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

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

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

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

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

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)

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

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

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

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

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

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

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

III. Guaranties – Case Study #1 NH Texas Properties Limited Partnership v. Mittleider, 267 Fed.Appx. 375 (5 th 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

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

III. Guaranties – Case Study #2 Moffitt 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

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

III. Guaranties – Case Study #3 Sunset 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

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

III. Guaranties – Case Study #4 Windham 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

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

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

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

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

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

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

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

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

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

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

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

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 VIII. Landlord Bankruptcy

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

Michael K. Kuhn Jackson Walker L.L.P McKinney Street, Suite 1900 Houston, Texas Michael K. Kuhn Jackson Walker L.L.P McKinney Street, Suite 1900 Houston, Texas