Protect Yourself When Tenants Use Letters of Credit

A letter of credit (LC) offers distinct advantages over a cash security deposit. If the tenant defaults, drawing on the LC should be as easy and automatic as making a withdrawal from the tenant’s security deposit account. Unfortunately, it doesn’t always work out that way. The key is what the LC says.

While the issuing bank drafts the actual LC instrument, landlords can still exert a measure of control by including lease language setting out specific requirements about what it says and how it works. Then, if the LC the tenant wants to use doesn’t meet the lease conditions, you can reject it and require the tenant to post cash security instead.

With regard to an LC, your lease should do the following:

1. Give You the Right to Review LC. Specify that you can reject the LC if it’s not satisfactory to you in both form and substance, and require the tenant to provide a “specimen” or draft LC that you can review with your attorney before signing the lease. Another potential approach is to attach a model of the LC form you want the tenant to use as an exhibit to the lease.

2. Require LC to Be Irrevocable. Say that the LC must be “irrevocable”—in other words, that the issuer can’t revoke or revise the LC without your consent.

3. Require LC to Be a "Standby." Say that the letter must be a “standby” LC—that is, one that functions as an assurance of payment that the landlord may draw on if a default occurs, as opposed to a commercial LC that serves as an actual source of funds. While this may sound like legal mumbo jumbo, the distinction has significant practical consequences because it means you may still be able to get paid if the tenant goes into bankruptcy.

4. Require LC to Set Clear Triggers. Perhaps the most important protection you need is assurance that you’ll be able to draw on the LC if and when you need it. So, require that the LC clearly provides that any default the tenant commits triggers your right to draw.

5. Require LC to Be Unconditional. The next step is to ensure that if a default does occur, you can draw on the LC simply by presenting the original LC, a sight draft, and a written statement certifying that the tenant is in default under the lease. Accordingly, require an LC that’s “unconditional.” What you don’t want is for the bank to have discretion over whether to pay you or the authority to tie you up in red tape, for example, by requiring you to file explanatory affidavits each time you draw on the LC. You also need to make sure you can fulfill the draw conditions unilaterally, without the tenant’s (or any other third party’s) signature or cooperation and in spite of a tenant’s bankruptcy filing.

For 10 more LC protections to put in your lease, as well as a model lease clause including them all, see “Get 15 Lease Protections When Tenants Use Letters of Credit Instead of Security Deposits,” available to subscribers here.