Strengthening Letter of Credit Security Provisions

There are several ways in which landlords can proactively mitigate being stuck in this worst-case scenario. One is to implement internal procedures to monitor effectively the financial wherewithal of the issuers of the LOC in its leasing portfolio. Another is to strengthen lease provisions regarding the manner in which an LOC can be drawn or when it must be replaced, with an added focus on addressing the issues posed by the recent FDIC policy. This article focuses on this latter method.

Seek Flexibility

As a general matter, the landlord should seek maximum flexibility when drafting the terms and conditions under which an LOC can be drawn. Some typical examples of such flexibility include:

• If otherwise entitled to a draw, the landlord should have the unfettered right to draw the entire amount of the letter of credit without any liability to the tenant;
• The landlord should not be limited in its right to draw against the letter of credit only to the extent of the damages actually suffered by the landlord, as damages may not yet exist at the time of the landlord's draw;
• The landlord should avoid requirements that it specify to the issuing bank the landlord's intended use of the drawn funds;
• The landlord should have the right to draw against the letter of credit, among other reasons, in the event of a tenant bankruptcy, dissolution and due to the tenant's failure to pay debts generally as due;
• The landlord should be permitted to draw against the letter of credit if the letter of credit is not renewed within 60 days of its schedule expiration;
• Specific draw conditions should always be narrowly limited or avoided entirely; and
• The tenant should acknowledge within the lease that it has no personal property rights in the letter of credit.

However, the recent actions by the FDIC demonstrate that although the above items represent necessary protections, they are insufficient if the problem is the financial status of the LOC issuer. Additional protective language is required in order to address these concerns. Moreover, as the recent rapid deterioration of once venerable financial institutions demonstrates, these protections remain important even when the tenant and/or the issuer appear entirely safe and credit-worthy at the time of lease execution and/or LOC approval.

Adverse Events

For example, the lease should provide that the occurrence of certain adverse financial events relating to the issuer forms an independent basis for the landlord to draw on the LOC and to retain the proceeds until a replacement issuer can be obtained. It is inadequate if FDIC conservatorship/receivership is the only adverse event triggering the landlord's right to draw on the LOC. As noted above, the LOC is unlikely to be honored by the FDIC in such a circumstance anyway. However, a landlord can stipulate in the lease that if the issuer no longer satisfies certain objective financial criteria, the LOC is no longer acceptable and must be replaced. An example is to require a minimum credit rating for the issuer at all times, whether from Standard & Poor's, Moody's or otherwise. The Web sites of the major rating agencies provide landlords with a ready mechanism to verify these ratings. Another objective approach is to stipulate that the issuer maintain a certain level of capital reserves or exceed another financial metric.

Adding a Subjective Basis

Inclusion of such objective criteria is worthwhile and should generate little controversy in lease negotiations. However, it is possible that the objective metrics available to landlords fail to keep up with the speed at which an issuer's financial situation deteriorates, or that the objective information is otherwise unavailable or imperfect. As such, due to the severity of the worst-case scenario described earlier, landlords may also want to consider adding a subjective basis for this type of LOC draw.

For example, a lease can provide that a draw by a landlord would be permitted if, in a landlord's sole discretion, there is a reasonable likelihood that the issuer will be placed under FDIC conservatorship at any time over the next (60/90) days, or if a material adverse event has occurred that substantially increases the likelihood, in the landlord's sole discretion, that the issuer will be placed under such conservatorship within such time frame. Furthermore, because the basis for such a draw would be inherently subjective, the lease should provide that the landlord shall have no liability to the tenant for any such draw as long as the draw was made in good faith.

The benefit of such a subjective standard is speed and flexibility ' upon the occurrence of an event regarding an issuer that gives a landlord concern, the landlord does not need to wait for objective information to be available. The landlord is also not relying on the ability of the rating agencies to presage FDIC conservatorship. Although tenants may resist providing landlords with this amount of discretion, a landlord can mitigate such concerns by providing that the LOC proceeds will be returned to the tenant as long as an acceptable replacement letter of credit is provided within a designated time frame. For tenants with greater bargaining ability, a landlord could also provide for a notice and cure period, in order to give the tenant time to find a replacement letter of credit before the funds are drawn in the first instance.

Conclusion

It is important to note that the concepts discussed above do not represent a comprehensive list of all issues that should be addressed in a lease provision that covers an LOC. In addition, there could exist specific business aspects of a particular deal which would require special drafting. However, against the backdrop of the FDIC notices and the general uncertainty of the financial markets, it does appear that landlords would be wise to take a fresh look at their standard lease to see how it can be improved going forward and to see if there are any holes in their current portfolio.

Adam Walsh and Eric Greenberg are attorneys in the Real Estate Practice Group of Seyfarth Shaw LLP. Their practices concentrate on commercial real estate leasing and other transactional matters. Walsh is in the Washington, DC, office and can be reached at 202-828-3522 or [email protected]. Greenberg is in the Boston office and can be reached at 617-946-4977 or [email protected].

Over the last several months, many landlords have seen a sizable number of their once financially stable tenants close their doors practically overnight as a result of looming bankruptcies, corporate restructuring or other issues. In all too many cases, these once reliable tenants are leaving those landlords with only a security deposit to fall back on. In addition, if the security deposit is in the form of a letter of credit (LOC), now more than ever the landlords must also keep one eye on the financial stability of the LOC issuer.

Recent Actions by the FDIC

This need is highlighted by the recent actions by the Federal Deposit Insurance Corporation (FDIC). In 2009, the FDIC began to issue written notices stating that it would not honor letters of credit issued by financial institutions that it had placed into receivership. However, unfortunately for landlords, the FDIC does not publish its internal “watchlist” of troubled or failing banks and financial institutions. With no publicly available FDIC watchlist, landlords need to be increasingly proactive in order to head-off a worst case scenario: A landlord with a financially precarious tenant assumes that at a minimum it will be able to recover the face amount of the LOC when and if such tenant defaults, but discovers too late that such LOC has become worthless, due to the financial condition of the issuer.

There are several ways in which landlords can proactively mitigate being stuck in this worst-case scenario. One is to implement internal procedures to monitor effectively the financial wherewithal of the issuers of the LOC in its leasing portfolio. Another is to strengthen lease provisions regarding the manner in which an LOC can be drawn or when it must be replaced, with an added focus on addressing the issues posed by the recent FDIC policy. This article focuses on this latter method.

Seek Flexibility

As a general matter, the landlord should seek maximum flexibility when drafting the terms and conditions under which an LOC can be drawn. Some typical examples of such flexibility include:

• If otherwise entitled to a draw, the landlord should have the unfettered right to draw the entire amount of the letter of credit without any liability to the tenant;
• The landlord should not be limited in its right to draw against the letter of credit only to the extent of the damages actually suffered by the landlord, as damages may not yet exist at the time of the landlord's draw;
• The landlord should avoid requirements that it specify to the issuing bank the landlord's intended use of the drawn funds;
• The landlord should have the right to draw against the letter of credit, among other reasons, in the event of a tenant bankruptcy, dissolution and due to the tenant's failure to pay debts generally as due;
• The landlord should be permitted to draw against the letter of credit if the letter of credit is not renewed within 60 days of its schedule expiration;
• Specific draw conditions should always be narrowly limited or avoided entirely; and
• The tenant should acknowledge within the lease that it has no personal property rights in the letter of credit.

However, the recent actions by the FDIC demonstrate that although the above items represent necessary protections, they are insufficient if the problem is the financial status of the LOC issuer. Additional protective language is required in order to address these concerns. Moreover, as the recent rapid deterioration of once venerable financial institutions demonstrates, these protections remain important even when the tenant and/or the issuer appear entirely safe and credit-worthy at the time of lease execution and/or LOC approval.

Adverse Events

For example, the lease should provide that the occurrence of certain adverse financial events relating to the issuer forms an independent basis for the landlord to draw on the LOC and to retain the proceeds until a replacement issuer can be obtained. It is inadequate if FDIC conservatorship/receivership is the only adverse event triggering the landlord's right to draw on the LOC. As noted above, the LOC is unlikely to be honored by the FDIC in such a circumstance anyway. However, a landlord can stipulate in the lease that if the issuer no longer satisfies certain objective financial criteria, the LOC is no longer acceptable and must be replaced. An example is to require a minimum credit rating for the issuer at all times, whether from Standard & Poor's, Moody's or otherwise. The Web sites of the major rating agencies provide landlords with a ready mechanism to verify these ratings. Another objective approach is to stipulate that the issuer maintain a certain level of capital reserves or exceed another financial metric.

Adding a Subjective Basis

Inclusion of such objective criteria is worthwhile and should generate little controversy in lease negotiations. However, it is possible that the objective metrics available to landlords fail to keep up with the speed at which an issuer's financial situation deteriorates, or that the objective information is otherwise unavailable or imperfect. As such, due to the severity of the worst-case scenario described earlier, landlords may also want to consider adding a subjective basis for this type of LOC draw.

For example, a lease can provide that a draw by a landlord would be permitted if, in a landlord's sole discretion, there is a reasonable likelihood that the issuer will be placed under FDIC conservatorship at any time over the next (60/90) days, or if a material adverse event has occurred that substantially increases the likelihood, in the landlord's sole discretion, that the issuer will be placed under such conservatorship within such time frame. Furthermore, because the basis for such a draw would be inherently subjective, the lease should provide that the landlord shall have no liability to the tenant for any such draw as long as the draw was made in good faith.

The benefit of such a subjective standard is speed and flexibility ' upon the occurrence of an event regarding an issuer that gives a landlord concern, the landlord does not need to wait for objective information to be available. The landlord is also not relying on the ability of the rating agencies to presage FDIC conservatorship. Although tenants may resist providing landlords with this amount of discretion, a landlord can mitigate such concerns by providing that the LOC proceeds will be returned to the tenant as long as an acceptable replacement letter of credit is provided within a designated time frame. For tenants with greater bargaining ability, a landlord could also provide for a notice and cure period, in order to give the tenant time to find a replacement letter of credit before the funds are drawn in the first instance.

Conclusion

It is important to note that the concepts discussed above do not represent a comprehensive list of all issues that should be addressed in a lease provision that covers an LOC. In addition, there could exist specific business aspects of a particular deal which would require special drafting. However, against the backdrop of the FDIC notices and the general uncertainty of the financial markets, it does appear that landlords would be wise to take a fresh look at their standard lease to see how it can be improved going forward and to see if there are any holes in their current portfolio.

Adam Walsh and Eric Greenberg are attorneys in the Real Estate Practice Group of Seyfarth Shaw LLP. Their practices concentrate on commercial real estate leasing and other transactional matters. Walsh is in the Washington, DC, office and can be reached at 202-828-3522 or [email protected]. Greenberg is in the Boston office and can be reached at 617-946-4977 or [email protected].