Get 15 Lease Protections When Tenants Use Letters of Credit Instead of Security Deposits

As a means of securing a tenant’s obligations under the lease, a letter of credit (LC) offers distinct advantages over a cash security deposit. The landlord’s underlying assumption is that if the tenant defaults, drawing on the LC will be as easy and automatic as making a withdrawal from the tenant’s security deposit account. Unfortunately, it doesn’t always work out that way. The key is what the LC says. Accept an LC with terms unfavorable to your interests, and your security can vanish into thin air. Here’s a leasing strategy you can use to make sure this doesn’t happen to you.

Letters of Credit 101

Typically, the tenant gets the LC by applying to a bank of its choice and then hands over the instrument to the landlord. Then, if the tenant defaults, the landlord presents the LC to the bank for payment along with two other documents: a sight draft directing the bank to pay the LC to the landlord, and a certification statement signed by the landlord explaining its reasons for drawing on the LC. But, as with any other financial instrument, each LC has its own particular set of payment terms and conditions.

Who’s Who: There are three basic technical terms—the LC principals—you need to understand when dealing with LCs:

• Issuer or issuing bank: the financial institution that issues the LC.
• Applicant: the person who applies for the LC—that is, the tenant.
• Beneficiary: the person to whom the LC is paid—that is, the landlord.

GET 15 LEASE PROTECTIONS

While the issuing bank drafts the actual LC instrument, landlords can still exert a measure of control by including lease language setting out specific requirements about what it says and how it works. Then, if the LC the tenant wants to use doesn’t meet the lease conditions, you can reject it and require the tenant to post cash security instead. Our Model Lease Clause: Use Lease Clause to Set Letter of Credit Requirements, includes the following 15 protections:

1. Get Right to Review LC (must-have)

The first thing you want to do is to control the process by:

• Specifying that you can reject the LC if it’s not satisfactory to you in both form and substance; and
• Requiring the tenant to provide a “specimen” or draft LC that you can review with your attorney before signing the lease.

Another potential approach is to attach a model of the LC form you want the tenant to use as an exhibit to the lease [Clause, par. a].

2. Require LC to Be Irrevocable (must-have)

Say that the LC must be “irrevocable”—in other words, that the issuer can’t revoke or revise the LC without your consent [Clause, par. b(ii))].

3. Require LC to Be a "Standby" LC (must-have)

Say that the letter must be a “standby” LC—that is, one that functions as an assurance of payment that the landlord may draw on if a default occurs, as opposed to a commercial LC that serves as an actual source of funds. While this may sound like legal mumbo jumbo, the distinction has significant practical consequences because it means you may still be able to get paid if the tenant goes into bankruptcy [Clause, par. a].

Example: A Maryland court ruled that a landlord could draw on the LC after a shopping center tenant’s rent check was returned for insufficient funds even though an involuntary bankruptcy petition had been filed against the tenant. An LC is an obligation of the issuer to the beneficiary rather than an asset of the tenant’s bankruptcy estate, the court explained [In re Farm Fresh Supermarket of Maryland, Inc., 257 B.R. 770 (2001)].

4. Require LC to Set Clear Triggers (must-have)

Perhaps the most important protection you need is assurance that you’ll be able to draw on the LC if and when you need it. So, require that the LC clearly provides that any default the tenant commits triggers your right to draw [Clause, par. f].

5. Require LC to Be Unconditional (must-have)

The next step is to ensure that if a default does occur, you can draw on the LC simply by presenting the original LC, a sight draft and a written statement certifying that the tenant is in default under the lease. Accordingly, require an LC that’s “unconditional.” What you don’t want, is for the bank to have discretion over whether to pay you or the authority to tie you up in red tape, for example, by requiring you to file explanatory affidavits each time you draw on the LC. You also need to make sure you can fulfill the draw conditions unilaterally, without the tenant’s (or any other third party’s) signature or cooperation and in spite of a tenant’s bankruptcy filing [Clause, par. b(iv)].

6. Require LC to Be Transferable (must-have)

Say that the LC must be transferable without the tenant’s consent. This is vital protection because you may need to transfer your right to draw on the LC to a lender, buyer, or transferee should you decide to sell or transfer the property once the tenant’s lease term begins [Clause, par. b(v)].

7. Make Tenant Pay Transfer Fee (nice-to-have)

Say that the tenant is solely responsible for paying any fees the bank charges for transferring the LC in connection with a sale or transfer of the property. Negotiating tip: Don’t be surprised if tenants push back on this one. Recognize that while it’s highly desirable, the clause making tenants pay transfer fees isn’t a deal breaker [Clause, par. c].

8. Require ISP to Govern LC (must-have)

It’s important to include language saying that the LC must be governed by so-called International Standby Practices (ISP). Explanation: The ISP and Uniform Customs and Practices (UCP) are the two commonly recognized commercial standards for LCs. And while banks can follow either one, the ISP is designed specifically for standby LCs and provides better protection for landlords [Clause, par. b(i)]. That’s because:

1. Under the UCP, you can’t get paid if the issuing bank closes due to a “force majeure”—that is, unforeseen event beyond the bank’s control.

2. Under the ISP, LCs are automatically deemed irrevocable unless the letter expressly says otherwise.

3. Under the ISP, if the LC says it’s “transferable,” it’s considered to allow for multiple transfers.

9. Require Issuing Bank to Be Stable (must-have)

Say that the bank that issues the LC must be financially stable and have a substantial net worth, for example, not less than $1 billion [Clause, par. d].

10. Require LC to Be Payable Locally (nice-to-have)

Include language saying that the LC must be payable at a bank in the same city as your property to avoid having to travel long distances to get paid. If the tenant isn’t from the U.S. or simply wants to use a foreign bank, require it to arrange to have a local bank “confirm”—that is, assume the issuing bank’s obligation to pay the LC [Clause, par. d].

11. Don’t Accept Limits on Draw Amounts (almost must-have)

Say that the LC must give you the right to draw the full amount or only part of the LC, as you decide. Don’t, in other words, agree to limit draw rights to the amount by which the tenant is in default. While this may seem reasonable, it ties your hands in the event of relatively minor defaults or those that don’t involve a payment. If either of these things happens, you want to have the option of drawing down the full LC and converting it to a cash security deposit to protect yourself against future defaults [Clause, par. f].

12. Require Tenant to Restore Draws (almost must-have)

Say that if you draw on the LC, the tenant must either restore the LC to the original pre-draw amount or substitute equivalent cash security instead. While the tenant may object, this is similar to common lease provisions requiring tenants to replace any part of a security deposit taken by a landlord when a default occurs [Clause, par. f(iii)].

13. Provide for Upward or Downward Adjustment (nice-to-have)

As with a security deposit, the issue of what LC amount is adequate security is often a major point of negotiation. One way to make things less contentious is to provide for flexibility based on what happens after the lease begins. Thus, you may want to require the tenant to increase the LC amount (or get an additional LC) if the rent increases, the tenant acquires additional space, its net worth takes a substantial hit, or other events occur that render the original LC amount inadequate. By contrast, the tenant may want reciprocal “burn down” rights automatically reducing the LC face amount if things happen that render the original LC amount overkill, such as a reduction in space leased, a demonstrated increase in the tenant’s net worth, or going through a specified amount of time without a default [Clause, par. g].

14. Require LC to Continue After Lease Ends (must-have)

Say that the LC’s expiry date must be at least 60 to 90 days after the lease ends to give you ample time to inspect the premises, determine the extent of damages and, if necessary, draw on the LC to cover the damage after the tenant vacates [Clause, par. e].

15. Require LC to Be Evergreen (must-have)

LCs typically last 12 months, which is obviously much shorter than most leases. And because banks may be unwilling to issue a single LC covering the entire lease term, you may need to require the LC to include a so-called “evergreen clause” providing for automatic renewal each year during the lease term unless the bank notifies the landlord of its intention not to renew. Upon receiving such notice, the landlord would then have the immediate and unconditional right to draw the entire LC amount even if the tenant isn’t in default unless the tenant provides a replacement LC at least 30 days before the expiration date [Clause, par. e].