Lost to most headline readers in the immediate shuffle is the somewhat contained issue of letters of credit as security for commercial leases. Commercial landlords and tenants and their advisors, however, sure didn’t miss it.
Rather, calls came in immediately upon Silicon Valley Bank’s failure on Friday, March 10 – landlords were concerned that they wouldn’t be able to access their tenants’ security deposits leading to the devaluation of their investments and tenants wondering if they’ve found themselves in default under their sizable lease obligations and how they could comply with landlords demands.
We saw our first notices from commercial landlords holding letters of credit from Silicon Valley Bank demanding replacement letters of credit from tenants as early as Monday, March 13. The same were sent and came in with respect to Signature Bank and First Republic just as fast in the days following.
As most still reading likely know (or vaguely recall from their lease negotiation process), a letter of credit is essentially an IOU from a bank held by a landlord as a security deposit rather than holding the tenant’s funds in a bank.
Commercial leases vary greatly as to the effect of an issue bank. In the past few weeks, we’ve reviewed leases that simply require a tenant to simply obtain and “maintain” a letter of credit from an institution approved at the time of lease execution to commercial to leases with pages and pages of ongoing technical requirements for issuing banks. Most commercial leases contain language somewhere in between and each instance requires detailed lease review.
Many sophisticated commercial leases require that the issuing bank must have and maintain specified credit ratings and/or amounts on deposit. If the requirements are not met landlords can require that the tenants obtain replacements from a qualifying bank or be held in default of the leases.
Less often commercial lease language addresses the issue by permitting a landlord to demand a replacement if there’s reasonable concern as to the financial stability of the issuing bank and/or the landlord’s ability to draw down the letter of credit if the tenant defaults. While generally favorable for a landlord there’s often subjectivity here.
When a bank fails or is in major financial distress, as we’ve seen in the past few weeks, one would think it fairly clear that the ratings / requirements aren’t met and that the landlord has reasonable grounds to doubt the inability to pay.
However, with the federal government and the banking system itself taking over / shoring up these failing institutions to differing degrees, some tenants have argued that the landlords don’t have the right to demand for replacement and pointed out where lease language doesn’t match up.
Tenants have maintained that since the accounts in these banks are fully “covered” or the bank has been taken over by a larger institutions, there’s no entitlement to demand replacement. Landlords should instead take a wait and see approach. Obtaining the replacement costs tenants significant time, effort and fees, require them to switch banks entirely (not necessarily a bad idea, just difficult and time consuming) and may even require posting or tying up double the amount of the security deposit while a swap is being made.
Landlords quickly point out that even where, in the case of Silicon Valley Bank, the FDIC and the newly created bridge banks now administering Silicon Valley Bank’s assets are backing the depositor’s accounts and the bank’s obligations generally, they retain the right to amend existing contractual arrangements such as letters of credit. Moreover, the FDIC and the bridge banks just don’t meet the technical requirements under existing leases for issuing banks – those were written for rated financial institutions not quasi-governmental entities.
Practically speaking, landlords are often required to surrender originals of a letter of credit to the issuing bank in order to draw down on the applicable funds. The prospect of walking a letter of credit into a Silicon Valley Bank branch (get in line) or a Signature (now Flagstar) Bank branch isn’t terribly appealing and may not be possible.
Even if a letter of credit allows draw down by email or fax (yes, fax is still used for these), the landlords don’t know for sure if the requests will be honored by a bank in receivership or in the middle of or following a takeover.
If you’ve ever tried calling a major bank with general questions about drawing down on a letter of credit, you’ll understand why it makes sense for these landlords to require tenants to do the legwork and provide comfort that the leases are secured by the appropriate security.
In most cases we’re seeing cooperation following replacement demands – tenants are mostly recognizing that landlords have valid concerns and landlords, while not giving up their “rights” to demand replacement letters of credit as quickly as their leases permit, are often affording their tenants the necessary leeway. That said, major disputes are more than likely.
As we counsel our clients through this ongoing process, leasing lawyers are already examining how commercial lease language should be adapted considering the realities of bank failures.
We can expect commercial leases to more often include strong protective language in the event of bank failures including making crystal clear that landlords can demand a replacement letter of credit when a bank is in receivership or similar process. Tenants will no doubt push for language forestalling an event of default for reasons of an issuing bank’s failure and allowing them reasonable time to provide a replacement, post cash upon cancellation of a letter of credit and avoid posting double security.
If nothing else, uncertain times like these underscore the importance of carefully crafted and negotiated lease language. We at Ingram will continue to provide expert counsel to our landlord and tenant clients alike on these issues as well as on the myriad other complexities inherent in the commercial leasing relationship.
By: Neal Weinstein
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