Best Practices for Law Firm Lease Security
Law firms are a unique type of tenant. Their substance is largely comprised of cash and human capital, often with little else of substance apart from billings in progress. Therefore, properly securing a lease for a law firm tenant may require a more creative structure to protect against material credit losses.
In 2017, we published an entry on key questions to ask when reviewing a law firm tenant and provides some context on how to investigate potentially risky law firm tenants. Complicating matters, most law firm leases that TRA reviews include substantial build outs in class A buildings. It would inherently seem that there is potential for a mismatch on credit quality of the tenant and the economics of some leases. Many landlords view law firms as strong tenants with the potential to improve the cache of a building, and as such, there as an incentive to codify a lease.
This post is not all bad news. Big law is relatively low risk with substantial practice area diversification and a stable of rain making equity partners that reduces key man risk. The most high-profile big law implosion in recent memory is Dewey & LeBouef, which collapsed in large part due to alleged fraud rather than poor practice management. More careful consideration should be paid toward mid-sized and smaller law firms, where the partner pool is smaller and practice area diversification is more limited. It is with these tenants that ownership should exercise more caution in structuring lease security.
Lease Security Best Practices
For mid-sized and smaller law firms, protection against partner attrition becomes more critical. The loss of one or more equity partners could mean the business suffers. Most law firms are structured as limited partnerships, limited liability companies, or professional corporations. This means that earnings are often substantially distributed to the partnership or membership annually, leaving little cash on the books.
Landlords have several options in securing leases to these firms. First let’s start with the security deposit. This is often the “go to” instrument, and for law firms it can be very effective as long as it provides sufficient coverage for a lease’s economic exposure. The main criticism against the security deposit is that in bankruptcy, security deposits often become a part of a company’s “estate,” so a landlord may not collect the full deposit.
Second, the personal guarantee may appear enticing as well, since lawyers are often high earning professionals. But collection on a personal guarantee can vary by jurisdiction, with limitations on assets that creditors can attach. Time and cost are also a factor, and optically, it may not always be in a landlord’s interest to aggressively pursue individuals in distress.
The same is not true for letters of credit. Letters of credit are contractual obligations guaranteed by a third-party lender (almost always a bank), and these letters are not typically included as part of a company’s estate in bankruptcy or default. That makes this instrument preferred when leasing to law firms. Many law firms maintain credit facilities with their lenders to finance day to day case-loads. Letter of credit sub-facilities are often attached to these broader credit facilities, making them an available and useful tool for lease security.
TRA has reviewed countless law firm tenants, and we are an invaluable resource to our clients when advising on law firm lease security. Contact us to learn how we can assist you with any questions on law firms or beyond to see how we can strengthen your due diligence and lease security standards.