As high technology companies form an increasingly significant portion of the commercial tenant base, the commercial real estate industry has developed new strategies to help ensure these tenants meet the rental and other obligations of their commercial leases. One such form of lease security that is rapidly gaining acceptance among commercial landlords, tenants, brokers and lenders is the lease bond.

What is a Lease Bond?

A lease bond is a contract between three parties: (1) landlord, (2) tenant, and (3) surety underwriter. The lease bond, which may be held by the landlord in lieu of a cash security deposit, letter of credit, or a personal or corporate guaranty, serves as security for the tenant's full and complete performance of the terms of its commercial lease. The lease bond is similar in many practical respects to both a letter of credit and a guaranty. If the tenant fails to uphold the terms and conditions of its lease, the landlord may submit a claim against the bond, which is paid by the surety underwriter much like a draw made by the landlord would be paid by a bank under a letter of credit.

With a lease bond, the surety underwriter (and not the tenant) is ultimately liable to the landlord for the tenant's breach of its lease. The surety underwriter's liability on the lease bond is strictly monetary; the surety underwriter is generally not required to physically perform the unfulfilled non-monetary obligations of the tenant.

How Is a Lease Bond Created?

Most national and international insurance underwriters/sureties issue lease bonds directly or through agency relationships. During the course of lease negotiation, the tenant may request that a surety underwriter issue a lease bond to secure its financial obligations under the lease. The surety underwriter then reviews the tenant's general business history, credit rating, financial statements, capitalization, and in some cases, business plan. Based upon this review, the surety underwriter issues a lease bond in exchange for the payment of a specified premium. For many tenants, the amount of the premium will be considerably less than the cost of posting and maintaining a letter of credit throughout the term of the lease.

Prior to the execution of the lease and issuance of the lease bond, the landlord negotiates the terms under which the surety will tender payment if the tenant breaches the lease. Negotiations tend to focus upon the notice and cure rights granted to the surety company, time period(s) for payment, and other issues which may ultimately affect the landlord's ability to collect under the lease or lease bond. As with all negotiations of this nature, the stronger the tenant's credit rating, financial statements, and capitalization, the more favorable the notice, cure and payment terms of the lease bond will be for the tenant.

How Does a Lease Bond Work?

After the parties negotiate the terms of the lease bond, it is held by the landlord in the same way the landlord would hold a letter of credit. Should the tenant fail to perform its leasehold obligations, the landlord notifies the tenant (as per the lease) and surety underwriter (under the lease bond) of the lease default in accordance with the respective notice provisions of the lease and the lease bond. Once a tenant default is established under the lease, the landlord is entitled to make a claim against the lease bond for prompt payment by the surety underwriter. In addition, the landlord may pursue other remedies against the tenant that are available under the lease or applicable law.

Benefits to Landlords

Lease bonds provide benefits to both landlords and tenants. For landlords, the primary benefit is that the credit of the surety underwriter, rather than the credit of the tenant, ultimately secures the tenant's financial performance of the lease. The benefit here is twofold. First, the risk/benefit analysis made by the landlord largely focuses on the financial strength (Treasury rating and underwriting capacity) of the surety company, which is readily available from many sources, rather than the financial strength of the tenant. This is significant, because information of this nature may not be available for recently founded dot-coms, emerging growth, and technology companies entering the commercial real estate marketplace. Second, once the lease bond is posted the landlord need only submit a claim against the bond to obtain payment, if the tenant breaches the terms of the lease. Payments to the landlord would be made pursuant to the terms and conditions of the lease bond, which, as stated above, are negotiated by the landlord and surety underwriter prior to execution of the lease and issuance of the lease bond. Lease bonds are also beneficial to landlords because the proceeds of a lease bond are not currently subject to the jurisdiction of bankruptcy courts. Unlike a cash security deposit, the proceeds of a lease bond are not customarily considered an asset of the tenant. As a result, landlords need not enter into protracted litigation to collect from potentially bankrupt tenants. Instead, landlords need only file a valid claim against the bond to receive payment. Finally, because lease bonds tend to be less expensive for tenants, when compared to the cost of posting and maintaining a letter of credit or cash security deposit, landlords ultimately benefit from the opportunity to lease space to these tenants, many of whom either find the cost of a letter of credit to be prohibitive, or they are not willing to sacrifice working capital in order to post a cash security deposit.

Benefits to Tenants

Tenants also benefit from the use of lease bonds. The primary benefit to the tenant comes from the fact the obligation secured by the lease bond is not treated as a contingent liability on the tenant's financial statements. As a result, the tenant's financial statements and borrowing capacity are not adversely affected by the execution of a lease and the issuance of necessary lease security. For technology companies and other firms seeking to raise capital through the sale of stock in initial public offerings, the off-balance sheet treatment of such liabilities greatly enhances the value of such firms in the eyes of potential Wall Street analysts, lenders, and venture capital firms.

Tenants also benefit from the posting of a lease bond because the premium is negotiated up-front, allowing the tenant to compare the overall cost of a lease bond against the costs associated with posting a letter of credit or cash security deposit. Although premiums charged by surety underwriters are based upon the creditworthiness of the tenant, they are typically less than the cost of establishing and maintaining a letter of credit or traditional cash security deposits. Moreover, the tenant does not lose the ability to invest or use the funds in its core business, which would otherwise be pledged under a letter of credit or cash security deposit. This is especially helpful for emerging growth companies, many of whom are attempting to both raise and conserve precious capital in a fast-paced and ever-changing market place with few constraints or traditional and time-tested business practices.

Finally, lease bonds benefit tenants by removing the requirement that a tenant or its principals provide a personal or corporate guaranty under the lease. This is of special advantage to the tenant organized as a general or limited liability partnership, the individual members or founders of which may often be asked to individually bear the financial responsibility for the firm's actions, successes, and failures.

Conclusion

In today's rapidly changing economy, the need for creative solutions to lease securitization issues has never been greater. As more dot-coms, emerging growth, and technology companies enter the commercial real estate marketplace, the emergence of the lease bond as a viable solution to lease securitization issues is becoming an accepted standard in the commercial real estate industry. Lease bonds have many benefits for both landlords and tenants, and as their use and acceptance grows, there is little doubt lease bonds will become a preferred vehicle of lease security in the new millennium.

About the Authors

John G. Lavoie focuses his practice on real estate transactions with emphasis on the acquisition and disposition of commercial real estate, including the purchase, sale and leasing of office, industrial, retail and unimproved commercial real property. Mr. Lavoie is a member of the Bar in Virginia and the District of Columbia.

Michael J. Kirwin also focuses his practice on real estate transactions, primarily concentrating on the acquisition and disposition of commercial real estate, including the purchase, sale, leasing and financing of both large and small commercial properties. Mr. Kirwin is a member of the Bar in Maryland and Florida.

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