Lease Surety Bonds: An Alternative to Letters of Credit for Securing Tenant's Financial Obligations
 
October 5, 2001
 

In the "old days," landlords tried to protect their substantial, up-front cash investments in commercial lease deals by getting cash security deposits from the tenant and third-party guarantees, and by not limiting personal liability of creditworthy principals. More recently, the preferred mechanism switched to requiring the tenant to post a stand-by letter of credit (L.C.) from a bank in favor of the landlord. The latest evolution in this trend has led to the birth of a new species, the lease surety bond. Promoted by insurance industry issuers and brokers as a viable alternative to an L.C., and seen by both landlords and tenants to be less burdensome and less costly, lease surety bonds are a hot product. This article describes generally what a lease surety bond is, how it works, what its benefits and burdens are, and how to go about obtaining one.

What Is a Lease Surety Bond?

Think of it as being similar to performance or completion bonds that are obtained in the construction context. These are hybrid insurance products, which are alternatively called "surety bonds," "indemnity bonds," "lease bonds," or "lease surety bonds," and there are now a growing number of carriers in the market who issue this product.

Three different parties appear in the text of the surety bond. First, there is the insurance company that issues the bond, typically identified as the "surety"; second is the tenant, labeled the "principal"; and third is the landlord for whose benefit the bond is issued, called the "obligee" or "beneficiary."

The surety bond operates legally as a contractual promise on the part of the surety to perform for the tenant under the lease, should the tenant fail to perform. Just like a letter of credit, or even a regular insurance policy, the surety bond has a term, which is typically one year, but on rare occasions can be as long as five years. (Since most landlords want to have "coverage" for more than one year, surety bonds that have only a one-year term are required by the landlord to be replaced by the tenant with a new bond, typically at least 30 days in advance of the expiration of the existing bond, in order for the tenant to avoid being in default under the lease.) If the tenant then goes into default under the lease and stops paying rent, the landlord presents the surety bond to the insurance company, and demands to be "made whole."

Getting the Bond

In order to obtain a surety bond, the tenant must, in every case, sign some type of general indemnity agreement in favor of the surety, by which the tenant obligates itself contractually to make the surety "whole" in the event that it has to pay out on the surety bond. Therefore, the surety, before it issues the bond, conducts an underwriting process designed to assure itself that the tenant can meet its required financial criteria. In fact, according to experienced insurance brokers in this area, this is the most important factor in deciding whether to attempt to use the surety bond mechanism. As a practical matter, Fortune 100, and to a lesser extent, Fortune 500 company tenants will be able to meet the underwriting criteria of most surety companies. However, the weaker the tenant appears financially, the less likely the tenant can obtain a bond in the first place. (Ironic, since the weaker the tenant, the more the landlord will want the protection of the bond.) Therefore, anyone considering this option should, at the earliest point in the negotiations, have the tenant engage a competent insurance broker to help determine whether such a bond can be underwritten.

In addition to the indemnity agreement, it is very likely that a surety will require the tenant to pledge some type of collateral. Luckily, however, most sureties will not require as much collateral as would a bank agreeing to issue a letter of credit. This points out to the tenant one of the benefits of a bond over the L.C. In addition to smaller collateral, because a bond technically is not a "liability," a bond does not need to appear on the tenant's financial statements and is, therefore, referred to as an "off balance sheet" contingent obligation. This enhances the tenant's ability to obtain more financing in other contexts.

Occasionally in the case of a financially questionable tenant, the surety also asks the tenant to obtain a letter of credit from the tenant's issuing bank in favor of the surety to secure the bond. This raises the question, why is this any easier than simply having a tenant get an L.C. directly for the landlord and avoid the surety bond? The answer is that the surety typically will not require that the L.C. in its favor be for 100% of the surety bond's face-value obligation. It may require only a relatively small percentage of that amount. Thus, the letter of credit backing a bond does not need to be as large or as costly as one that would back up the lease directly, and thus does not tie up as much of the tenant's capital or assets.

Collection Problems

Now the bad news. It is generally harder to collect on a surety bond than it is to simply draw-down cash under a letter of credit. There are several reasons for this.

First, the underlying obligation covered by most surety bonds is to perform on behalf of the tenant under the lease. In effect, therefore, the surety company, when faced with a demand by the landlord, is given the right to "cure" the tenant's default, which the surety could do by starting to pay rent each month, as and when due. A surety bond thus only covers the monthly "rent" obligation. It typically does not cover "accelerated" rent. Also, it does not specifically cover the recoupment of any cash costs of the landlord, to the extent that those cash costs are not factored into, and included within, the quoted rent under the lease. These features are in contrast to most letter of credit mechanisms, where the landlord is, in effect, given the opportunity to draw-down as much of the letter of credit as it needs to cover all of its damages, which, in the context of a lease termination or eviction, could include accelerated or future rent and cash costs.

Presumably, the surety also can cure by finding and presenting the landlord with another tenant willing to step in and take over the lease. Although the validity of this type of cure has not been specifically tested in court, based on analogous settings, it is likely that the surety will be able to do this, if the bond is so written.

Also, there is a time lag. Upon a default, under most surety bonds, the landlord must wait a certain period of time (30, 60 or 90 days) before it is allowed to make a claim on the surety, and/or the surety is given a period of time after receiving the notice of a claim within which to start paying the obligation or begin its "cure" on behalf of the tenant.

The likelihood of a dispute and the necessity for resorting to litigation to resolve the dispute, is therefore much higher with a surety bond than with an L.C. Insurance companies in general have a built-in incentive to avoid or delay paying out on a claim, and going to court to compel them to do so is not an uncommon scenario.

Costs

The costs for most surety bonds are comparable to the costs of getting a letter of credit. A typical annual fee for a letter of credit can range from one to two percent, averaging around 1.25 percent, of the face amount of the letter of credit. Surety bonds typically cost about the same, and in the case of an annual surety bond that is set up from the start as part of a long-term renewal commitment of several years, it is sometimes possible to negotiate a discount on the total of the annual fees. Tenants desiring to pursue a surety bond should engage a competent insurance broker experienced in this field. The costs of such brokers typically are absorbed by the surety company and factored into the fees quoted above.

The other "costs" to consider are those involving time, effort and risk. Since bonds are typically one year in length, and must be renewed, there are reporting and underwriting efforts that must be engaged in every year by the tenant and the surety. Regardless of the term length, most sureties will annually redo their underwriting of the tenant. In the case of one-year bonds, if the financial condition of the tenant has deteriorated, the surety may in fact refuse to issue the next bond. The lease should anticipate this and provide for an alternative requirement, such as, that the tenant must either post cash security at that point, or obtain a letter of credit. (That may be easier said than done.) Also, as with any other obligation that expires during the term of the lease, the lease should provide that the tenant must keep renewing the bond at least 30 days prior to the expiration of the old one.

Finally, because of the novelty of the mechanism, there may be higher transaction costs and legal fees incurred in negotiating and documenting the surety bond arrangement. As these vehicles become more common, however, these costs should go down.

Conclusions

We are going to see more of these new surety bonds as time goes on, particularly with the larger, creditworthy tenants. It is important to remember that this is an insurance product, and therefore carries with it all the benefits and burdens of dealing with the insurance industry. Yet it must always be remembered that the sureties that underwrite this product do so with the expectation that they will not in fact suffer losses. Rather, they are set up as "deal facilitation" mechanisms, with the intention that, like a title insurance policy, if properly underwritten and structured, the insurer will not incur any loss at all. Above all, any landlord or tenant desiring to attempt this mechanism should be sure to obtain competent insurance brokerage and legal assistance, from people who are experienced in surety bonds.

For more information, contact Robert Andreani at 1-888-688-8500 or via e-mail at randrean@hklaw.com.