both you and the tenant.

Here’s why you should use a letter of credit (LOC) as security for the tenant’s alterations, instead of a bond, and how you can spell out this requirement in the lease. Also on the plus side: An LOC is easier to get and use, and more reliable than a bond.

Comparing LOC with 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. 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, LOC, stocks, or negotiable bonds—which could leave the contractor strapped for cash.

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

Include Requirements in Alterations Provisions of Lease

If you’ll require the tenant to give you an LOC before it performs alterations, add an LOC clause to your lease where it discusses alterations. Like our Model Lease Clause: Require Letter of Credit Instead of Bond for Tenant’s Alterations, your LOC clause should require the following:

LOC must be irrevocable. Require the tenant to give you an LOC that’s irrevocable, unconditional, transferable, and negotiable [Clause, par. a]. It’s important that the LOC be “irrevocable,” so that the bank that issues it can’t cancel it without your consent.

Amount must be sufficient to protect you. Set an amount for the LOC 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) [Clause, par. a].

LOC must be issued by stable bank with local office. Require that the LOC be issued by a bank or trust company—known as the “issuer” or the “issuing bank”—that’s reputable. Say that the bank should have an office located in the same city as your building, center, or office where LOCs can be presented for payment, since they aren’t generally accepted at any branch. You don’t want to have to travel a long distance to get paid [Clause, par. a].

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

Tenant must renew LOC. If the tenant’s alterations will last more than one year, the issuing bank is unlikely to issue one LOC to cover the whole time. It’s likely to issue an LOC for one year. In that case, you’ll want to require the tenant to renew the LOC without any gaps between the expiration of the old LOC and start of the new LOC. To achieve this, say in the lease that the tenant must renew or replace the LOC at least 30 days before it’s set to expire and keep renewing it until the work is completed. 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 LOC. You can then hold the money as a cash security deposit instead [Clause, par. b].

Practical Pointer: Even if the project looks as if it will take less than a year to finish, the tenant still should give you an LOC 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. If the project is completed in less than a year, you’ll return the LOC to the tenant at that time, rather than waiting until the year is up.

You get draw right. Get the right to draw down on the LOC if, in your determination, the tenant doesn’t properly perform, complete, or fully pay its workers for the alterations. Give yourself the right to draw down on the LOC 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 [Clause, par. c].

Tenant must meet conditions to get LOC back. Agree that you’ll return the LOC (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) [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 LOC clause. There may be such a clause because you’re requiring the tenant to give you a separate LOC as a regular security deposit. Then your alterations clause could simply refer to the requirements set out in the LOC clause, instead of repeating them.