Page 10 — Retail Properties Quarterly — May 2019
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A
s businesses adapt to the
ever-changing market,
tenants increasingly are
attempting to reduce their
costs when it comes to real
estate. One way that tenants can
do this is through the use of surety
bonds as the security for leases.
Surety bonds provide for a third-
party contractual guaranty, requir
-
ing the surety to pay if the princi-
pal to a contract defaults. Surety
bonds have long been used in the
construction context due to their
simplicity and the general success
with enforcement of the surety
bonds. Recently, tenants have start
-
ed to request to use surety bonds
instead of a security deposit, letter
of credit or personal guaranty due
to the fact that surety bonds can be
cheaper and they do not require the
tenant to tie up the same amount
of capital as a letter of credit or
security deposit.
While surety bonds provide for
a cheaper means to obtain secu
-
rity for the lease, when there is a
default, they may be more difficult
to enforce than a security deposit or
a letter of credit.
•
Enforcement issues. While let-
ters of credit often are used as lease
credit enhancements, there is not
the same history with sureties and,
thus, the evidence on their enforce
-
ability is limited. Sureties generally
do not have the same relationship
with the tenant as a bank provid
-
ing a letter of credit does and thus
tend to be less willing to pay a draw
request. Banks tend to pay draw
requests, as long
as the letter of
credit is properly
drafted. On the
other hand, sure
-
ties are more likely
to dispute a draw
request. Insur
-
ance providers are
incentivized not to
pay a draw request
to increase profit
-
ability. It likely
will be easier for
a landlord to collect on a monetary
default rather than a nonmonetary
default, due to the decreased likeli
-
hood that a surety will have the
grounds to dispute a monetary
default. If litigation occurs, courts
generally enforce the surety bond
as written, since a surety bond is an
independent contractual obligation,
similar to any other contract. As a
result, while collection on a surety
may be delayed beyond what a
landlord could expect from a letter
of credit payment or performance
guaranty, landlords ultimately
should be able to realize the pro
-
ceeds of a surety bond.
•
Bankruptcy proceedings. One
benefit of a surety bond with regard
to tenant bankruptcy is that an
automatic stay should not apply to
a draw on a surety bond or letter
of credit. This is contrasted with
a cash deposit where permission
from the bankruptcy court would
be required to apply the deposit to
unpaid rent. However, even with
a surety bond, it is possible that a
required act prior
to the draw will
be subject to the
automatic stay. An
example of this is
if a surety bond is
only payable after
a lease is termi
-
nated or a notice
of default is deliv-
ered, then the ter-
mination or notice
of default may be
subject to an auto
-
matic stay. If the landlord is unable
to obtain relief from the stay, then
the landlord’s ability to draw on the
surety bond will be delayed. Thus,
landlords should include language
that, in the case of tenant bank
-
ruptcy, no notice shall be required
before landlords may draw on the
surety bond.
When a landlord does draw on
the surety bond, if the money is
held as a cash security, it could be
treated like a deposit and be sub
-
ject to an automatic stay. To avoid
this, landlords should make partial
draw requests and apply the money
to outstanding rents or return any
unused funds to the surety.
A surety bond must be drawn
upon if it is about to expire and is
not renewed; otherwise, a landlord
cannot benefit from the surety
bond. Based on the foregoing, if a
tenant does not replace the surety
at the expiration, a landlord should
have the option to use the drawn
proceeds to unilaterally fund a
replacement surety bond so that
the landlord does not have to hold
the money as a cash security.
•
Risks of surety bonds and ways
landlords can protect against them.
Landlords should always require
that the surety has a top credit rat-
ing, under AM Best or other reliable
rating agency, in order to ensure
that they will have the ability to pay
any draw request.
Surety bonds should allow for a
landlord to draw on a surety bond
without any action by a tenant in
order to reduce the ability of the
surety to claim that it does not have
to pay the draw request, which in
turn will reduce the risk of litigation
and the automatic stay dilemma
set forth above. Ideally, the surety
should waive any of its defenses
and those of a tenant, which is a
customary request in the context
of guaranties. However, sureties
are likely to push back on such a
request, as they are less familiar
with lease guaranty concepts and
more familiar with construction
bonds, where such waivers are not
necessarily commonplace.
•
Conclusion. Ultimately, surety
bonds, as security for leases,
appear to have a higher risk of
nonenforceability than a letter of
credit; however, with the appropri
-
ate measures, it is likely a land-
lord will be able to collect on the
surety bond. For all of the above
reasons, there is a chance that
collection under a surety bond
may be delayed, but, in the end,
such collection is unlikely to be
prevented.
▲
Surety bonds: An alternative security for leases
Legal
Tal Diamant
Shareholder,
Brownstein Hyatt
Farber Schreck
Elaine Bailey
Associate,
Brownstein Hyatt
Farber Schreck
