More Information About Letters of Credit and Bank Guarantees

More Info About Letters of Credit

      The parties to a letter of a credit are as follows:

Issuer – the bank or thrift issuing the letter of credit is the Issuer.
Account Party – the party who obtains the letter of credit from the Issuer is the Account Party. Often, the Account Party arranging for a standby letter of credit delivers cash or other collateral to the Issuer to secure repayment of any draws on the letter of credit.

Beneficiary – the party who holds the standby letter of credit and who is authorized to draw under the letter of credit on the conditions stated in the letter of credit is the Beneficiary. 

A standby letter of credit is issued by the Issuer to the Beneficiary at the request of the Account Party, and requires the Issuer to pay a specified sum to the Beneficiary upon satisfaction of the conditions of drawing specified in the standby letter of credit. The standby letter of credit will specify the maximum amount that may be drawn, the expiration date, the place where drafts must be presented and what certifications or deliveries must be made in connection with the draw request. Virtually all letters of credit utilized in real estate transactions are “sight draft” letters of credit, which means that the Beneficiary can require payment under the letter of credit upon delivery of a simple sight draft, which looks very much like a bank check, together with any other required certifications. 

Letters of credit are governed by Article 5 of the Uniform Commercial Code (the “UCC”), which has been enacted in every state and the District of Columbia. In addition, parties generally agree that the letter of credit will be governed by the Uniform Customs and Practice for Documentary Credits (the “UCP”) or the International Standby Practices 98 (the “ISP”), both of which are promulgated by the International Chamber of Commerce. Standby letters of credit issued by US financial institutions are also subject to regulation by one or more of the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, the Federal Reserve Board and the Office of the Comptroller of the Currency. 

Standby letters of credit are generally issued and held pursuant to a separate contract between the Account Party and the Beneficiary – such as a lease, loan agreement, purchase agreement or public improvement agreement. The “underlying contract” between the Account Party and the Beneficiary is separate and independent of the letter of credit as a legal matter, but it will specify the requirements that the letter of credit must satisfy and when it can be drawn. If these documents are drafted properly, they will generally contain language that requires the Issuer to meet certain specified standards as to its financial strength. 

Following is some typical lease language (although any actual language you use should be crafted to fit the particular case): 

The Letter of Credit shall be issued by a commercial bank acceptable to [Landlord] and (1) that is chartered under the laws of the United States, any State thereof or the District of Columbia, and which is insured by the Federal Deposit Insurance Corporation; (2) whose long-term, unsecured and unsubordinated debt obligations are rated in the highest category by at least two of Fitch Ratings Ltd. (Fitch), Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Ratings Services (S&P) or their respective successors (the Rating Agencies) (which shall mean AAA from Fitch, Aaa from Moody’s and AAA from Standard & Poor’s); and (3) which has a short term deposit rating in the highest category from at least two Rating Agencies (which shall mean F1 from Fitch, P-1 from Moody’s and A-1 from S&P) (collectively, the LC Issuer Requirements). If at any time the LC Issuer Requirements are not met, or if the financial condition of such issuer changes in any other materially adverse way, as determined by [Landlord] in its sole discretion, then [Tenant] shall within [five (5)] days of written notice from [Landlord] deliver to [Landlord] a replacement Letter of Credit which otherwise meets the requirements of this [Lease] and that meets the LC Issuer Requirements (and [Tenant]’s failure to do so shall, notwithstanding anything in this [Lease] to the contrary, constitute an Event of Default for which there shall be no notice or grace or cure periods being applicable thereto other than the aforesaid [five-day] period). Among other things, [Landlord] shall have the right under such circumstances to immediately, and without further notice to [Tenant], present a draw under the letter of credit for payment and to hold the proceeds thereof.

Following is some typical language for the governing documents (and once again, any actual language you use should be crafted to fit the particular case): 

In the event the issuer of any letter of credit held by [Landlord] is insolvent or is placed into receivership or conservatorship by the Federal Deposit Insurance Corporation, or any successor or similar entity, or if a trustee, receiver or liquidator is appointed for the issuer, then, effective as of the date of such occurrence, said Letter of Credit shall be deemed to not meet the requirements of this Section, and then [Tenant] shall within [five (5)] days of written notice from [Landlord] deliver to [Landlord] a replacement Letter of Credit which otherwise meets the requirements of this [Lease] and that meets the LC Issuer Requirements (and [Tenant]’s failure to do so shall, notwithstanding anything in this [Lease] to the contrary, constitute an Event of Default for which there shall be no notice or grace or cure periods being applicable thereto other than the aforesaid [fiveday] period); or, alternatively, [Tenant] shall, within such [five-day] period deliver cash to [Landlord] in the amount required above.

Letters of credit typically follow a fairly pre-determined format. However, the Issuer will often agree to include customized language which might include, among other things, the Beneficiary’s automatic right to draw in the event the letter of credit is due to expire without being renewed or replaced, or if the Issuer’s credit rating drops below a specified level.

It is obvious that a Beneficiary is in a much better position if it draws upon a letter of credit for payment, and retains the proceeds, before the Issuer is subject to a receivership or conservatorship order by FDIC. Failure to do so could render the letter of credit worthless and leave the Beneficiary without a viable course of action to re-establish the deposit or other security. 

While beyond the scope of this article, the type of account in which the proceeds are held, in the case of a tenant security deposit, should be carefully considered in order to minimize potential bankruptcy risks. 


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