Get Right to Increase Security Deposit After Key Events
Security deposits are essential for commercial real estate owners to protect their interests when leasing space to tenants. That’s because a security deposit can be used in a number of ways to minimize the effect when a tenant doesn’t meet its lease obligations. But a security deposit amount that seems adequate at the start of the lease may not cover damages from a tenant’s breach later. For example, you may agree during the lease to let the tenant change its use, and discover only after the tenant moves out that this change caused damage to the space; if the security deposit is too small, it won’t cover the full cost of the repairs.
Leaving yourself room for security deposit flexibility is key, so that you don’t discover too late that the amount of the security deposit is too small to protect you. An airtight security deposit clause that will serve your interest for the duration of the lease should, like our Model Clause: Make Security Deposit Fit Needs Throughout Lease Term, include eight potentially costly events that would allow you to increase the tenant’s security deposit.
Specify Game Changers in Lease
Typically, there are eight events that would justify a security deposit increase. Get the right to an increase if any of the following occurs:
Event #1: Change in use. At some point, the lease might be amended because the tenant wants to make a “material”—that is, important—change to its use clause [Clause, par. a(i)]. For instance, instead of an accounting office, the tenant wants to use the space for a print shop. But that new use might result in additional damage to the space (for example, the tenant’s heavy printing equipment may cause excessive wear and tear to the floors). So you may need extra money in the security deposit to repair the damage. The key is to make sure that you alone get the right to determine whether the use change is material.
Event #2: Alteration of space. It’s not uncommon for a tenant to perform alterations to the space [Clause, par. a(viii)]. You’ll need extra money in the security deposit in case any construction liens are filed on the space or its fixtures or if you need to fix any damage to the space caused by the work.
Event #3: Shift in financing. The tenant could also request a transfer of the lease or a sublet to a financially weaker party. When a tenant requests your approval of an assignment or a sublet, and you determine that its prospective assignee or subtenant is financially weaker than the tenant, you need to protect yourself in the event that you approve the change [Clause, par. a(ii)]. You’ll want extra money in the security deposit because a financially weaker assignee or subtenant is more likely to fail to cover all of its financial obligations to you.
Event #4: Drop in tenant’s net worth. You discover that the tenant’s net worth drops below an amount that’s acceptable to you [Clause, par. a(iii)]. If the tenant’s net worth drops, it may be a sign that the tenant is having financial problems. To alleviate your concerns about its financial stability, the tenant should give you more security. Then you have more protection if the tenant later becomes financially shaky.
Event #5: Drop in guarantor’s net worth. If you discover that the guarantor’s or the indemnitor’s net worth drops below an amount that’s acceptable to you—or the guarantor or the indemnitor goes bankrupt, violates the guaranty or indemnity, or dies—that should also trigger an increase [Clause, par. a(iv)]. Because the purpose of the guaranty or indemnity is to provide additional security, an increased security deposit can act as a substitute for the guaranty or indemnity if the guarantor or indemnitor can no longer be relied upon.
Event #6: Chronic lease violations. If the tenant violates the lease more than once during a 12-month period, there should be consequences. Even if the tenant cures—that is, fixes—its lease violations, increasing the security deposit will show the tenant that violations will cost it. That may deter such behavior in the future. Start out by saying that a second violation within 12 months triggers the increase [Clause, par. a(v)]. (For a strong tenant or a tenant that will be valuable to your center, consider agreeing to a three-default trigger.)
Don’t give in if the tenant argues that your right to increase the security deposit should be triggered only if the tenant doesn’t cure the lease violation. This stops the tenant from repeatedly violating the lease and then curing the violation before you can do anything. Also, don’t limit the provision to only material violations; you and the tenant could end up arguing over which violations are material and which aren’t.
Event #7: Expanding space. If you give the tenant an option to expand its space and it exercises the option, say that your security deposit should likewise expand [Clause, par. a(vii)]. Otherwise, the security deposit may be inadequate to protect you.
Event #8: Lease renewal. If you give the tenant an option to renew and it exercises the option, make sure you increase the security deposit in proportion to any renewal rent hike [Clause, par. a(vi)]. Otherwise, the security deposit may be inadequate to protect you.
Understand Options for Calculating Increase
How much should the security deposit increase? When deciding on how much to increase the security deposit in the previous situations, you have two options to consider.
Option #1: Unlimited increase. The first is to specify that it will be an unlimited increase. Start off your negotiations with the tenant with this hardball approach. That is, don’t put a specific dollar amount increase in the lease. Instead, get the right to increase the security deposit as much as you see fit if any of the eight events occurs. To do this, say in the clause that you can increase the security deposit by an amount that you’ve determined, in your sole discretion, is necessary to protect your interests [Clause, par. b].
Option #2: Limit an increase. The second approach is to limit the increase, which savvy tenants will expect you to do because there are no controls on how much you could increase the security deposit. If the tenant demands some limit on the increase, offer this compromise: After a triggering event, you’ll increase the security deposit to a set amount; three times the original security deposit or three months’ minimum rent, whichever is higher, is reasonable.
When a tenant tries to negotiate a smaller increase, keep in mind that you’ll want enough security to cover lease violations, rent or space increases, or extra wear and tear to the space if there’s a use clause change or alterations damage. After all, you’re the one taking on the risk if you agree to an amount that won’t cover those events.
Practical Pointer: If you use the hardball approach to calculate the increase, as a precaution, remember to ask your attorney if the amount of the security deposit increase that you select will be enforceable. Otherwise, for example, you and the tenant could later get into a dispute over your demand for a security deposit increase, and a court could rule that your increase is so high that it’s an unenforceable penalty.
Set Time for Payment of Increase
When you’re negotiating how quickly the tenant must pay the security deposit increase, try to negotiate immediate payment. Start off by saying in your clause that the tenant must pay the security deposit increase immediately, upon your demand [Clause, par. b]. If the tenant argues that it’s unreasonable to require immediate payment, you can compromise by giving the tenant a few days to make the payment. Ten days is a reasonable amount of time.
There are two options for what form the security deposit increase may be paid: cash or letter of credit. So how should you decide? You may want to require the tenant to pay you in cash if the existing security deposit is in cash. But keep in mind that if a tenant goes bankrupt, you’ll have easy access to a letter of credit, but not to a cash security deposit.
Get Termination Right for Refusal to Pay
Make sure that you have the right to terminate the lease if the tenant doesn’t promptly pay the security deposit increase. This will give the tenant a strong incentive to pay the security deposit on time. Have the lease terminate within a set time—for example, 10 days—after you notify the tenant of the termination. Also, require the tenant to move out of the space within that same time period and pay rent until the lease terminates [Clause, par. c].
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