• Landlords: Beware of Taking Letters of Credit as Security When Banks are Failing
  • May 15, 2009 | Author: Robert R. Kibby
  • Law Firm: Munsch Hardt Kopf & Harr, P.C. - Dallas Office
  • Letters of credit have long been considered a "safe" (and even preferable) credit enhancement alternative to cash security deposits, but as the Federal Deposit Insurance Corporation (FDIC) closes multiple banks throughout the nation due to the economic crisis, commercial landlords face a new threat to their "security" — the FDIC now advises that it will not honor letters of credit issued by institutions under FDIC receivership.  Virtually all commercial leases require some sort of security deposit or other credit enhancement to secure the tenant's performance of its lease obligations. Historically, a cash deposit was delivered to the landlord upon lease execution. Landlords learned some hard lessons, however, during recent real estate downturns, finding that upon a tenant's bankruptcy, the cash security deposit was swept into the tenant's bankruptcy estate, leaving the landlord high and dry.

    Because letters of credit are generally unaffected by a tenant's bankruptcy, they became a preferred alternative to a cash security deposit. In light of this latest pronouncement by the FDIC, however, landlords must rethink this strategy and be more proactive in protecting their security throughout the term of the lease.

    The following are suggestions to consider:

    • Prior to accepting a letter of credit as security, and at the time of any renewal of the letter of credit, landlords must carefully evaluate the strength of the issuing institution. Landlord's approval of an issuing institution should be in its sole discretion.
    • Landlords should establish an on going review system to monitor the strength of the issuers of all letters of credit held as security. While the FDIC does not publish a list of institutions it deems "at risk," private sector bank rating information is available from multiple sources and a list of failed banks is available through the FDIC.
    • Leases should allow landlords to require a new letter of credit from a more financially solid issuer (i) upon failure of the issuing bank, (ii) upon any renewal of the letter of credit or (iii) if the bank rating of the issuing institution is no longer acceptable to Landlord. Landlords may choose to call an event of default upon a tenant's failure to provide the new letter of credit within the requisite time frames. As an alternative, for particularly strong tenants, landlords may choose to accept a cash deposit in lieu of a replacement letter of credit.

    Because most tenants have posted cash collateral with the issuing bank in order to obtain the letter of credit held by the landlord, a landlord's watchful eye concerning potential bank failure may also protect that deposit and as a result, benefit the tenant as well as the landlord.