Using Letter of Credit vs. Cash Security Deposit

While the economy has steadily improved in many areas, it’s still important to protect yourself from the perils of a bankrupt tenant. When negotiating with a prospective tenant—especially one that’s small or not financially strong—keep in mind that if it experiences financial problems the security deposit could wind up being your only access to funds that can compensate you if the tenant stops paying rent or otherwise breaches the lease. A cash security deposit can leave you vulnerable in the event of a tenant’s bankruptcy. To protect yourself, consider a more reliable alternative: a letter of credit (LOC) security deposit, but don't forget that there may be other options as well depending on your situation.

Trend toward LOCs. Owners have been increasingly favoring letters of credit rather than cash as security from tenants. That's because in recent court cases, even though a lease specified that the cash was to be used as a security deposit, some courts still treated it as part of the general funds of the tenant, essentially making it available for all creditors of the tenant. An LOC should be more secure because, unlike a cash security deposit, it isn’t an obligation of the tenant. Technically, it’s not the tenant’s money; it’s the obligation of a third party to pay the owner a certain amount of money upon a certain event, such as a breach of the lease.

Consider other options. Using an LOC isn’t totally risk-free, but there have been enough court cases ruling that an LOC isn’t part of the tenant’s bankruptcy estate to make it worth considering. Consult with your attorney about whether this is a good option for you and explore other options, such as the tried and true personal guaranty or a corporate guaranty from a parent company. This will depend largely on what type of tenant you are dealing with. Certain deals will also dictate what form of security is customary. For example, in the case of a franchise tenant, it’s routine to require a parent company guaranty or a franchisor guaranty.

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