Avoid Losing Letter of Credit to FDIC

Time was, commercial property owners weren't terribly concerned about which bank issued the letter of credit securing its tenant's obligations under a lease. Banks were assumed to be solvent and well capitalized.

But recently, amid a rash of bank failures, the Federal Deposit Insurance Corporation (FDIC) has been forced to step in and assume control. As of March 2009, approximately 13 U.S. banks have gone under—more than half the number of bank failures in 2008. And at the current rate of one per week, analysts expect the trend to have a negative impact on commercial property owners. Accordingly, owners are checking the solvency and capitalization of the bank issuing the tenant's letter of credit as part of their due diligence.

When the FDIC takes over a bank, it has the authority under federal law to repudiate—that is, reject—contracts that are burdensome to the bank. Typically, in the commercial leasing context, those contracts consist of leases entered into by the bank as a tenant or letters of credit issued by the bank to secure other tenants' obligations under leases.

Protecting yourself against a repudiation of a lease is difficult. But with letters of credit, owners can take steps to protect themselves, says San Francisco attorney Rikesh R. Patel.

How Repudiation Can Harm You

When the FDIC repudiates a tenant's letter of credit, you'll lose access to valuable funds that you might need to tap in the event that your tenant defaults under its lease. And unfortunately, under the federal law that permits FDIC repudiation, you may not have any recourse or be able to claim damages resulting from the repudiation.

Example: You enter into a lease that requires the tenant to provide a letter of credit in the amount of $100,000 to secure the tenant's obligations under the lease. You accept a letter of credit, issued on behalf of the tenant, from a recently established bank chosen solely by the tenant. A year into the lease, the issuing bank becomes insolvent and is taken over by the FDIC, which then repudiates the letter of credit. The tenant then defaults on its rent, and you have no security to remedy that default. Your only option is to sue the tenant under state law.

Add Protection from Repudiation to Lease

To avoid this situation, Patel suggests negotiating the following two terms when accepting a letter of credit as security under the lease:

• Give yourself the absolute right to choose which bank issues the letter of credit. That way, you can choose a bank that you believe is solvent, well capitalized, and not susceptible to takeover by the FDIC; and

• If, after you accept the letter of credit, one or more of certain conditions are met—such as an FDIC takeover of the issuing bank, FDIC repudiation of the letter of credit, or the issuing bank being placed on the FDIC “watchlist”—preserve the right to request a substitute cash security deposit from the tenant in the amount of the original letter of credit, or a substitute letter of credit in the amount of the original letter of credit from a bank selected by your sole discretion.

After you've successfully negotiated these protections with your tenant, memorialize your agreement by adding the following language to your lease:

Model Lease Language

Tenant shall deliver to Landlord [insert either: a cash security deposit in the amount of the initial letter of credit or a replacement letter of credit in the same form and amount of the initial letter of credit and from a banking institution acceptable to Landlord in its sole and absolute discretion] within five (5) days following the date the bank that issued the letter of credit then held by Landlord enters into any form of regulatory or governmental receivership or other similar regulatory or governmental proceeding, including any receivership instituted or commenced by the Federal Deposit Insurance Corporation (FDIC), or is otherwise declared insolvent or downgraded by the FDIC.

Insider Source

Rikesh R. Patel, Esq.: Ellman Burke Hoffman & Johnson PC, 601 California St., 19th Fl., San Francisco, CA 94108; (415) 777-2727; rpatel@ellman-burke.com.

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