Pundits are writing on the Internet that Judge Michael McVey’s opinion filed nearly a month ago with the Maricopa County Superior Court sounds the death-knell for the medical marijuana industry in Arizona. No landlord will make a lease accepting the risk of not getting paid by its tenant on the basis that the federal government will wholesale begin to enforce its Controlled Substances Act. Before folks head for the exits of this vaudeville show, however, they may find the independence principle instructive.
Judge McVey ruled in the case of HAMMER v. TODAY’S HEALTH CARE II (CV 2011-051310, filed April 17, 2012) that a half million dollars of loans could not be recovered by the lenders from the medical marijuana business principals to whom the loan was extended. Court records show Michele Rene Hammer and Mark Haile in August 2010, each agreed to lend Today’s Health Care II $250,000 to finance a “retail medical-marijuana sales and growth center.” You can read a bit more of the facts on the Arizona Republic’s Website on the story at http://www.azcentral.com/news/politics/articles/2012/05/08/20120508arizona-medical-pot-ruling-may-reverberate.html#ixzz1urXWGCcj.
Judge McVey ruled that since, under federal law medical marijuana is illegal to possess or sell, the purpose of the loan, to open a dispensary and grow site, was illegal also. A contract for an illegal purpose is not enforceable; this is the common law general rule in most states. In addition, although the parties did not address this argument to the court, Judge McVey held that the lenders could not recover their loan funds through equitable theories like unjust enrichment or promissory estoppel. While the latter theory might make the promise enforceable, McVey ruled, it would be illegal for the promise to be enforced.

Several bloggers have read this opinion, which may be challenged before the Court of Appeals (there are exceptions to the general rule that a contract for illegal ends is unenforceable, especially when the result of “voidness” violates a fundamental public policy of the state), as meaning that a landlord cannot count on receiving its rent, and that a tenant cannot be ensured that the landlord will not evict the tenant summarily during the lease term on the grounds that continued occupancy by a medical marijuana business is illegal. (The latter event is especially weird since essentially every astute landlord now knows this fact.)

I can’t help tenants here, but one thought that occurs to me for landlords is that they can require a different route of payment than just depending on a mailed check. (Cash would be good, sure, if you’re a landlord, but that’s not what I mean.) Typically, however, accepting a year or two’s worth of rent (assuming a tenant could afford this “nut”) in advance is a violation of the landlord’s covenant not to do this found in the landlord’s security documents (when landlords have leveraged their property). But a landlord has additional options here. One I focus on here is the irrevocable standby letter of credit. A medical marijuana business operator can pay a willing bank, upon application, to post a letter of credit as enhancement for the tenant’s promise to pay rent. If the standby letter of credit is “clean and evergreen,” meaning that the bank will require little in the way of demonstrating the tenant’s default and the letter of credit will renew automatically for the duration of the lease term, then the landlord will be able to go to the bank, make a claim under the letter of credit, and get paid its delinquent rent upon doing nothing more than providing a letter on its letterhead confirming that the rent is delinquent.

Enter the independence principle. When the tenant-applicant pays the fee of the bank for the issuance of the letter of credit, their relationship is confined to the obligation of the bank to perform under the terms of the letter of credit. The letter of credit, when the terms of same have been agreed upon between the issuing bank and the landlord, becomes a contract between the two latter parties to which the tenant is not a party. The bank must, however, collect the premium for the letter of credit for its duration, in advance, to hedge against the chance it cannot get reimbursement from the applicant-tenant. This means that the tenant is going to have to produce some serious cash if it wants to induce the bank to issue the letter of credit in favor of the landlord as that instrument’s beneficiary.

So, while a lease may be illegal between a landlord and tenant and thus the rent obligation is not enforceable against the tenant, it is not illegal for the bank and the prospective landlord to sign a contract under which a landlord may get paid in the event of a third party’s default. Because that contract is independent of the lease, the independence principle protects the landlord from having to “eat” unpaid rent loss. This is the message of Article 4 of the Uniform Customs and Practices for Documentary Credits version 600 (2007), which landlords will want to govern the letter of credit’s interpretation and enforcement. The bank gets to generate fees for letter of credit issuance; and the landlord doesn’t have to collect any rent before the moment of a delinquency in an installment. This program allows the landlord to dodge the mortgage bullet from its lender who doesn’t want the landlord pocketing long green and concealing this fact from the lender. The lender can take a security interest in the letter of credit proceeds payable for its beneficiary’s benefit should a default occur.