Tulipmania, Redux

I. INTRODUCTION

Many observers, including this author, have compared the recent demand for internet-related stocks to the Dutch tulip craze of the seventeenth century. In an earlier article, I commented that the price of Dutch tulip bulbs had skyrocketed 5900% before collapsing, and noted that internet companies, like tulip bulbs, had skyrocketed in price, but generated little revenue and often failed to return a profit.1 The comparison is now even more apt, as the prices of many internet-related companies, have, like the tulip bulb prices of the seventeenth century, collapsed. In that article, I noted that prudent landlords often required substantial security deposits from internet-related companies, usually in the form of a letter of credit, to secure the tenant's obligation under the lease, and discussed how lenders could perfect their rights and interest in letters of credit posted by internet-related companies, to protect themselves in the event the tenants failed.

Now that so many internet-related companies have failed, lenders are less interested in how to perfect a security interest in such letters of credit (and far less interested in making a loan on an office building with an internet-related tenant), and more focused on when and how to draw under such letters of credit. Landlords are facing these same issues. Many of these issues can be addressed by careful drafting of both the lease and the letter of credit, but hindsight is, of course, 20/20. In the event that a landlord or lender is drawing on a letter of credit where such problems were not properly addressed in the lease or the letter of credit, there are still steps a lender or landlord can take to increase its chances of successfully drawing on the letter of credit and retaining the proceeds thereof.

II. LETTER OF CREDIT DRAFTING ISSUES

The following are some drafting tips for landlords and lenders relying on a letter of credit as security under a lease:

The ideal letter of credit, from the lender's and landlord's point of view, is an unconditional, sight letter of credit, which is a letter of credit that requires only that the holder present the letter of credit in order to be paid.

Many letters of credit posted by tenants provide that in order to draw, the beneficiary must certify that the tenant is in default and all applicable notice and cure periods have expired. If the lease provides a notice and cure period for defaults and the tenant defaults and files for bankruptcy before the landlord can give the notice required, the landlord will be prevented by the automatic stay from giving the notice, and therefore, from drawing on the letter of credit. It is important, therefore, that there be no notice and cure rights under the letter of credit before the holder is allowed to draw under the letter of credit.

If the tenant insists upon a letter of credit where the landlord certifies that the moneys thereunder are due and owing to the land-lord, the lease should provide no notice and right to cure, particularly for monetary defaults.

If the tenant insists upon notice and right to cure for monetary defaults, the lease should provide that the letter of credit may be drawn in the event of the tenant's insolvency, with no notice and right to cure periods for the insolvency default.

The letter of credit should provide that it shall be automatically renewed for successive, additional one year periods, unless, at least thirty days prior to any such date of expiration, the issuer gives written notice to the landlord that the letter of credit will not be renewed, in which case the landlord should be able to draw on the letter of credit.

The letter of credit should not expire until at least sixty days after the expiration date of the lease, to allow the landlord or lender sufficient time to draw on the letter of credit after the lease terminates.

The letter of credit should provide for partial draws. As discussed below, in certain situations a landlord may wish to draw on the letter of credit for each default as it occurs.

III. LETTER OF CREDIT ENFORCEMENT ISSUES

If a letter of credit has not been drafted with the above considerations in mind, the following are steps a landlord or lender may take to insure that it may still draw on the letter of credit:

If a letter of credit or lease provides that all notice and cure periods must expire before the holder is entitled to draw under a letter of credit, the landlord must be vigilant in sending the notices required under the lease and letter of credit as soon as a default occurs.

Because a letter of credit is not an asset of the bankrupt tenant's estate, a draw under the letter of credit should not be prevented by the automatic stay in bankruptcy as long as any notice and cure periods expire before the bankruptcy is commenced. The holder can increase the chances it will be able to draw the letter of credit before a bankruptcy if the landlord gives a default notice at the earliest possible opportunity. The default notice need not be a three day notice to pay rent or quit under the Code of Civil Procedure, but may simply be a notice stating the default.

Some landlords and lenders are anxious to draw on the entire letter of credit as soon as a default occurs, either because the letter of credit is about to expire, or because the landlord or lender does not wish to draw monthly on a chronically delinquent tenant. The landlord or lender should be aware, however, that once the letter of credit is drawn upon and the unused cash proceeds retained by the landlord or lender, any portion not applied by the landlord prior to a bankruptcy filing may be barred by the automatic stay from being offset against the landlord's damages after a bankruptcy filing. In addition, once the letter of credit is drawn upon, the bankrupt tenant may attempt to obtain an order to use the cash proceeds as cash collateral in the bankruptcy. As discussed below, as an alternative, in some instances it may be prudent to leave the lease in effect and draw on the letter of credit each month as the rent becomes due, although the landlord then runs the risk of being a creditor in any bankruptcy of the tenant.

IV. LEASE DRAFTING ISSUES

The following are some drafting tips for the landlord:

A. Interplay Between Drawing on the Letter of Credit and Lease Language Concerning Events of Default

As discussed above, if the lease provides that the landlord will not draw on the letter of credit until all notice and cure periods have expired and the tenant goes into bankruptcy before the landlord gives notice, the automatic stay in bankruptcy will prevent the landlord from giving the default notice. Therefore, the lease should provide that the landlord may draw on the letter of credit immediately in the event of a default. The lease should provide that the land-lord may draw on the letter of credit not only if the tenant is in default, but if the tenant fails to renew the letter of credit at least thirty days before its expiration.

If the tenant insists on a notice and cure period for monetary defaults, the lease might provide that the letter of credit may be drawn immediately upon the insolvency of the tenant. Then, if the landlord or lender is prevented from drawing on the letter of credit by the bankruptcy because of the inability to give notice due to the automatic stay, the landlord/lender will be able to draw under the letter of credit by reason of the insolvency.

The lease should also provide that the landlord may draw upon all or any portion of the letter of credit. The lease should further provide that if the landlord draws on the entire letter of credit, but does not use the entire amount of the draw, any excess shall be held by the landlord as "collateral for lease obligations." For reasons discussed below, the excess should not be called a "security deposit" in the hope that the landlord will not be forced to comply with section 1950.7 of the Civil Code although, given the breadth of the definition of "security deposit" in section 1950.7, any such hope may be in vain. Because, as stated above, any unused portion of the letter of credit held as cash by the landlord or lender may be barred by the automatic stay from being offset against the landlord's damages after a bankruptcy filing, the lease should provide that any unused portion of the letter of credit shall be deposited in a...