In many types of real estate transactions, one party will demand that the counterparty obtain and provide a standby letter of credit. What is a standby letter of credit? Essentially, a standby letter of credit is a substitute for cash funds that can be held by the demanding party. The requirement to provide a standby letter of credit can be imposed for several reasons, but all concern one central issue: providing a mechanism to secure various contractual obligations.
There are various scenarios in which a standby letter of credit is demanded, including but not limited to:
- a landlord demanding a tenant to a lease agreement provide one as a substitute for a cash security deposit;
- a lender demanding a borrower provide a standby letter of credit, which can be for several reasons, like
- securing payment obligations,
- to fund loan reserve accounts, or
- to serve as a good-faith deposit for the lending transaction
- contractors or materialmen demanding such a letter of credit from a real estate developer as a bond for the payment of various obligations;
- a real property seller demanding the buyer supply a standby letter of credit in place of a traditional contract downpayment; and
- the buyer of real property demanding the seller place a standby letter of credit into escrow as security for the accuracy and completeness of various representations and warranties made during or in connection with the transaction at issue.
Standby letters of credit are utilized in the above (and other) scenarios, and sometimes preferred to other methods of securing obligations because an independent third-party issues and honors these letters of credit. Indeed, pursuant to the Uniform Commercial Code, “the issuers obligation to honor presentation is independent of the existence, performance, or nonperformance of the parties’ obligations in the underlying agreement.”[1] These independent third-party issuers are usually banking institutions. Due to the independent nature of the issuer, this aspect of standby letters of credit is called the independence principle. So long as the requirements negotiated between the parties to the standby letter of credit are met, regardless of the actual existence of a dispute, default, or other issue regarding the underlying agreement so secured, the issuer will honor the terms of the standby letter of credit and pay out the funds to the presenting party.
The independence principle provides several advantages to holders of standby letters of credit. One of these advantages is being able to bypass lengthy litigation to obtain the security that the standby letter of credit provides. Using traditional methods of securing contractual obligations, such as a guaranty or indemnification, opens the party to be so secured to lengthy litigation to be able to obtain the funds securing the obligations. If a guarantor does not willingly turn over funds should a default were to arise under the underlying agreement, the secured party must seek relief from a court of competent jurisdiction. Additionally, the use of a standby letter of credit lessens the risk of a bankruptcy filing, and the associated automatic stay, preventing collection of a security deposit or enforcement of a guaranty.
Lastly, the party supplying the standby letter of credit has significantly fewer defenses available to it to prevent collection of the funds. If you are a party to a real estate transaction who is seeking counsel regarding a standby letter of credit – whether you are the party demanding a standby letter of credit be obtained or the party who must obtain the standby letter of credit – KI Legal’s experienced real estate attorneys are prepared to assist you in the negotiation, execution, and – if necessary – collection on a standby letter of credit. Contact us today by calling (212) 404-8644 or emailing info@kilegal.com.
[1] Uniform Commercial Code Section 5-103(d).
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