Demands on Liquidity in Commercial Leasing
When entering into a lease agreement, either commercial (retail or industrial) or residential, the ‘lessee’ (the person leasing the premises for use), may be able to provide bank guarantees to meet their financial liabilities to the lessor (‘landlord’). These can include, but is not restricted to, an advance on the rent as a surety, or a refundable amount (sometimes referred to as a ‘security deposit’) which acts as a ‘bond’ against which the landlord can draw down any amount left unpaid and outstanding when the lease ultimately lapses for whatever reason.
This bond is available to the landlord for the purpose of ensuring rental payment; carrying out any repairs for damage caused by the tenant; or to remediate the rental premises to its contracted-for vacant condition if this has been left undone when the tenant quits the premises.
These financial assurance obligations can place an onerous burden on an entrepreneur seeking to commence commercial trading operations, given the need for working capital. In order to conserve cash assets, a potential lessee can request the landlord/lessor to accept a bank guarantee in lieu of cash. Generally, landlords cannot unreasonably refuse to accept such a bank guarantee.
The issue of these instruments is not covered by any specific prudential legislation. All agreements between the three parties fall under private contract law and the obligations of the parties will be detailed in the written contracts agreed to between them.
What are Bank Guarantees?
A Bank Guarantee is a banking product (usually referred to as an ‘instrument’) designed to provide assurance of payment to a person to whom money may become payable at a future time. Use of these instruments allows the party with the payment obligation either to retain access to and use of some of their cash resources to maintain ongoing commercial liquidity or to leverage their cash assets by arrangement with their bank. These instruments carry a wide range of different names for what are essentially the same thing, including ‘demand guarantee’, ‘financial guarantee’, ‘documentary credit’, ‘letter of credit’, or ‘bank bond’, among other terms. The name of the instrument is not important – its function is the important element.
There are usually only three parties to such transactions in an Australian domestic setting – the ‘Applicant’, the ‘Beneficiary’ and the ‘Issuing Bank’, which is the banking institution or other financial organisation who undertakes to make payment. The Applicant will generally be the lessee. The Beneficiary will generally be the landlord lessor, or a person/company nominated by them.
An Applicant/lessee can apply to their bank for a Guarantee to be issued to the Beneficiary to fulfill their obligations under the lease. Once the application has been received, the bank will assess the financial position of the Applicant and determine whether they have the financial wherewithal to support the obligation they are undertaking. In certain circumstances, the bank may wish to ring-fence some (or all) of the funds that have been guaranteed under the instrument by placing the cash in a trust account. While this also limits access to the capital, the Applicant will enjoy the benefit of any interest from the trust account and the bank will remain in a better position to evaluate the Applicant’s financial position over time.
Landlords of commercial premises will generally prefer a bank guarantee to a cash deposit because of the administrative difficulties and costs associated with holding cash on trust. Supply of the instrument will almost invariably be a term of the lease itself.
Banks’ Payment Obligation
For landlords, bank guarantees without an expiry date would be preferable but some commercial banks in Australia are reluctant to issue such instruments without an expiry date. With Guarantees that expire, the Beneficiary/landlord will need to maintain a register of all guarantees provided by all their tenants and ensure that replacement guarantees are provided before the lapse date of the instrument.
Bank Guarantees are payable on demand without reference to the Applicant/lessee. This means that, if the holder of a Bank Guarantee decides to make a demand for payment, the issuing bank is not required to contact their client to advise them of the demand. However, in practice, the bank will contact their client to advise of the demand in case there is something amiss with the transaction. There is a wide range of administrative matters that banks use to delay payment, such as whether the demand complies strictly with the terms of the Guarantee.
The most important characteristics for an Applicant/lessee to understand about these instruments is their (a) irrevocability; and (b) independence. The first of these simply means that, once issued, the instrument cannot be revoked without the agreement of all three parties. This provides the Beneficiary with a great deal of certainty with respect to the existence of the payment obligation but it should be noted that such instruments will often have an expiry date. Beneficiaries will invariably insist on an extension to the lapse date as it falls due or, in the event this is not provided, may draw on the guarantee to the full amount before it lapses.
The second of the characteristics, independence, refers to the fact that the obligation to pay held by the bank is unrelated to any matter or dispute between the lessee and lessor. This means that if the Beneficiary/landlord chooses to draw on the Guarantee, there is generally nothing that the Applicant can do to stop this. There are exceptions to this instrument independence, including where the Beneficiary has acted fraudulently, illegally or unconscionably in seeking the guarantee or in making the demand for payment. If the Applicant/lessee believes that the Beneficiary is acting unlawfully, they may apply to the Court for an injunction to either stop the bank paying the guarantee or stop the Beneficiary from making a demand for payment until their grievances with respect to the demand can be heard. In the absence of any of these events, the bank will make payment on demand without further reference to the Applicant.
Further, no other contractual dispute relating to the terms of the lease (or any other matter) between the lessee and lessor will interfere with the payment obligation undertaken by the bank. In normal practice, a Guarantee is a substitute for cash and will be treated as cash by the issuer and the Court. The Landlord/lessor will usually hold the physical copy of the Guarantee but this must be returned to the lessee once all liabilities have been met.
What costs are associated with Bank Guarantees?
Bank instruments are relatively expensive for the Applicant/lessee (although these costs may be offset by any interest earned on the capital held by the bank). Quite often the issuing bank will tie up liquid assets of the business to underwrite the value of the guarantee by placing them into a trust account. Alternately, banks will take a mortgage or other lien over a physical asset to underwrite the obligation to pay.
Banks will charge a one-off fee to issue the guarantee which may be a flat amount or a percentage of the amount guaranteed. Further regular charges are payable by the Applicant while the Guarantee is active for the bank to maintain the obligation to pay and to re-issue the guarantee should it lapse in time. These charges will differ considerably depending on a range of factors, including the dollar value of the guarantee, the risk incurred by the bank, the relationship of the Applicant with their bank, and/or the duration of the guarantee.