March 20, 2023

Spring Cleaning of Letters of Credit as Lease Security Deposits: Time to Reconsider?

Holland & Knight Retail and Commercial Development and Leasing Blog
Meg Raker Brown
Retail and Commercial Development and Leasing Blog

In light of the recent turmoil in the banking market, it is a good time for landlords to do some spring cleaning and review any letters of credit being held as lease security. As a general rule, letters of credit have been the preferred form of security deposit from a tenant to a landlord. The main attraction is the perception that letters of credit may continue to be available to a landlord even in the event of a tenant bankruptcy. Courts have generally upheld that presentment of a letter of credit to a third-party issuer does not violate the automatic stay of a tenant party's bankruptcy case. (See, e.g., In re Farm Fresh Supermarkets of Maryland, Inc. 257 B.R. 770 (Bankr. D. Md. 2001)).

Landlords may begin to rethink this approach, or at least reconsider the issuers from whom they will accept a letter of credit as lease security. Although the federal government has shown an initial willingness to backstop depositors' accounts in the banking system, a letter of credit is not considered a "deposit" and is not FDIC-insured. Although a landlord may not be totally without recourse in the event of a bank failure, the landlord will be considered one of many among the various unsecured creditors if trying to draw on the letter of credit.

Some leases will include a provision that gives the landlord the right to draw upon the letter of credit in circumstances that have to do with the issuer itself, rather than a default of the tenant. These may include a fall in the minimum asset threshold or rating by a commercial paper rating system. These leases may require, though, that the landlord give 30 days' notice to the tenant to replace the letter of credit before the landlord may draw. If the issuer is in quick decline, however, 30 days may not be enough time to protect the landlord's security. This may be a reminder that selection of the issuer of the letter of credit upfront may have real implications to your lease security down the road. Landlords may also want to negotiate for stronger draw rights based on an issuer default.

If you are a landlord, this is also a good time to review those letters of credit in your file. Be sure that you:

  1. have the original issued letter of credit on hand
  2. review the lease terms and letter of credit terms governing draw requirements
  3. make sure that the letter of credit itself (and term) are in good standing
  4. keep track of the various issuers in your portfolio and the particular credit of each on a going-forward basis
  5. give immediate notice to the tenant demanding a replacement letter of credit, if circumstances warrant

While this may be a "gold-standard" wish list, there are of course real world implications that the parties will need to address if faced with these situations. If a tenant does not maintain its security, this may be one of many problems that parties would be facing at the moment. In general, a landlord's diligence up front, quick action and efforts to work with the tenant or exercise the default remedies in the lease, if needed, will help protect the overall security in an otherwise precarious scenario.

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