A Letter of Credit Instead of a Cash Deposit? Read the Clause Before You Sign the Lease

Posting a standby letter of credit instead of a cash security deposit looks like the smart, cash-light move. But what actually sets your risk is not the amount — it is a few clauses most tenants skim: when the landlord can draw, what happens if the bank will not renew, and whether the balance ever comes down.

I am Arthur Zhao. The first time a commercial tenant is told the lease wants the deposit posted as a letter of credit, the usual reaction is relief: “good, I don’t have to hand over real cash.” That is half right. A letter of credit (LC) does keep your cash free — but it trades one risk (money set aside) for another (a bank’s independent promise, plus a stack of clauses). And those clauses are far more complex, and far more dangerous, than a cash deposit.

I have watched tenants treat an LC as “a deposit in another form,” sign it quickly, and only learn what the autonomy principle means when the landlord draws the money while the tenant is convinced there was no default. This piece is not about whether to use an LC — your cash position and your bargaining power decide that. It is about the handful of clauses you must read line by line if you do, and how they really differ from a cash deposit.

Letter of Credit vs Cash Deposit: Where the Mechanics Actually Differ

Standby, Irrevocable, Clean: What Those Words Actually Mean

Almost every LC in a commercial lease is an irrevocable standby letter of credit. “Irrevocable” means the bank cannot cancel it unilaterally. “Standby” means it is meant to be drawn only if something goes wrong — a backstop, not a payment method. And it is usually clean: the landlord draws by presenting a demand plus a simple written statement that an amount is owing, with no supporting documents required.

The critical point is the same in every version: the bank does not judge whether you actually breached the lease. That is the autonomy principle (autonomy principle) — the LC is the bank’s promise, independent of your dispute with the landlord. The bank checks only whether the conditions written into the LC are met. If they are, it pays.

The Line to Watch: The Landlord Can Draw Without Proving You Defaulted

Many LCs let the landlord draw simply by delivering its own written statement that an amount is due. It reads harmless. It is not. Under the autonomy principle, the bank will not verify whether you truly defaulted — the landlord signs the statement, the bank pays.

You have almost no way to stop the draw itself. In 2020 ONCA 681, the Ontario Court of Appeal confirmed that the only thing that can block payment is the narrow fraud exception — and it must be genuine dishonesty or deceit, not an ordinary contract dispute. Your realistic remedy is to sue the landlord after the fact for a wrongful draw, by which point the money has already left the bank.

So the clause worth paying a lawyer to negotiate is the draw condition: require the landlord to attach a default notice, give you a cure period, or limit draws to specific categories of arrears. That single sentence decides whether the LC is a security or a loaded weapon.

What Issuing an LC Actually Ties Up — and Costs

An LC is not a free substitute for cash. When the bank issues it, it usually does one of two things: it draws down your credit facility, directly shrinking the borrowing room you have for operations; or it requires you to post cash collateral, in full or in part. In the 2020 ONCA 681 case, the $2.5 million letter of credit was backed by an equal amount of cash collateral the bank held.

On top of that, the bank charges an annual issuance/renewal fee, typically quoted as a percentage of the face amount — the exact rate depends on the bank and your credit profile, so I will not put a number on it here. Add the three together — tied-up credit, possible cash collateral, and the yearly fee — and “no cash out of pocket” turns out to mean “ongoing financing capacity consumed, plus an annual charge.” Before you negotiate, ask your own bank exactly how it would issue this LC and what it would tie up.

Evergreen Auto-Renewal — and the Full Draw That Non-Renewal Triggers

An LC has an expiry date; the lease usually runs longer. The fix is an evergreen clause: the LC renews automatically for another year unless the issuing bank sends a non-renewal notice before expiry. Under ISP98 (the International Standby Practices) Rule 3.13, this is the standard mechanism for standby LCs.

Here is the trap. The moment the bank decides not to renew — say your financials weaken and the bank tightens your credit — most leases let the landlord draw the entire face amount before expiry and hold it as cash. In other words, the bank’s decision not to renew is itself a draw trigger, even if you have never missed a dollar of rent.

Read two things: the notice period and method for non-renewal, and whether non-renewal lets the landlord draw the full amount or instead gives you time to post a fresh LC. The second is far friendlier to you.

Does the Balance Come Down Over Time? The Burn-Down Clause

LC amounts are usually set highest early in the term — the landlord is covering fit-out allowances, free-rent periods, and the stretch before you have proven you pay. But as the lease runs and you perform, that security should not stay pinned at its peak forever.

That is what a burn-down clause does: on defined reduction dates, as long as you are not in default and meet the agreed conditions, the LC amount steps down. If your lease has no burn-down, you tie up the same credit for the entire term — a real, ongoing financing cost.

Burn-down is negotiable, and tenants routinely leave it on the table. Writing it in lets the security get lighter as your track record gets stronger.

When the Tenant Goes Bankrupt: Why Landlords Prefer the LC

This is where an LC and a cash deposit diverge most — and the real reason landlords insist on one.

If your company goes bankrupt, a cash deposit falls into your estate and is distributed among all creditors by priority, and the landlord’s access can be constrained by the bankruptcy stay. An LC, by contrast, is the bank’s independent debt and generally sits outside your estate. In 2020 ONCA 681, even after the trustee had disclaimed the lease, the landlord was held entitled to draw the entire principal of the letter of credit.

Why do landlords care so much? Because a landlord’s claim for your future rent is capped. Under Ontario’s Commercial Tenancies Act s. 38 and the federal Bankruptcy and Insolvency Act s. 136(1), the landlord’s preferred claim in bankruptcy runs to roughly three months’ arrears plus about three months’ accelerated rent; anything beyond that ranks as an ordinary unsecured claim. An LC steps around that cap — the landlord collects the full face of the LC rather than a diluted slice of a bankruptcy distribution.

Bankruptcy, security and lease law intersect here; the above is framework, not a legal judgment on your situation. If you are going to sign, have a commercial real estate lawyer review the clauses.

Arthur Zhao

Real Estate Broker · FRI · ABR · SRS · PSA · MCNE · E-PRO · CLHMS & GUILD Elite · REAIS

VP & Branch Manager, Bay Street Group Inc.

Get expert answers on buying, selling, and renting in the GTA