A landlord or bank seeking payment of obligations owed to it may well want to consider a letter of credit (“LOC”). An LOC is a financing “facility” where a bank is paid a fixed amount of money by the customer or a tenant, in return for which the bank guaranties the obligations to the merchant, supplier or landlord, as applicable (the “beneficiary”)
The LOC allows the beneficiary to be paid by the LOC Bank, merely by presenting to the Bank the original LOC and a statement by the beneficiary that satisfies the conditions set forth in the LOC. For example, in a commercial lease situation a landlord may hold an LOC as the security deposit in lieu of cash. The LOC would typically require a landlord to present the original of the LOC and a statement to the effect that an “event of default” has occurred under the lease (more on this below) and that all applicable grace periods have expired. Upon the landlord’s presenting each of these documents, the LOC Bank will pay the amount of the LOC. How any excess of the amount actually due is handled is described under the lease, but this is true of a normal security deposit as well. This is just one variation of how LOCs can be used in conjunction with a lease. The LOC is useful in this context because a tenant will often put up a larger amount via an LOC than it would if it actually had to deposit the cash.
In agreeing to a form of LOC with a bank and with its debtor, a creditor should be aware of several things. Generally, the creditor�s rights to a draw under an LOC should have as few conditions as possible, and none of those conditions should require the cooperation of the debtor. The LOC obviously will have a dollar limit; the creditor should be sure that the limit covers or at least approaches its exposure. If the limit that the debtor can obtain is not sufficient to cover a creditor’s exposure, it might be an indication that the creditor should not be doing the transaction. Next, all LOCs must have a date certain on which they terminate. A creditor must make sure that that date falls on or after the date when the customer or tenant may make his last payment (more on this below, also).
Two of the basic strengths of an LOC are that (1) drawing on an LOC is generally not prohibited by the debtor’s bankruptcy and (2) the LOC bank will very likely be more creditworthy than another “personal guarantor” that the landlord might be able to obligate.
LOCs are generally a strong form of security in a bankruptcy because they are considered to be “outside” of the debtor’s bankruptcy estate. This means that drawing on an LOC (if the LOC is drafted properly) is not stayed by the debtor’s bankruptcy and that money drawn under the LOC can be used to pay obligations which are due to the creditor and which arose both before and after the bankruptcy filing. If an unsecured creditor has to look only to the debtor for pre-bankruptcy debt, any payment of that obligation would largely be lost.
The potential bankruptcy of a tenant or a customer does however, affect how an LOC and the contract it supports are drafted. Following are two examples.
First, under bankruptcy law a payment that is not for “contemporaneous value” and that is made within 90 days of a bankruptcy filing can be avoided as a preference by the debtor’s bankruptcy trustee. For example, if a debtor pays a vendor $10,000 for a past due debt, and eighty-five days later the debtor files for bankruptcy, the bankruptcy trustee could “claw back” (i.e., make the vendor repay) the $10,000. That vendor, if he had an LOC supporting the contract, could then make a claim under the LOC to receive the money. The point of this example is that in negotiating the LOC, the expiration date should be ninety days after the final date under the contract that the debtor could pay the money, if that date can be ascertained. There the creditor is assured that an LOC will cover him even if the debtor pays him on the last possible day under the contract and then files for bankruptcy within 90 days.
Second, under bankruptcy law, an “automatic stay” which goes into effect upon filing stops a creditor from pursuing a debtor in any way, including sending a default notice. This can be a problem, if, for example, a lease states that an “event of default” occurs only after notice has been given, and the LOC states that an event of default is a pre-condition to a draw. The stay can actually stop the draw on the LOC. As a solution to this, the creditor can go to the bankruptcy court, (probably) get “relief from the stay,” serve the notice on the debtor, and draw on the LOC. However, it takes time, and it takes legal fees to do this. The better course is to solve this problem at the drafting stage. To the extent possible, a creditor should not obligate itself to give written notice prior to a default in its documents and should not condition its LOC on an “event of default.” Rather, if the creditor can, it should just condition the draw on a statement that the creditor is entitled to a draw. Debtors and tenants sometimes balk at this language; however, it is worth noting that use of a cash security deposit by a landlord is typically not conditioned on an “event of default”, so why should use of an LOC serving as a security deposit be so conditioned?
Finally, from a business perspective, if the customer or tenant has a banking relationship with a particular bank and demonstrates some degree of creditworthiness, a letter of credit for a reasonably sized transaction will likely be available. If the bank agrees to issue a letter of credit, it is a fairly good indication it is satisfied with the creditworthiness of the party. Thus, asking for an LOC may provide the creditor with a third party’s opinion of the financial strength of the customer or tenant.
Letters of credit make good business sense and most of the time prevent the need to file court papers. In this economic climate they should be considered.
– Rod Fluck