United States: Letters Of Credit Posted By Dot-Com Tenants – How Lenders Can Avoid Becoming A Victim Of Tulipmania

Many have compared the current demand for internet-related stocks to the Dutch tulip craze of the seventeenth century. In Holland, over a three-year period, the price of Dutch tulip bulbs skyrocketed 5900%, until the price collapsed. Many internet companies, like Dutch tulips, have skyrocketed in price, but generate precious little revenue, let alone return a profit. As a consequence, when these internet-related companies seek to lease space, prudent landlords often require substantial security deposits, usually in the form of a letter of credit, to secure the tenant’s obligation under the lease.

As more and more lenders seek to underwrite loans supported by dot-com tenant leases, the issue of perfecting a lender’s right and interest in these underlying letters of credit becomes increasingly important. Once properly addressed, if the mania for internet-related stocks turns out to be like the tulipmania of seventeenth century Holland, at least the lenders will have ultimate recourse to the letter of credit security deposit, rather than be left holding the wilting petals of yet another faded bloom.

Currently, California law provides, in essence, three "levels" of perfection with respect to an interest in a letter of credit. First and foremost, the lender can obtain a California Uniform Commercial Code ("CUCC") Division 9 security interest in its borrower’s (i.e., the landlord’s) interest in the proceeds of the tenant-posted letter of credit, and the lender can perfect the same by taking possession of the original letter of credit. While this provides the lender with a perfected security interest in the proceeds of the letter of credit, it does not address the issues of who can draw on the letter of credit, and once drawn, where do the proceeds go? Fortunately, these issues can be addressed, at least in part, through the provisions of the CUCC Division 5, which allows for both an assignment of proceeds and an absolute transfer of the letter of credit.

The provisions concerning letters of credit in the CUCC appear in Divisions 5 and 9. Section 5114(f) of the CUCC leaves to Division 9 of the CUCC the method of creating and perfecting a security interest in or granting of an assignment of a beneficiary’s rights to proceeds. Section 9104(n) of the CUCC provides that Division 9 of the CUCC does not apply to the "transfer of an interest in a letter of credit other than the rights to proceeds of a written letter of credit." Sections 9304(1) and 9305 of the CUCC provide that a security interest in the right to proceeds of a letter of credit is perfected by the secured party’s taking possession of the letter of credit.

Thus, by executing the usual security agreement, a lender’s security interest in the letter of credit proceeds will attach and be enforceable between the lender and the landlord but will not be perfected. By also taking possession of the original dot-com tenant letter of credit, the lender will perfect its security interest in the proceeds of the letter of credit as against third parties and, perhaps, even more importantly, a trustee in bankruptcy in the event of the landlord’s bankruptcy. However, the lender must be aware of the inherent limitations of this structure: (i) unless the borrower/landlord makes the appropriate draw under the letter of credit, there, in fact, will be no proceeds against which the lender may seek recourse; and (ii) even if the letter of credit is properly drawn by the landlord, the proceeds are, nevertheless, paid directly to or at the direction of the borrower and not the lender. Only the beneficiary of the letter of credit is authorized under Division 5 of the CUCC to present the letter of credit and execute drafts thereunder. Pity the lender who, holding a soon-to-expire dot-com tenant letter of credit, has a perfected security interest in the proceeds but, when faced with a recalcitrant borrower, effectively has no way to draw on the letter of credit and obtain the proceeds.

Division 9 of the CUCC has been revised, effective July 1, 2001. Sections 9203(b)(3)(D) and 9314(a) of the CUCC allow the attachment and perfection of a security interest in "letter-of-credit rights" by obtaining "control" rather than by possession of the original letter of credit. Control is a method of perfection first introduced in California for investment property in 1997. In revised Section 9107 of Division 9 of the CUCC, perfection by control is adapted for a broader range of collateral. "Control" of letter-of-credit rights is defined under revised Division 9 of the CUCC as meaning that "the issuer or nominated person has consented to an assignment of proceeds of the letter of credit under subdivision (c) of Section 5114 or otherwise applicable law or practice." Even if the lender obtains "control" in order to perfect its security interest in the proceeds of the letter of credit under revised Division 9 of the CUCC, unless the landlord draws under the letter of credit, there will be no proceeds for the lender to receive.

The transition provisions of revised Division 9 of the CUCC provide that a security interest that is enforceable immediately before July 1, 2001 and that would have priority over the rights of a person that becomes a lien creditor at that time is a perfected security interest if, on July 1, 2001, the requirements for enforceability and perfection are satisfied. The transition provisions of revised Division 9 of the CUCC also provide that perfection by possession remains effective only for one year after the effective date of revised Division 9 of the CUCC unless the requirements of revised Division 9 of the CUCC are met during that year. Therefore, if a lender does not obtain the issuer’s consent under Section 5114(c) of the CUCC for letters of credit in transactions occurring before July 1, 2001, the lender must obtain such consent by July 1, 2002, otherwise or the lender will lose its perfected security interest in the proceeds of the letter of credit.

Section 5114(b) of the CUCC provides that a beneficiary may assign its right to part or all of the proceeds of a letter of credit. Section 5114(c) of the CUCC provides, however, that an issuer of a letter of credit need not recognize an assignment of proceeds of a letter of credit until it consents to the assignment. Section 5114(d) of the CUCC provides that although an issuer is not obligated to give or withhold its consent to an assignment of proceeds of a letter of credit, consent may not be unreasonably withheld if the assignee possesses and exhibits the letter of credit and presentation is a condition to honor. Section 5114(a) of the CUCC specifically states that "proceeds of a letter of credit" do not include a beneficiary’s drawing rights or documents presented by the beneficiary.

Thus, in addition to taking steps to create and perfect a security interest in the proceeds of the letter of credit, the lender can obtain some additional comfort by obtaining an assignment of the proceeds of the letter of credit under Division 5 of the CUCC. Nevertheless, while the lender will ensure that no one other than it obtains the proceeds of the letter of credit, the lender will still not have addressed the issue of who has control over when and if the letter of credit will be drawn. The transition provisions of revised Division 9 of the CUCC provide an additional incentive for obtaining the consent of the issuer to the assignment. Given that a security interest that (a) is enforceable immediately before July 1, 2001, and (b) would have priority over the rights of a person that becomes a lien creditor at that time is a perfected security interest if, on July 1, 2001, the requirements for enforceability and perfection are satisfied, it is recommended that lenders obtain the consent of the issuing bank to the assignment for transactions entered into prior to July 1, 2001 to preserve the perfection of their security interest in the letter-of-credit rights. If the lender fails to obtain such consent in advance, it must do so prior to July 1, 2002 or it will lose its perfection in the letter-of-credit rights.

One Way for a lender to obtain the "full" benefits of a letter of credit issues in favor of its borrower is to require the borrower to transfer the letter of credit to the lender in conjunction with the borrower’s grant of a security interest in the letter of credit proceeds in favor of the lender as described above. The lender is expressly substituted as the beneficiary and, thus, obtains the right to draw directly under the letter of credit under the terms of the lease and receive the proceeds thereof. The CUCC distinguishes between the "transfer" of a letter of credit and the "assignment" of its proceeds.

Another advantage of becoming the transferee beneficiary of a letter of credit is that because the letter of credit is not an asset of the tenant’s estate; thus, in the event of the tenant’s bankruptcy, a draw under the letter of credit should not be prevented by the automatic stay in bankruptcy. However, Section 502(b)(6) of the Bankruptcy Code limits a landlord’s allowed claim from a rejection of a lease of non-residential real property to the greater of (i) one year’s rent and (ii) 15% of the remaining rent reserved in the lease, not to exceed three years. Therefore, if a tenant commences a reorganization case under Chapter 11 and rejects or is deemed to reject its lease, a subsequent draw upon the letter of credit in excess of the landlord/beneficiary’s allowed claim may raise significant issues. Although a conforming draft should be honored under the "independence principle," it is possible that the landlord, or, in turn, its lender/transferee beneficiary may be subject to attacks seeking to mandate restitution or disgorgement of the "excess amount." Such attacks could be asserted by the debtor-in-possession or by a bankruptcy trustee or even by the issuer of the letter of credit. For example, both an issuer who honors a draw and an account party that reimburses an issuer are each accorded rights akin to subrogation under Section 5117 of the CUCC. A creative debtor-in-possession might seek to derivatively assert such rights under Bankruptcy Code Section 544(a) or under restitution theories to seek recovery of any amounts drawn under a letter of credit which are in excess of the allowed claim under Section 502(b)(6) of the Bankruptcy Code.

Section 5112 of the CUCC provides that a letter of credit cannot be transferred unless it provides that it is transferable. Lender and its counsel must, however, be aware of the Uniform Custom and Practices for Documentary Credits ("UCP"), which is published by the International Chamber of Commerce. The UCP is binding upon the parties to a letter of credit if it is incorporated into the letter of credit. Article 48(c) of the UCP provides that a letter of credit subject to the UCP is transferable only if the issuing bank consents to the transfer, even if the letter of credit states that it is transferable.

In practice, most borrowers are reluctant to transfer a letter of credit security deposit to their lender prior to a default under the loan because they do not want to lose the flexibility of negotiating with their tenants prior to a default under the loan. In addition, obtaining an assignable letter of credit may introduce another party to the transaction―the issuing bank—whose demands may impose additional complexity or expense to the loan transaction. Under revised Division 9 of the CUCC the lender, landlord and issuing bank will already be forced to deal with each other more than they have in the past; consequently, widely recognized commercial practices that mitigate the additional complexity of securing the bank’s consent may evolve over time.