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down a letter of credit because the letter of credit is the direct obligation of the issuing
bank to the landlord; and the tenant, although affected by a draw on the letter of credit,
has no property interest in the letter of credit. Landlords therefore prefer letters of credit
in high risk situations, and restaurants often present a high risk situation. There are,
however, administrative drawbacks to a letter of credit that should not be ignored. If the
letter of credit is lost, or a critical notice from the issuing bank is ignored by the
landlord’s administrative staff, or the landlord changes its address and fails to receive a
critical bank notice, the letter of credit may become a worthless (or lost) piece of paper,
leaving the landlord completely unsecured. Any landlord requiring the tenant to provide
a letter of credit as security needs to be cognizant of the administrative risks and take
proper precautions.
Landlords may also consider having the letter of credit secure the obligation of a
guarantor, rather than the tenant itself. The reason for the structure, as always, is
bankruptcy considerations. If the tenant files for bankruptcy and rejects the lease, the
landlord’s claim for lease termination damages is capped (the “Cap”) under the
Bankruptcy Code at the sum of (a) the unpaid rent due as of the earlier of the date the
tenant filed for bankruptcy and the date the tenant vacated the premises and (b) the
greater of (i) one year’s rent (calculated without any reference to acceleration of rents,
even if the lease provides for such acceleration), and (ii) 15% of the rent due for the
remaining term of the lease (not to exceed three years’ rent). Bankruptcy Code
§502(b)(6). The Cap limits the lease termination damages the landlord can realize on its
claim against the tenant in bankruptcy, and if the security deposit held by the landlord,
whether cash or letter of credit, exceeds the Cap, the landlord will be required to disgorge
the excess (subject to a possible exception for other kinds of damages). If, however, a
principal of the tenant guaranties the lease and secures its guaranty with a letter of credit,
the Cap will not limit the lease termination damages the landlord may recover from the
guarantor (unless the guarantor also files for bankruptcy, in which case there is an issue).
Before adopting this somewhat tortuous structure, the landlord should obviously evaluate
the possible benefits to be realized from a guaranty secured by a letter of credit.
Term. Because the tenant’s investment is often substantial, restaurant leases tend
to be relatively long term leases, with a minimum term of ten years plus one or more
extension options.
Real Estate Taxes. Depending on location, the tenant may pay a percentage of all
real estate taxes levied against the property (e.g., 10% or 100% of the property’s real
estate taxes) or a percentage of increases in taxes over a base year (usually the tax fiscal
year in which the lease is signed), as is typical of New York City, or above a “stop” (a
fixed amount). The tenant’s percentage should, in theory, be a fraction equal to the
rentable square footage of the premises divided by the rentable square footage of the
entire building or shopping center (and should never be determined with reference to the
“leased” area of the building or shopping center). However, measurement standards vary
from jurisdiction to jurisdiction and also depend on the nature of the building project
(e.g., mixed use office building, strip center, or shopping center). Formulas used in
shopping centers tend to take on a life of their own, with possible adjustments of the
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