Court battle may determine fate of letters of credit.

Aug. 18 showdown involves two L.A.-based lenders

A California court of appeal has agreed to rehear this month a case which California Bankers Association officials say could ruin the letter of credit as a financing instrument across the state.

A letter of credit is a document issued by a bank or other financial institution guaranteeing a customer's payment for up to a certain amount. Letters of credit have been used primarily for international trade transactions, but recently have become a commonly used financing tool in California real estate deals.

The case in which the letter of credit's future is supposedly to be decided involves a dispute between two local banks, Beverly Hills Business Bank and Toluca Lake-based Western Security Bank.

Beverly Hills Business Bank tried to draw on a $375,000 letter of credit issued by Western Security Bank on behalf of a developer, Vista Place Associates. The letter was issued during a restructuring of a $3.25 million loan which Vista Place had defaulted on. Vista Place had originally gotten the loan to acquire a piece of property upon which it planned to develop a shopping center.

When Vista defaulted on its loan a second time, Beverly Hills Business Bank foreclosed on the property and then tried to draw on the letter of credit. But Western Security Bank, advised by Vista Place that what Beverly Hills Business Bank was doing violated California real estate law, denied payment of the letter of credit to the Beverly Hills bank.

The matter ended up in court. And on June 22, 1993, the Second District of the California Court of Appeal ruled in favor of Western Security. The court held that a lender may not draw on a letter of credit held as secondary collateral after the lender forecloses on the property through a nonjudicial foreclosure sale.

If the decision is allowed to stand, "the letter of credit system in California will be destroyed," said Chris Chenoweth, general counsel for the California Bankers Association, a business trade organization which represents almost all of the state's 420 or so banks. "It is that serious."

The Bankers Association and Long Beach-based McDonnell Douglas Financial Corp., a non-bank lender which uses letters of credit as collateral on real estate loans, have both filed briefs in support of Beverly Hills Business Bank, which was renamed Independence One Bank last December. Oral arguments in the rehearing are scheduled to be heard on Aug. 18.

"Quite a bit is at stake," said George Hisert, an attorney representing the California Bankers Association. The bankers association's view is that letters of credit "should be like cash," Hisert said.

But on June 22, the California Court of Appeal ruled that another law, called the anti-deficiency law, which protects borrowers' interest in the event of a nonjudicial foreclosure, supersedes laws relating to letters of credit.

Under that anti-deficiency law, a lender can not foreclose on a property through a nonjudicial foreclosure and then come back and sue the borrower for the difference between the value of the loan and the value of the property.

In the case in question, Beverly Hills Business Bank made a $3.25 million loan to Vista Place Associates. That loan went into default and, as part of the restructuring, the partners in Vista Place gave Beverly Hills Business Bank letters of credit worth $375,000, Hisert said. Not long after that restructuring, Vista Place went into default again, and Beverly Hills Business Bank foreclosed on the property through a nonjudicial foreclosure, said Steven Cote, an attorney representing Independence One Bank.

Then-called Beverly Hills Business Bank paid $2.75 million for the property, because it had dropped in value by about $500,000, Cote said.

The bank then tried to draw on the letters of credit issued by Vista Place partners to recover the difference between the value of the loan and the value of the property, Cote said.

But Western Security Bank declined to pay the letters of credit, which were no longer secured by collateral, and sued Beverly Hills Business Bank to get a court to determine the law on paying the letters of credit.

Beverly Hills Business Bank, which by then had been renamed Independence One Bank, won a Superior Court decision, but that decision was overturned by the California Court of Appeal in June.

Allan Cooper, an attorney representing Western Security said, "A letter of credit is like a cashiers' check....And what this (appeal) court said was, whenever you're dealing with real estate and anti-deficiency principles, you're not entitled to cash that check."

John Anglin, attorney with the firm of Walker Wright Tyler & Ward, which represents Vista Place, said: "We never told Western Bank not to pay the letters of credit. What we said was, under California law, we weren't responsible for reimbursing them."

Anglin added that California Bankers Association officials are "exaggerating" the importance of the case.

"We don't think the world as we know it in respect to letters of credit is going to end as a result of this case," Anglin said. Instead, he said, banks will henceforth proceed in the proper sequence against delinquent borrowers by first drawing on the letter of credit and then taking the property through nonjudicial foreclosure.