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MCLE SELF-STUDY

Read this article and take the accompanying test to earn one hour of Minimum Continuing Legal Education credit. Follow instructions on answer form. This month's article and test provided by the State Bar's Real Property Section.


Letters Of Credit

The Supreme Court's ruling on SB 1612 had a significant impact on current real estate transactions

by MICHAEL F. O'NEILL

In Western Security Bank, N.A. v. Superior Court (Beverly Hills Business Bank), the California Supreme Court declared that SB 1612, the landmark 1994 urgency statute that provided that the antideficiency laws do not bar a draw under a standby letter of credit supporting a commercial real estate loan following a nonjudicial foreclosure, applies to letters of credit issued prior to the statute's effective date.

In its ruling, the court overturned the court of appeal for the second appellate district's holding that SB 1612 constituted a major change in prior California law.

Instead, Justice Ming Chin's opinion held that SB 1612 merely clarified earlier case law and so, even in 1991, an issuing bank had no right to refuse to honor an otherwise legitimate draw request merely because it was made following a trustee's sale.

While the court did not apply SB 1612 retroactively (since the statute effected no change in the law), the practical result is the same — SB 1612 governs commercial real estate letters of credit issued before its enactment.

The court's opinion eliminated any distinction for antideficiency purposes between commercial standby letters of credit issued prior to Sept. 15, 1994, (the effective date of SB 1612) and those issued after that date.

While the number of pre­SB 1612 letters of credit is obviously declining over time, such letters of credit nevertheless remain in place on many outstanding commercial real estate loans.

The court's confirmation that SB 1612 applies to pre­SB 1612 as well as post­SB 1612 commercial letters of credit, therefore, has a significant impact on many current real estate transactions.

While beneficiaries of pre­SB 1612 commercial standby letters of credit will certainly welcome the Supreme Court's decision, issuing banks should also be pleased by the Supreme Court's confirmation that their duties in response to draw requests under pre­SB 1612 commercial standby letters of credit remain limited to an examination of the four corners of the drawing documentation and that they need not worry about the antideficiency implications of any draw request or the parties' allegations regarding such implications.

Furthermore, while real estate borrowers who are account parties under pre­SB 1612 commercial standby letters of credit will certainly regret the loss of a possible draw defense, the decision in Western Security nevertheless benefits them in a larger sense since it broadly confirms the viability of standby letters of credit as credit enhancement devices in California commercial real estate financing transactions.

The decision in Western Security was grounded on the court's recognition that commercial standby letters of credit became popular credit enhancement devices in California not because they were clever subterfuges to avoid the antideficiency laws but for the same reason they became popular elsewhere in the United States (including states having no antideficiency laws or one-action rule) — because they satisfied the economic needs of both borrowers and lenders for a workable cash collateral substitute in circumstances where the real estate collateral alone was insufficient to support the requested financing.

In its opinion, the court acknowledged that the use of commercial standby letters of credit arose in response to borrowers' reluctance to tie up needed cash in pledged accounts or certificates of deposit and lenders' need to receive the functional equivalent of cash security.

Following a period of uncertainty created by the court of appeal's first opinion in this case, SB 1612 allows borrowers and lenders to use letters of credit to accomplish these divergent economic goals.

The Supreme Court's recent opinion further clarifies that even pre­SB 1612 letters of credit can serve their intended purpose

The rocky judicial road to the Supreme Court's decision in Western Security began in 1993, when the court of appeal startled California lenders with its holding that a draw under a standby letter of credit following a nonjudicial foreclosure was barred by California Code of Civil Procedure (CCP) §80d.

This conclusion was based on the court's broad reading of two key cases involving actions by lenders against third parties following nonjudicial foreclosures: Union Bank v. Gradsky, which prohibited a lender's action against a guarantor following a nonjudicial foreclosure, and Commonwealth Mortgage Assurance Co. v. Superior Court, which prohibited a lender's action against a mortgage insurer following a nonjudicial foreclosure. In the court of appeal's view, CCP §580d, as construed by these two cases, generally blocks any post-nonjudicial foreclosure recoveries against a borrower, including any draw on a standby letter of credit under which the borrower is contractually obligated to reimburse the issuer.

This first decision by the court of appeal was appealed to the California Supreme Court. While this appeal was pending, the California legislature, in direct response to the appellate court's 1993 decision, adopted SB 1612, which became effective as an urgency statute on Sept. 15, 1994.

SB 1612 made several statutory changes aimed at undoing the effects of the court of appeal's first decision, the most important of which was the addition of CCP §580.5.

This section explicitly provides that neither the one-action rule of CCP §726 nor the antideficiency laws (CCP §580a, §580b and §580d) apply to the presentation or drawing of a letter of credit, regardless of whether the presentation or drawing occurs before or after a judicial or nonjudicial foreclosure. In addition, SB 1612 attempted to distinguish letters of credit from guaranties and mortgage insurance contracts and, therefore, from the operation of both the Gradsky and the Commonwealth cases, by amending California Civil Code §2787 to expressly state that a letter of credit, unlike a guaranty or an insurance contract, is not a suretyship obligation. Finally, SB 1612 amended §5114 of the California Commercial Code to strengthen the "independence principle" applicable to letters of credit.

Following the adoption of SB 1612, the Supreme Court returned the Western Security case to the court of appeal for reconsideration in light of the new legislation.

Upon reconsideration, the court of appeal refused the invitation to declare its previous decision erroneous under pre­SB 1612 law and instead concluded that SB 1612 was a significant change in California law and was not specifically made retroactive by the legislature.

The court of appeal then confirmed its previous decision that, under the law in effect prior to SB 1612, CCP §580d (as interpreted by Gradsky and Commonwealth) barred any post-nonjudicial foreclosure draw under any standby letter of credit.

The appellate court also concluded that the "independence principle" applicable to letters of credit did not require that a post-nonjudicial foreclosure draw be honored because such a draw violated the antideficiency laws and so constituted "fraud" or other defect not apparent on the face of the documents under paragraph (b) of subdivision (2) of §5114 of the California Commercial Code. As a result, the appellate court held that under both the antideficiency laws and the "fraud" exception to the independence principle, an issuing bank could refuse a draw request following a nonjudicial foreclosure.

This second decision by the court of appeal was also appealed to the Supreme Court, which granted review and filed its decision reversing the court of appeal on April 7, 1997.

The primary question confronting the Supreme Court on appeal was whether SB 1612 clarified or changed California law. If SB 1612 reflected the law prior to its adoption, the case was basically decided since SB 1612 expressly permits commercial standby letter of credit draws after a trustee's sale. If, on the other hand, SB 1612 modified California law, the Supreme Court would need to determine whether the legislature intended SB 1612 to have retroactive or only prospective effect.

Looking at the substantive provisions of SB 1612, the Supreme Court concluded that only the adoption of CCP §580.5 could even arguably be construed as a change in California law.

In analyzing the impact of §580.5, the Supreme Court agreed with the court of appeal that the Gradsky and Commonwealth decisions embodied the law in this area prior to the adoption of SB 1612.

However, the Supreme Court's narrow interpretation of these two cases contrasted sharply with the broad construction placed on them by the court of appeal.

To the Supreme Court, Gradsky and Commonwealth dealt with two types of suretyship obligations (guaranties and insurance indemnities) and were governed entirely by principles of suretyship law (as these interact with the antideficiency laws). The Supreme Court argued that the broad language in Gradsky and Commonwealth cited by the court of appeal was dicta unnecessary to the holdings of these cases.

The court stated that this sweeping language simply "accentuated the courts' vigilance regarding attempted evasions of the antideficiency and foreclosure laws" and did not articulate a rule applicable to non-suretyship forms of credit support.

Finally, the Supreme Court firmly rejected the idea that letters of credit were the functional equivalents of or otherwise analogous to guaranties or other suretyship obligations.

Instead, the Court asserted that letters of credit, though essentially sui generis, were functionally most similar to cash collateral.

In the Supreme Court's view, therefore, the antideficiency laws are not undermined by permitting post-nonjudicial foreclosure draws on letters of credit any more than they are undercut by the rule permitting liquidation of cash collateral following a trustee's sale of the real property collateral.

The Supreme Court's decision in Western Security is important to the practicing lawyer representing a real estate borrower or lender because it indicates that the impact of the antideficiency laws on any credit enhancement device will largely depend on whether the device is classified as a suretyship or non-suretyship obligation.

Thus, while actions under suretyship instruments such as guaranties, mortgage insurance contracts, or bonds are potentially subject to antideficiency defenses following a trustee's sale, claims under non-suretyship obligations such as letters of credit, cash collateral accounts of borrowers, and other pledges of personal property collateral by borrowers are not.

Furthermore, both borrowers' and lenders' counsel should be sensitive to the fact that even obligations that are not inherently of a suretyship nature may become so if they are undertaken by a third party rather than the borrower.

Thus, for example, a third party deed of trust, pledge or assignment will entitle the trustor, pledgor or assignor to assert suretyship defenses and, therefore, at least arguably, to assert antideficiency defenses to claims made under these devices following a nonjudicial foreclosure.

Accordingly, to make a suretyship obligation enforceable following nonjudicial foreclosure, lender's counsel should include waivers of both suretyship and antideficiency protections in the instrument while recognizing that such waivers may not be enforceable in all circumstances.

Borrower's counsel, on the other hand, should be alert to the possibility of blocking post-nonjudicial foreclosure enforcement of suretyship instruments based on the absence of appropriate waivers.


Michael F. O'Neill is a vice president and senior counsel at Wells Fargo Bank in San Francisco, where he specializes in commercial real estate finance.

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