Using Letters of Credit to Secure Lease Obligations

2) Keep the Draw Conditions Simple;

3) Avoid Documents Not Within the Landlord's Control;

4) Allow Partial Draws;

5) Avoid Specification of Use of Funds;

6) Provide for Coverage of a Settlement Period After Lease Termination.

This conclusion provides six more tips that address issues such as providing coverage of the settlement period after lease termination, shortening the time period to honor the letter and using a transferable L/C. It also discusses matters of concern to the issuing bank.

Shorten the Time Period to Honor

Under the Uniform Commercial Code (“UCC”), the UCP and the ISP, an issuer has a reasonable time to honor or give notice of dishonor of up to 7 business days after documents are presented. If the L/C specifies no time period for the issuer to examine and honor, the reasonable time ' up to 7 business days ' is the default rule. Consider shortening the time period in the L/C for the issuer to honor to 3 business days. Given the simplicity of the documentation to effect a landlord's draw, 3 business days should be more than ample time. Besides getting the landlord its money sooner, the shorter time period will give the tenant less time to prepare to contest the draw in the event of a dispute between it and the landlord over the landlord's right to draw on the L/C.

Provide for Fax Presentments

Unless the L/C otherwise specifies, originals of each document called for by the L/C must be presented; copies or fax-signed documents will not comply. To facilitate draws, have the L/C specifically permit draw documents to be presented by fax. The L/C should specify the issuing bank's telecopier number to be used for presentment of draw documents by fax.

Avoid Presentment Letters of Credit

Presentment letters of credit require the original of the L/C, including all amendments, to be presented with the documents to effect a draw. Although requiring presentment of the original may provide the issuer with some assurance that it is dealing with the true beneficiary, and for multiple draws, allow it to make a notation of the amount drawn on the L/C to help it prevent overdrafts, there is no good reason from the beneficiary's standpoint to have presentment of the original L/C made as a requirement for a draw. If the original of the L/C is lost, the landlord may be unable to effect a draw. Copies are not permitted as substitutes for the lost original, and the issuer is under no obligation to issue a duplicate original. Cases have so held. Neither the UCC nor the UCP even have a rule dealing with lost originals. Although the ISP has such a rule, the issuer is not required to replace the original, but may do so in its discretion and on terms protective of it.

One reason to use presentment letters of credit is to assist the landlord's lender in obtaining an assignment of proceeds of the tenant's L/C. Under Revised Article 5 of the UCC, a beneficiary can require an issuer's consent to an assignment of proceeds if the original of the L/C is exhibited and the L/C is a presentment letter. If the L/C is not a presentment L/C, then neither the landlord nor its lender can insist on the issuer's acknowledgment to an assignment of proceeds if the issuer refuses. However, an assignability of proceeds can be built into the letter of credit, and most issuers will, in any event, allow assignments of proceeds of their L/Cs if their form of assignment is used.

Avoid Certificates That Must Be Signed By Specific Individuals

In one case, an individual landlord had died and his personally signed certificate was required to effect a draw on an L/C securing a tenant's lease obligations, which of course could not be supplied. The court upheld the issuer's right to dishonor. However, the requirement for a document to be presented by a specific named individual should be distinguished from the right of a successor entity to draw on an L/C. Both the UCC and the ISP permit transfers by operation of law so that a bankruptcy trustee, receiver, decedent's estate or successor by merger or name change is permitted to make a draw on an L/C of its predecessor, even though the L/C is not transferable. The rule does not extend to asset sales or other consensual or contractual transfers of the L/C unless the L/C is expressly made transferable and the terms of transfer are followed.

Use a Transferable Letter of Credit

An L/C is not transferable unless it expressly so states. If the landlord sells the leased premises, the purchaser will want not only the leases and cash security deposits transferred to it, but also all letters of credit held in lieu of security deposits. The landlord's lender may also insist on a transfer of the landlord's letters of credit held in lieu of a security deposit. Accordingly, each L/C taken by a landlord in lieu of a security deposit should be designated as transferable. To facilitate transfer, the L/C should refer to and contain as exhibits the form of transfer notice and acknowledgment, and specify the transfer fee.

Use an Automatic Renewal and Expiration Draft Provision

Most letters of credit are issued for a term of 1 year or less. Banks have regulatory, prudent lending and capital adequacy concerns about issuing longer-term letters of credit. Commercial leases, especially those with tenant build-out costs paid upfront by the landlord, tend to be long term. To bridge the gap between the need of the issuer to keep the expiration date of its L/C limited to a 1-year period, and the landlord's need to keep the L/C security in place for the duration of the lease, an automatic renewal provision should be included in the L/C. This provision will state that the L/C is deemed to be automatically renewed for additional 1-year periods unless the issuer notifies the landlord-beneficiary a certain number of days prior to the expiration date (eg, 60 days) that the L/C will not be renewed. Until the issuer gives timely notice of nonrenewal, the L/C will automatically extend for 1-year periods until an ultimate outside expiration date if one is stated or a cancellation and surrender of the credit is agreed to by the beneficiary.

As noted above, if an ultimate expiration date is stated, it should be 90 days or more beyond the termination of the lease, to give the landlord time to determine what its damages are, especially for damage to the leasehold or for holdover rent or, in the event of a tenant bankruptcy, to deal with a preference claim on account of the landlord's acceptance of late payments. If an outside expiration date is stated in the L/C, the landlord should remember to have this date extended by amendment to the L/C at the same time the lease is renewed or extended.

If notice of nonrenewal is given before the lease terminates, the L/C should also provide that the landlord can draw on it by submitting a document stating that the issuer failed to renew the credit. For automatic stay considerations, the renew or draw provision should be drafted as an independent ground for the draw, apart from any default under the lease. If the lease makes the failure to renew the L/C a set number of days prior to expiration a default under the lease, the landlord must decide whether it wants to terminate the lease and exercise its remedies or simply hold the draw proceeds as it would a cash security deposit and continue with the lease.

The agreement dealing with what to do with early expiration draw proceeds will usually be contained in the lease or by language contained in the certificate to be presented to the issuer to effect a draw for failure to renew, or both. Typically, some kind of escrow or security deposit arrangement will be negotiated. The parties can agree on escrowing proceeds of a draw on the L/C for failure to renew or they can agree that the landlord will hold them in a segregated account under its sole control, but subject to the contractual obligation to apply them to the lease obligations in the event of a default. The agreement or certificate will normally state where the proceeds from the draw for failure to renew will be deposited and what arrangements will govern the landlord's subsequent use of them. Because there is no current default other than failure to renew the L/C, there are no unpaid monetary defaults under the lease to which the draw proceeds can be applied.

Issuing Bank Issues

The landlord should check the creditworthiness and acceptability of the issuing bank. Some banks do become insolvent. Bank rating services such as Veribank are available to determine the strength and acceptability of the issuer. While many foreign banks are as strong as, or stronger than, U.S. banks, convenience for presentment and enforceability and jurisdiction concerns in the event of a dispute dictate that at least a U.S. branch of a foreign bank be used. If a foreign bank is used and its credit strength is questionable, consideration should be given to obtaining a confirmation from a reputable U.S. bank.

If presentment of documents is allowed to be made by fax, the location of the issuing bank is less important as a matter of convenience and logistics, although it can be important if suit must be threatened or brought against the issuing bank for wrongful dishonor. Obviously, the landlord would rather litigate in its own jurisdiction than in a distant city, state or country. If paper documents must be presented, then time and convenience favor use of a bank located in the vicinity of the landlord. However, this is not of major importance because documents can be sent almost anywhere in the United States in one business day by Federal Express or other courier and if documents are dishonored, notice of dishonor must be given by telecommunication.

Conclusion

If drafted properly and properly understood, letters of credit can provide an efficient and reliable payment assurance for securing tenant obligations under commercial leases. They can be beneficial to the tenant by not tying up its cash and providing the tenant with some assurances that draws do not occur unless warranted. They benefit the landlord because of their reliability, flexibility, liquidity and advantages in a tenant bankruptcy.

Part Two of a Two-Part Series

As discussed in Part One last month, a tenant may be able to apply for and have its bank issue to its landlord a letter of credit (“L/C”) to secure the tenant's obligations under a long-term lease. From the tenant's perspective, an L/C may be preferable to a large security deposit. An L/C will not necessarily tie up large amounts of the tenant's cash or other liquid collateral, as would a security deposit. Instead, the cash can be deployed as working capital in the tenant's business. Part One discussed six tips for drafting an L/C:

1) Use the ISP (International Standby Practices 1998) instead of the UCP (Uniform Customs and Practice for Documentary Credits);

2) Keep the Draw Conditions Simple;

3) Avoid Documents Not Within the Landlord's Control;

4) Allow Partial Draws;

5) Avoid Specification of Use of Funds;

6) Provide for Coverage of a Settlement Period After Lease Termination.

This conclusion provides six more tips that address issues such as providing coverage of the settlement period after lease termination, shortening the time period to honor the letter and using a transferable L/C. It also discusses matters of concern to the issuing bank.

Shorten the Time Period to Honor

Under the Uniform Commercial Code (“UCC”), the UCP and the ISP, an issuer has a reasonable time to honor or give notice of dishonor of up to 7 business days after documents are presented. If the L/C specifies no time period for the issuer to examine and honor, the reasonable time ' up to 7 business days ' is the default rule. Consider shortening the time period in the L/C for the issuer to honor to 3 business days. Given the simplicity of the documentation to effect a landlord's draw, 3 business days should be more than ample time. Besides getting the landlord its money sooner, the shorter time period will give the tenant less time to prepare to contest the draw in the event of a dispute between it and the landlord over the landlord's right to draw on the L/C.

Provide for Fax Presentments

Unless the L/C otherwise specifies, originals of each document called for by the L/C must be presented; copies or fax-signed documents will not comply. To facilitate draws, have the L/C specifically permit draw documents to be presented by fax. The L/C should specify the issuing bank's telecopier number to be used for presentment of draw documents by fax.

Avoid Presentment Letters of Credit

Presentment letters of credit require the original of the L/C, including all amendments, to be presented with the documents to effect a draw. Although requiring presentment of the original may provide the issuer with some assurance that it is dealing with the true beneficiary, and for multiple draws, allow it to make a notation of the amount drawn on the L/C to help it prevent overdrafts, there is no good reason from the beneficiary's standpoint to have presentment of the original L/C made as a requirement for a draw. If the original of the L/C is lost, the landlord may be unable to effect a draw. Copies are not permitted as substitutes for the lost original, and the issuer is under no obligation to issue a duplicate original. Cases have so held. Neither the UCC nor the UCP even have a rule dealing with lost originals. Although the ISP has such a rule, the issuer is not required to replace the original, but may do so in its discretion and on terms protective of it.

One reason to use presentment letters of credit is to assist the landlord's lender in obtaining an assignment of proceeds of the tenant's L/C. Under Revised Article 5 of the UCC, a beneficiary can require an issuer's consent to an assignment of proceeds if the original of the L/C is exhibited and the L/C is a presentment letter. If the L/C is not a presentment L/C, then neither the landlord nor its lender can insist on the issuer's acknowledgment to an assignment of proceeds if the issuer refuses. However, an assignability of proceeds can be built into the letter of credit, and most issuers will, in any event, allow assignments of proceeds of their L/Cs if their form of assignment is used.

Avoid Certificates That Must Be Signed By Specific Individuals

In one case, an individual landlord had died and his personally signed certificate was required to effect a draw on an L/C securing a tenant's lease obligations, which of course could not be supplied. The court upheld the issuer's right to dishonor. However, the requirement for a document to be presented by a specific named individual should be distinguished from the right of a successor entity to draw on an L/C. Both the UCC and the ISP permit transfers by operation of law so that a bankruptcy trustee, receiver, decedent's estate or successor by merger or name change is permitted to make a draw on an L/C of its predecessor, even though the L/C is not transferable. The rule does not extend to asset sales or other consensual or contractual transfers of the L/C unless the L/C is expressly made transferable and the terms of transfer are followed.

Use a Transferable Letter of Credit

An L/C is not transferable unless it expressly so states. If the landlord sells the leased premises, the purchaser will want not only the leases and cash security deposits transferred to it, but also all letters of credit held in lieu of security deposits. The landlord's lender may also insist on a transfer of the landlord's letters of credit held in lieu of a security deposit. Accordingly, each L/C taken by a landlord in lieu of a security deposit should be designated as transferable. To facilitate transfer, the L/C should refer to and contain as exhibits the form of transfer notice and acknowledgment, and specify the transfer fee.

Use an Automatic Renewal and Expiration Draft Provision

Most letters of credit are issued for a term of 1 year or less. Banks have regulatory, prudent lending and capital adequacy concerns about issuing longer-term letters of credit. Commercial leases, especially those with tenant build-out costs paid upfront by the landlord, tend to be long term. To bridge the gap between the need of the issuer to keep the expiration date of its L/C limited to a 1-year period, and the landlord's need to keep the L/C security in place for the duration of the lease, an automatic renewal provision should be included in the L/C. This provision will state that the L/C is deemed to be automatically renewed for additional 1-year periods unless the issuer notifies the landlord-beneficiary a certain number of days prior to the expiration date (eg, 60 days) that the L/C will not be renewed. Until the issuer gives timely notice of nonrenewal, the L/C will automatically extend for 1-year periods until an ultimate outside expiration date if one is stated or a cancellation and surrender of the credit is agreed to by the beneficiary.

As noted above, if an ultimate expiration date is stated, it should be 90 days or more beyond the termination of the lease, to give the landlord time to determine what its damages are, especially for damage to the leasehold or for holdover rent or, in the event of a tenant bankruptcy, to deal with a preference claim on account of the landlord's acceptance of late payments. If an outside expiration date is stated in the L/C, the landlord should remember to have this date extended by amendment to the L/C at the same time the lease is renewed or extended.

If notice of nonrenewal is given before the lease terminates, the L/C should also provide that the landlord can draw on it by submitting a document stating that the issuer failed to renew the credit. For automatic stay considerations, the renew or draw provision should be drafted as an independent ground for the draw, apart from any default under the lease. If the lease makes the failure to renew the L/C a set number of days prior to expiration a default under the lease, the landlord must decide whether it wants to terminate the lease and exercise its remedies or simply hold the draw proceeds as it would a cash security deposit and continue with the lease.

The agreement dealing with what to do with early expiration draw proceeds will usually be contained in the lease or by language contained in the certificate to be presented to the issuer to effect a draw for failure to renew, or both. Typically, some kind of escrow or security deposit arrangement will be negotiated. The parties can agree on escrowing proceeds of a draw on the L/C for failure to renew or they can agree that the landlord will hold them in a segregated account under its sole control, but subject to the contractual obligation to apply them to the lease obligations in the event of a default. The agreement or certificate will normally state where the proceeds from the draw for failure to renew will be deposited and what arrangements will govern the landlord's subsequent use of them. Because there is no current default other than failure to renew the L/C, there are no unpaid monetary defaults under the lease to which the draw proceeds can be applied.

Issuing Bank Issues

The landlord should check the creditworthiness and acceptability of the issuing bank. Some banks do become insolvent. Bank rating services such as Veribank are available to determine the strength and acceptability of the issuer. While many foreign banks are as strong as, or stronger than, U.S. banks, convenience for presentment and enforceability and jurisdiction concerns in the event of a dispute dictate that at least a U.S. branch of a foreign bank be used. If a foreign bank is used and its credit strength is questionable, consideration should be given to obtaining a confirmation from a reputable U.S. bank.

If presentment of documents is allowed to be made by fax, the location of the issuing bank is less important as a matter of convenience and logistics, although it can be important if suit must be threatened or brought against the issuing bank for wrongful dishonor. Obviously, the landlord would rather litigate in its own jurisdiction than in a distant city, state or country. If paper documents must be presented, then time and convenience favor use of a bank located in the vicinity of the landlord. However, this is not of major importance because documents can be sent almost anywhere in the United States in one business day by Federal Express or other courier and if documents are dishonored, notice of dishonor must be given by telecommunication.

Conclusion

If drafted properly and properly understood, letters of credit can provide an efficient and reliable payment assurance for securing tenant obligations under commercial leases. They can be beneficial to the tenant by not tying up its cash and providing the tenant with some assurances that draws do not occur unless warranted. They benefit the landlord because of their reliability, flexibility, liquidity and advantages in a tenant bankruptcy.