• Minimizing the Risks of Signing Restaurant Leases
  • March 18, 2016 | Author: Lawrence G. Lerman
  • Law Firm: Lerch, Early & Brewer, Chartered - Bethesda Office
  • One out of every four new Washington, DC restaurants will close or change hands within five years. In light of this high turnover, landlords and tenants should be aware of lease issues that arise when restaurant space becomes available, especially pertaining to alcohol licenses and security deposits. Below are a few practical tips to consider when signing a lease for a restaurant in Washington, DC.

    Rights to a Tenant’s Alcohol License

    In DC, an alcohol license is a hot commodity in a neighborhood where the city has imposed a moratorium on the issuance of new licenses (e.g., Georgetown, Glover Park, Adams Morgan) or where the neighborhood opposes the issuance of new alcohol licenses (e.g., 14th Street corridor).

    DC's Alcohol Beverage Control (ABC) Board, unlike the alcohol license control authorities in Maryland and Virginia, allows a landlord to obtain rights to its tenant's alcohol license when the restaurant operator ceases to function. When a restaurant closes, the license can be preserved by requesting that the ABC Board place the license in "safekeeping."

    Restaurant operators shopping for a location should ask if the landlord has an alcohol license in safekeeping, which can save the time and expense of applying for a new license -- a minimum three-month process requiring neighborhood approval. For landlords, having a license in safekeeping could generate higher rents and more tenant interest. This also benefits the replacement tenant, who can begin serving alcohol more quickly (thus paying higher-percentage rent because alcohol sales generate high revenue for most restaurants).

    Both the tenant and the landlord can request the license to be placed in safekeeping to be held until a replacement tenant is found. A restaurant operator with a license in safekeeping can transfer it to another location within DC, as long as there is not a license moratorium in that neighborhood jurisdiction.

    However, for a landlord it's not so simple. A landlord can obtain rights to the alcohol license and place it in safekeeping in a few ways:
    • The restaurant tenant grants the landlord a security interest in its license and authorizes the filing of a UCC financing statement in the lease agreement. If the landlord obtains this right in the lease, it should be disclosed on the alcohol license application (Question 5a). For landlords, this will come in handy when persuading the ABC Board to grant a request to place a license in safekeeping when a restaurant tenant defaults.
    • The landlord and tenant sign a settlement agreement whereby the tenant stops operating, vacates the building, and grants the landlord rights to its license in exchange for a release from future lease obligations and/or forgiveness of its past due rent. For restaurants located in highly desirable neighborhoods, tenants who owe back rent can use the value of the license as leverage when negotiating the settlement agreement. The landlord should then submit this settlement agreement to the ABC Board, requesting to put the license in safekeeping.
    • In the event of eviction, the landlord's attorney asks the judge overseeing the proceedings to award the alcohol license to the landlord. If the license has value, tenant's counsel should ask the judge to reduce any arrearage by the value of the license. If the landlord prevails in the eviction proceedings, it must then obtain an order allowing U.S. Marshals to seize the license and deliver it to the landlord upon eviction (in DC, the U.S. Marshals office is the only party that can execute evictions). After eviction, the landlord must file a request with the ABC Board to place the license in safekeeping along with the judgment and the order. If this request is not submitted to the ABC Board, the alcohol license can be cancelled (and there is no way to revive a cancelled license).
    Request a Letter of Credit instead of a Security Deposit

    Another issue that is often overlooked by both the landlord and tenant when negotiating the lease is the security deposit. Standard practice is to request a cash security deposit or a standby letter of credit, but which one you choose depends on your interests.

    Landlords are increasingly requesting standby letters of credit from a third-party institution for the deposit. In bankruptcy proceedings, letters of credit - unlike security deposits - are not automatically considered part of the bankruptcy estate. Restaurant tenants should understand that a letter of credit provides better protection for the landlord and can potentially reduce the benefits a bankruptcy filing might bring to a highly-leveraged restaurant seeking relief from a landlord's collection actions.

    Applying a cash security deposit will also reduce a landlord's overall damage claim, which is better for a tenant who has filed for bankruptcy. The bankruptcy code dictates that a security deposit is an asset of the bankruptcy estate, meaning the landlord must file a proof of claim of damages to apply the deposit against the landlord's damage claims. Generally, a landlord's future damage claim for unpaid rent will be limited to the greater of one year's rent or 15% of the rent due for the balance of the lease up to three years.

    In the case of a letter of credit, the circuit courts are split as to whether the letter of credit is even part of the bankruptcy estate or whether drawing down on the letter of credit would have the same effect as the application of a cash security deposit on the landlord's damage cap. Both the U.S. District Court in DC and the Maryland Bankruptcy Court have held that that neither the standby letter of credit nor its proceeds are included in property of the estate so that the holder of a letter of credit can draw upon it post-bankruptcy petition.

    This means that a tenant risks having the bank pay out the proceeds of the letter of credit, even after it has filed for bankruptcy. Therefore, when negotiating the security deposit, a tenant should favor a cash security deposit, even if it is a bit higher, over a letter of credit. If a landlord insists on a letter of credit, they will want to include provisions in the letter of credit that authorize the landlord to draw on the letter of credit upon any default of the lease by the tenant, including non-payment of rent. The tenant will want to limit the landlord's ability to draw on the letter of credit for monetary defaults.
    Keep Lines of Communication Open

    Landlords and restaurant and bar tenant operators both take on risk when entering into a lease agreement. Build-out can be expensive, while procuring zoning approvals and permits from government agencies can be time-consuming and result in timeline setbacks. Because a successful restaurant is beneficial to all parties, it is always a good idea for a landlord to maintain a good dialogue with its tenant.

    If a tenant begins to miss its monthly rent obligations, a landlord should engage in amicable dialogue, in addition to sending notices of default. This will enable the landlord to better understand the circumstances surrounding the late rent payments and decide whether it is worthwhile to temporarily lower rent or create a payment plan for past due rent or whether prompt exercise of its remedies is the best course for the landlord. These options are especially true if the tenant is credit worthy, since the cost of evicting and finding a new tenant can be high.