Credit Enhancements in Leases

1. MICHAEL K. KUHN Jackson Walker L.L.P. 1401 McKinney, Suite 1900 Houston, Texas CLE International 10th Annual Conference Negotiating Leases: Renegotiating in the Current Economic ClimateJanuary 25-26, 2010 Houston, Texas Credit Enhancementsin Leases

2. Is Credit Enhancement Necessary? ● Landlord’s investment in premises ● Tenant improvement allowance ● Tenant’s investment in premises ● Specialized tenant improvements ● Landlord’s ability to remarket premises

3. Types of Credit Enhancement • Cash security deposit • Letter of credit • Guaranty • Lease bond • Pledge of property • Landlord’s lien

4. I. Security Deposit • Cash • Amount – function of rent or fixed amount • Held in separate account? • No documentation needed other than lease • No third party involved • Easily assignable to subsequent owner • Statutory provisions governing handling

5. I. Security Deposit – Pros and Cons Pros for Landlord: -immediate cash -easily transferable Cons for Tenant: -need to be able to pay cash -cash is tied up

6. II. Letters of Credit • Credit based on issuing bank’s financial strength • Focus on draw requirements • Separate document (but attached to or described in lease)

7. II. Letters of Credit • Typically 12-month term (but typically “evergreen”) • Last renewal should extend past lease term

8. II. Letters of Credit– Pros and Cons Pros for Landlord: -bank’s credit -no tenant involvement Pros for Tenant: -does not tie up cash -automatic expiration

9. II. Letters of Credit– Pros and Cons Cons for Landlord: -not immediate cash -drawing procedure -transferability -inadvertent expiration -FDIC closure Cons for Tenant: -may need collateral -burden of renewals -transfer to new LL -faulty draws

10. III. Guaranties • Typically issued by an affiliate • Guaranty of payment not collection • “Cap” vs. “burn-down” vs. “springing”

11. III. Guaranties • “Cap”: first or last dollar? Does limitation describe a time period or dollar amount? • Waiver of defenses to payment • Must be supported by consideration

12. III. Guaranties – Pros and Cons Pros for Landlord: -covers all of tenant’s obligations -adaptable to specifics of deal Pros for Tenant: -easy to obtain -expires with lease

13. III. Guaranties – Pros and Cons Cons for Landlord: -guarantor’s credit may change -risk of guarantor bankruptcy -collection issues Cons for Tenant: -need guarantor’s cooperation -issue of assignment of lease & release of guarantor

14. III. Guaranties–Case Study #1NH Texas Properties Limited Partnership v. Mittleider, 267 Fed.Appx. 375 (5th Cir. (Tex.) 2008). Facts: • Guaranty language: “in the amount of $1,236,180 due under the lease … payable from the date hereof until February 1, 2006….” • Guarantor argued only guaranteed first $1,236,180 payable under lease

15. III. Guaranties– Case Study #1 Holding/Lessons learned: • Guaranty not limited to first $1,236,180 • Feb. 1 outside date not necessary if limited to first $1,236,180 • Should specify “only the first $1,236,180” if that was intent

16. III. Guaranties – Case Study #2Moffitt v. DSC Finance Corp.,797 S.W.2d 661 (Tex.App.—Dallas 1990) Facts: • Guaranty language: “[75%] of the outstanding balance…during the first [12] months of the Lease, then [50%]…during the remaining [48] months of the Lease.” • Default occurred during the second month of the lease

17. III. Guaranties – Case Study #2 Holding/Lessons learned: • Guarantor liable for 75% of first year’s rent and 50% of remaining four years’ rent (not 75% of all rent if default occurs in first 12 months) • Timing of default is not factor • Rule of construction: whichever is more favorable to guarantor

18. III. Guaranties – Case Study #3Sunset Center v. Associated Med. Hlt.,585 So.2d 977 (Fla.App. 3 Dist. 1991) Facts: • Guarantor’s obligation limited to the first 12 month period of the lease • Tenant defaults during first 12 months • Landlord argues Guarantor is fully liable for all unpaid rent until expiration • Guarantor argues limitation on amount

19. III. Guaranties – Case Study #3 Holding/Lessons learned: • Guaranty limits amount for which Guarantor is liable (not a timing issue) • Because lease was prepared by Landlord, the Court construed ambiguity against Landlord

20. III. Guaranties– Case Study #4Windham v. Cal-Tim,47 S.W.3d 846 (Tex.App.—Beaumont, 2001) Facts: • Lease signed in 1994; did not expressly reference a guaranty • Guaranty signed in 1995 without independent consideration, but contained consideration recital • Issue of whether there is consideration for guaranty

21. III. Guaranties– Case Study #4 Holding/Lessons learned: • There was consideration for the guaranty • Evidence that guaranty contemplated in base transaction • Discrepancy in timing alone not enough to rebut presumption that guaranty has consideration

22. IV. Lease Bond • Surety underwriter – akin to insurance • Limited to monetary, not performance, obligation • Uncommon

23. V. Pledge of Property • Security interest - perfection issues • Documented by security agreement and/or stock power • Governed by UCC • Uncommon due to procedural aspects

24. VI. Landlord’s Lien • Tenant’s personal property at premises • Contractual lien • created in the lease • definition of tenant’s personal property • UCC financing statements

25. VI. Landlord’s Lien • Statutory lien (Tex. Prop. Code §54.021) • foreclosure requires judicial action • limited in time to a period of rent • automatically perfected security interest

26. VI. Contractual Landlord’s Lien – Pros and Cons Pros for Landlord: -control FF&E in leased space, making it easier to relet following tenant default -valuable for restaurant, medical or industrial use

27. VI. Contractual Landlord’s Lien – Pros and Cons Cons for Landlord: -low resale value of property -liability for personal information -risk of conversion -lockout and recovery procedure

28. VII. Tenant Bankruptcy • Security Deposit • Timing for applying • Landlord has perfected security interest in deposit • Landlord may be compelled to turn over excess • Letter of Credit • “Independence doctrine” for Letter of Credit • Automatic stay will bar sending of default notice • Section 502 cap on lease rejection damages

29. VII. Tenant Bankruptcy • Guaranty • No bar to proceeding against guarantor unless guarantor also in bankruptcy • No Section 502 cap applies • Contractual landlord’s lien • Enforcement barred by automatic stay

30. VII. Tenant Bankruptcy– Case StudyIn re Stonebridge Tech., Inc., 430 F.3d 260 (5th Cir. 2005) Facts: • Tenant files bankruptcy • Lease definition of security deposit is cash and letter of credit • Tenant draws over bankruptcy cap on LoC

31. VII. Tenant Bankruptcy– Case Study Holding/Lessons learned: • Consistent with independence doctrine, LoC is not subject to bankruptcy cap • Landlord did not file Proof of Claim; stayed out of bankruptcy proceeding

32. VIII. Landlord Bankruptcy Security Deposit • Commingling of cash – tenant risks losing security deposit if lease is rejected by landlord • but tenant may be able to offset final rent payments to equal lost deposit • Tenant’s claim to security deposit takes priority over other claims – Tex. Prop. Code §93.005(b) Letter of Credit • No issue with letters of credit - triggered by tenant default

33. Practice Tips • Choose the appropriate form of credit enhancements • Consider the limitations • Words matter • Draft carefully, especially: • Draw requirements for Letter of Credit • Cap on guaranty (use example) • FDIC surprise on Letters of Credit • Bankruptcy surprises

34. Michael K. Kuhn Jackson Walker L.L.P. 1401 McKinney Street, Suite 1900 Houston, Texas 77010 713-752-4309 mkuhn@jw.com