Commercial tenants and subtenants are typically required to post a security instrument with the landlord or sublandlord to help limit their exposure to non-payment of rent and bankruptcy.
The three most common instruments are a personal guarantee, a cash security deposit and a bank-issued irrevocable letter of credit.
Don't ever agree to a personal guarantee for a commercial lease as it places too much risk on the individual's assets, which should be completely separated from the business entity.
A cash security deposit is money that the tenant deposits into the landlord's bank account and returned at the end of the lease term, subject to deductions for repairs or non-payment of rent.
Alternatively, a letter of credit allows a landlord to withdraw money from the tenant's account if there's a monetary default (i.e. a rental payment is missed).
In many cases, a letter of credit is better for both parties since it frees up cash resources for the tenant while providing the landlord with potentially more protection in the event of a default or bankruptcy.
Whereas a cash security deposit leaves the tenant's account and can tie up a considerable amount of working capital, a letter of credit keeps the money in their account where it can earn interest. The bank will charge an annual fee tied to the credit amount, usually between 1-3% of the total amount, and then charge interest in the event the landlord needs to make a withdrawal.
The letter of credit may also be better for the landlord or sublandlord because a cash security deposit might become part of a bankrupt tenant’s estate if the tenant files for bankruptcy before the landlord has applied it to back rent. That's because a cash security deposit is still considered the tenant's funds, and a petition in bankruptcy by the tenant is likely to freeze the security for disposition by the bankruptcy trustee.
Additionally, a letter of credit isn’t covered by automatic stays imposed by bankruptcy courts, so the landlord can draw on it immediately, without seeking approval from the court. This transaction guarantees the payment of rent, even if the tenant defaults.
There now is a new, third option that tenants and landlords should consider, and that's a surety bond which is essentially an insurance policy taken out by the tenant. Learn more about that option here.