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Lessor Ordered To Refund Draw On Letter Of Credit Because Lessee Was A Failed Bank

by Tom McCurnin
Leasing News Legal Editor

Equipment Lessor Did the Right Thing to Get Letter of Credit
to Secure Bank's Leasing Obligation. But Federal Statute Requires Lessor-Beneficiary to Refund Proper Draw After Bank Failed.

California Bank & Trust v. Piedmont Operating P'ship (2013) 218 Cal. App. 4th 1322, 1335

I like letters of credit as they provide a smooth, easy and efficient way to get paid without a lot of fuss. Present a draft and you get a check. And because of particular laws on the books called "the independence principal," the issuer of the letter of credit is required to pay if the beneficiary submits the correct documents.

But in today's case, a lessor secured its lease of office space to bank with a letter of credit from another bank. When the bank defaulted on the lease, the lessor drew against the letter of credit. So far, so good. Then the lessee bank failed, the FDIC took over, and two years later, the courts made the lessor give back the money. It's just not fair. Sadly, it's due to a specific federal statute, so the court had few choices. The facts follow.

Piedmont, as lessor, leased office space to a small bank, Alliance Bank. To further collateralize the lease, the lessor required Alliance Bank to post a $500,000 letter of credit issued by Union Bank. In return, Union Bank, took a deposit to secure its issuance of the Letter of Credit. So far, so good.

But Alliance Bank failed, and Piedmont drew against the Union Bank Letter of Credit and received the $500,000 from Union Bank. The FDIC took over, rejected the property lease, and transferred the assets (including the deposit at Union Bank) to California Bank & Trust. After the draw, Union Bank debited the $500,000 deposit account at California Bank & Trust. California Bank sued to recover its $500,000.

California Bank & Trust sued Piedmont on the grounds that a FDIC rejection of a lease means that no money is owed, and since there was a zero balance, the draw against the Letter of Credit for future rent was unlawful, and the lessor had to return the money.

Piedmont argued that the "independence principle" makes the Letter of Credit essentially untouchable and therefore, it had the right to draw against the letter of credit. The trial court agreed, blessed the Letter of Credit draw, let the lessor keep the money, and awarded Piedmont over $395,000 in attorney fees and costs.

On appeal, the court held that the effect of the FDIC statute which disallows claims against a failed bank has the net effect of disaffirming the lease and making the lease have a zero balance. Since rent was current at the time of the FDIC takeover, the lessor was statutorily prohibited from collecting future rent. The rationale of the statute is that while some creditors might suffer, the public as a whole benefits in that the liabilities of failed banks are minimized. The court side-stepped the independence principle, oddly stating that the draw against the Union Bank's Letter of Credit was proper, but keeping the $500,000 when future rent is not recoverable is simply not fair.

The court entered judgment for California Bank and against the lessor Piedmont, ordering that Piedmont should refund the $500,000 and the lessor was also liable for the bank's attorney fees. Lessor loses.

What are the lessons here?

First, Letters of Credit Remain Viable Collateral For Leases. This case is fact specific in that the lessee was a small bank which failed. This is unlikely that this scenario would occur again.

Second, When Leasing to a Bank, The Lessor Is At Risk In The Event of Failure. Under specific federal statutes, the FDIC can wave its magic wand and make you debt disappear. Yes, the lessor will have its equipment, but future rent will be barred. Take this into consideration when underwriting the lease.

The bottom line to this case is that the lessor expected to be able to recover its future rent from a bank via a letter of credit posted by another bank. Obviously, the lessor was unaware of the specific federal statutes which make this problematic.

California Bank and Trust v Piedmont OP (19 pages)
http://www.leasingnews.org/PDF/CaliforniaBankTTrustPiedmont.pdf

Tom McCurnin is a partner at Barton, Klugman & Oetting
in Los Angeles, California.

Tom McCurnin
Barton, Klugman & Oetting
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Suite 2200
Los Angeles, CA 90071
Direct Phone: (213) 617-6129
Cell (213) 268-8291
Email: tmccurnin@bkolaw.com
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