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Be Careful with Letters of Credit

AOL - Real Estate Invest And Finance

On March 10, 2023, the California Department of Financial Protection and Innovation closed Silicon Valley Bank, Santa Clara, California (“SVB”) and subsequently appointed the Federal Deposit Insurance Corporation (“FDIC”) as receiver thereof. On March 13, 2023, the FDIC transferred all deposits and substantially all assets and contracts of SVB to a newly created and FDIC-operated bridge bank, Silicon Valley Bridge Bank, N.A. On March 14, 2023, the FDIC announced that the bridge bank will be obligated to (and has the full ability to) make payments and perform the obligations of SVB under the transferred contracts. One of such transferred contracts is known as a letter of credit. A letter of credit is a contract between a bank (tenant’s issuing bank), the bank’s customer (tenant), and a beneficiary (landlord). The issuing bank guarantees that a specific payment (e.g., the security deposit) will be made to the beneficiary of the letter of credit if enumerated conditions are met.

Landlords routinely accept a security deposit in the form of a letter of credit in lieu of cash upon execution of a lease agreement as security for the performance by a tenant of all obligations on the part of such tenant thereunder. A landlord will typically have the right to draw on the letter of credit upon the occurrence of events enumerated under the lease (e.g., such tenant’s default, bankruptcy or holdover). While leases almost always include the obligation of the tenant to furnish a replacement letter of credit following the issuing bank’s failure to renew the letter of credit upon expiration or willful termination, landlords sometime overlook the sensibility of including provisions in the lease requiring replacements in connection with the financial stability of the issuing bank. The failure to cover a closure or credit rating downgrade of the issuing bank can prove costly. Importantly, once the issuing bank is closed by the state banking regulator and placed into conservatorship or receivership by the FDIC, the conservator or receiver has the authority, under 12 U.S.C. § 1821(e), to repudiate any contracts which have obligations it determines to be burdensome.

In relevant part, 12 U.S.C. § 1821(e)(1) provides:

In addition to any other rights a conservator or receiver may have, the conservator or receiver for any insured depository institution may disaffirm or repudiate any contract or lease —

(A) to which such institution is a party;

(B) the performance of which the conservator or receiver, in the conservator’s or receiver’s discretion, determines to be burdensome; and

(C) the disaffirmance or repudiation of which the conservator or receiver determines, in the conservator’s or receiver’s discretion, will promote the orderly administration of the institution’s affairs.

Issuing Bank Standards and Requiring a Replacement Letter of Credit

When accepting a letter of credit as the security deposit, landlords would be well advised to pay particular attention to craft a security deposit provision that broadly covers the financial health of the issuing bank. As discussed above, at a minimum, tenant should be required to provide a replacement letter of credit from a satisfactory issuing bank whenever the issuing bank of the existing letter has been closed by the state banking regulator and/or placed into conservatorship or receivership by the FDIC. As we have seen from the SVB closure, oftentimes once a bank has been closed and placed into receivership, it is already too late to withdraw any funds, let alone request revocation of a letter of credit from the issuing bank for subsequent replacement.

Placing minimum standards on the issuing bank helps the parties to identify a deterioration before closure. The issuing bank should be required to maintain a minimum long-term credit rating with Moody’s Investors Service, S&P Global Ratings or a similar nationally recognized statistical rating organization. In the days preceding the closure of SVB, Moody’s downgraded the credit rating of the bank to Baa1 from A3 (i.e., reducing the bank’s credit rating from upper medium grade to lower medium grade) citing “deterioration in the bank’s funding, liquidity and profitability.” This credit rating downgrade could be a triggering event requiring a tenant to immediately replace the current letter of credit with a replacement from an issuing bank that meets the credit rating requirements of the lease.

The simple lesson learned from this failure is that landlords should place as much focus on the financial health of the bank that issues its letter of credit as it does on the tenant applying for the letter. There is no way to avoid the anxiety that comes from a bank closure and wondering whether your security is affected. However, this anxiety can be minimized by exhausting all possible events that might warrant the replacement of a letter of credit and creating a security deposit provision that is crafted from the outset to quickly protect your security in the event of a significant deterioration at the issuing bank.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.