Landlords beware of letters of credit pitfalls.

Although letters of credit can rarely be avoided in major commercial leases today, landlords should insist on several key clauses before accepting them, warns Jack Loehr, attorney with Wien, Malkin & Bettex.

"Nowadays most landlords, unwilling to risk losing a large tenant, have little choice but to accept letters of credit rather than cash as security for a lease," he says. "But they must also take steps to protect their interests."

Three key particulars on which landlords should insist, according to Loehr, are that a letter of credit must be drawn on a money-center bank; must be payable on sight; and must contain no requirement for a landlord certification of the existence of the tenant's default or other justification for the draw.

"Money-center banks are dependable, says Loehr. "Their names and reputations are known throughout the banking, real estate and business communities."

But the comfort a landlord enjoys from requiring that such institutions issue tenants letters of credit derives from a good deal more than their high level of prestige, Loehr continues.

"For example, there is current case law to the effect that the FDIC may not be required to honor letters of credit issued by a failed bank," he says. "Clearly, the larger and more successful the bank, the less likely that it will fall under the aegis of the FDIC, and the more likely that a landlord will be able to draw on its letter of credit."

Loehr notes that a money-center bank is more concerned with its own reputation than with the tenant's, and is more beholden to its position in the banking, financial and real estate communities, rather than to the needs of a particular customer - i.e. a tenant. In essence, the landlord can feel the bank will not risk its reputation to delay payment on a letter of credit because of the institution's relationship with the tenant.

Loehr also urges that letters of credit not require as a condition to draw a certification from the landlord describing the basis for its claim under the letter of credit, whether a tenant defaults, fails to renew the letter of credit, or other reason.

"These documents should not contain any conditions whatsoever," he says. "Any excess or unnecessary wording is grist for an attorney's mill. A tenant's lawyer, eager to protect what he or she sees as his client's interests, will use any legal means to delay, or even prevent, a landlord from drawing on his client's letter of credit. Indeed, these documents must be as simple as possible," Loehr continues. "If a bank clerk feels that a draft or other required documentation for drawing under a letter of credit is not quite right, he can delay the procedure. This can prove disastrous if the landlord's deadline to redeem the letter is only one or two days away."

To the extent a bank wishes not to act in the face of conflicting demands, it can use an ostensibly incomplete or inadequate draw request from the landlord as its justification, says Loehr. "Essentially, the more complicated the requirements to draw under the letter of credit, the greater the possibility the draw can be rejected as non-performing," he adds.

In short, according to Loehr, a letter of credit that is not payable "on sight" can prove to be a significant pitfall for a landlord.

In addition, a letter of credit must clearly indicate where it may be drawn, including hours of operation (if limited) and other pertinent limitations on use, says Loehr.

"It is imperative that a landlord be able to redeem the letter of credit locally," he explains. "If he's based in New York, for example, he cannot jeopardize his ability to redeem the letter in time by having to travel to some other part of the country."

Ironically, according to Loehr, there is one instance in which a letter of credit is actually preferable to cash.

"In cases where the tenant files bankruptcy, the landlord will be glad that he agreed to a letter of credit, rather than cash," he explains. "A bankruptcy court can claim a cash security deposit, but cannot claim security that is in the form of a letter of credit."