Sign of the Times: Credit Enhancement with Letters of Credit in Real Estate Contracts

September 22, 2011

Parties regularly indemnify each other in commercial real estate contracts for a variety of potential liabilities: failure to pay third party professional or legal fees (always “reasonable” of course!), filing fees, costs and judgments in unexpected lawsuits, more general third party costs incurred due to consequences of the other party’s action or failure to act in a way promised. But just throwing the words “shall indemnify” into a contract without thinking through the mechanics of what the indemnification will cover, how the indemnified party will know a right to an indemnification is triggered, what cash will be readily available to pay the indemnified party and how the indemnified party will access that cash is risky business indeed. As a result, in uncertain times, letters of credit are becoming more commonly used to back up indemnities.

We have seen indemnities and covenants backed by letters of credit in several types of contracts recently:

  1. Leases/Tenant Improvements. After the 2008 market dip and the corresponding shower of bankruptcies, tenants with leases requiring extensive and expensive landlord constructed and/or funded tenant improvements required those landlords to post letters of credit sufficient to finance the completion of those tenant improvements. Traditionally, concern over the creditworthiness of a tenant was a one-way street; suddenly, it seemed, tenants were equally concerned with a landlord’s financial ability to set aside bankruptcy remote funds to complete the tenant’s build out. Letters of credit naming a prime tenant as the beneficiary became more common for tenant build out.
  2. Easements. Adjoining property owners who need and benefit from improvements in an easement area located on the property next door – perhaps a road, a utility, a parking lot – have traditionally asked: what if, when the time comes, that neighbor doesn’t pay for the permit or doesn’t finish construction or maintain the improvement properly to serve my needs? When the only answer is: “Well you can bring a lawsuit for performance”; but if the other party has no funds to perform or is bankrupt, the remedy is hollow. Again, an indemnity backing up the covenant and a letter of credit backing up the indemnity can help.
  3. Post Closing Indemnities. Recently, we have noted that covenants to do (or not to do) certain acts, indemnities and letters of credit have entered sellers’ consciousnesses when there are obligations to third parties the buyer is assuming with the purchase of a property. Perhaps there are obligations to third parties to build or perform certain tasks post closing. Perhaps there are obligations to sublessees not to default under an over-lease to a sublessor (or ground lessor). Perhaps there is an indemnity to defend against likely lawsuits. Whatever the reason, sellers should also ask whether there is a reason their sale agreements should contain post closing indemnities of the seller from the buyer backed by a letter of credit before they sign.

The complexities of letters of credit have been covered at length in legal treatises. Parties who think a letter of credit is a generic document and that everyone means the same thing when they agree to “back it up with a letter of credit” can be surprised. At a minimum, the party benefitting from a letter of credit in a contract should ask:

  1. What is the creditworthiness of the issuing bank?
  2. Do I want “commercial” or a “standby” letter of credit?
  3. What set of rules governs this letter of credit in its boilerplate? Is it Article 5 of the Uniform Commercial Code (“Article 5”) or the Uniform Customs and Practice for Documentary Credits 2007 Revision, International Chamber of Commerce Publication No. 600 (“UCP 600”) or the International Standby Practices (“ISP98”)? Why do I care and what makes the most sense for how I expect this to work if I need to draw down this letter of credit?
  4. Is the letter of credit truly evergreen, or does it terminate on a fixed date? If it is evergreen and the applicant does not pay the letter of credit fee to the issuing bank on time to renew it, do I get notice of that non-payment from the issuer before the letter of credit terminates, and do I have sufficient time to present the letter of credit for payment?
  5. Does the letter of credit accurately and clearly describe how I would present it for payment (to whom? where? with what documentation?), and do I have the means and tools to do so?
  6. Does the letter of credit accurately and clearly describe under what circumstances I can present it?

Issuing banks will only disburse on a letter of credit if every detail is in order and circumstances are exactly as worded in the letter of credit and in the governing rules elected (see Section C above). If you elect to use a letter of credit as credit enhancement for an important contract indemnity, don’t let impatience to “get the deal done” cause you to plug the concept of a generic letter of credit into the agreement without reviewing with counsel carefully the wording and details of the very letter of credit you plan to use.

For more information, visit our Greater Washington-Baltimore Region Transactional Real Estate practice.