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Is it safe to accept a letter of credit as a security deposit?

January 28, 2013

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Even as the economy crawls its way forward, the prospect of tenant bankruptcy remains a real threat for landlords. That risk is a good reason to reconsider whether you should continue to accept letters of credit as security deposits.

Benefits and risks

Commercial landlords have historically preferred that their tenants provide letters of credit, rather than cash, for security deposits. A cash security deposit might become part of a bankrupt tenant’s estate if the tenant files for bankruptcy before the landlord has applied it.

Letters of credit, though, aren’t affected by a bankruptcy filing and won’t become subject to claims by the tenant’s creditors. A letter of credit also isn’t covered by automatic stays imposed by bankruptcy courts, so the landlord can draw on it immediately, without seeking approval from the court.

But enforcing letters of credit can be tricky and time-consuming, delaying the actual receipt of the deposit. And letters of credit can come with an annual fee payable by the tenant, which can make them resistant.

The banking crisis has highlighted another risk related to letters of credit. Prior to the crisis, banks were widely considered quite capable of paying off letters of credit. When they began to fail, however, the Federal Deposit Insurance Corporation (FDIC) alerted commercial landlords that it isn’t legally required to honor bank-issued letters of credit that fail or fall into FDIC receivership.

Key safeguards

To reduce the risk of lost security deposits, landlords should consider revising their leases so that:

•    They must approve of the bank issuing the initial letter of credit,

•    If that bank becomes materially weaker during the lease term, the tenant must provide an additional letter of credit from another bank,

•    If the issuing bank is declared insolvent by the FDIC, or it closes, the tenant must immediately provide a substitute letter of credit, and

•    The landlord has sole discretion to approve the issuer of a substitute letter of credit.

It’s also a good idea to regularly review bank ratings and check the FDIC’s list of failed banks against the list of banks that have issued any letters of credit that you currently hold.

Protect yourself

Letters of credit are less secure than they once were but are still viable. By using a properly drafted lease and monitoring your bank’s health, you can improve your odds of recovering security deposits after tenants default.

For more information contact Dan Lacey at [email protected]

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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