Lease Security Deposits Might Not Be So Secure

By Joshua Stein

This article discusses the importance of providing tenant security deposit protection language in lease agreements, particularly in states that do not have laws regarding the same.

Tenants often deliver substantial security deposits when they sign leases. Those deposits are supposed to backstop the tenant’s obligations. At the end of the lease, if the tenant has behaved, the landlord is supposed to return the security deposit to the tenant. It’s not the landlord’s money, or is it? Maybe it is—if the landlord files bankruptcy and the right (or wrong) state’s law applies.

A recent case, 10FN, Inc. v. Cerberus Business Finance, LLC, 21CV-5996 (VEC) (S.D.N.Y. Oct. 18, 2022), considered exactly this sequence of events. A tenant under a lease in Chicago gave the landlord a substantial security deposit. The court found that those funds were, under Illinois law, effectively nothing more than a loan to the landlord. When the landlord filed bankruptcy, the tenant had the same rights as any other creditor that didn’t have any security for its claim. In this case, as is often the case, that meant the tenant would recover very little on account of its unintended loan to the landlord.

The court based its decision in part on the words of the lease itself. The lease required the tenant to post with the landlord, and then maintain, a security deposit. The lease said nothing, though, about ownership of the security deposit or how the landlord was supposed to hold it. Nowhere did the landlord agree to hold the security deposit in trust, escrow, a segregated account, or any other special way to protect the tenant.

The lease said the landlord would return the deposit, minus any proper offsets, to the tenant 30 days after the lease expired. As a result, the court concluded, the tenant’s security deposit was just money that the tenant gave the landlord and that the landlord was supposed to give back later—nothing more than a loan.

Some states set a higher standard for how a landlord handles a security deposit. In New York, for example, the landlord must hold any security deposit in trust for the benefit of the tenant. By law, the deposit remains the money of the tenant, not the landlord. N.Y. Gen. Oblig. Law § 7-103(1), (2).

Unfortunately for the tenant in this particular case, Illinois doesn’t have a statute like New York’s, at least for commercial tenants. That meant the landlord could freely commingle the commercial tenant’s security deposit with its other funds.

When the landlord filed bankruptcy, the tenant’s rights regarding its security deposit were the same as any other rights of any other creditor to receive money from the landlord. Tenant just had another unsecured claim in the bankruptcy, entitled to payment of pennies on the dollar if that.

This sad saga teaches tenants that when they deliver security deposits under leases, especially substantial security deposits, they should give some thought to the legal protections for those security deposits. Favorable lease language helps. So does favorable state law.

If the parties sign their lease in a state that doesn’t protect security deposits, should the tenant insist that New York law govern the security deposit? That sounds tempting. On the other hand, one hardly wants to have to analyze the validity of such a choice of law when negotiating an ordinary lease outside New York. And the suggestion just seems bizarre.

If state law doesn’t deliver total certainty about a tenant’s interest in its security deposit, and the tenant has any negotiating leverage at all, the tenant might insist on establishing an escrow or similar arrangement to protect its security deposit. This is especially true if the tenant has reason to think the landlord may soon suffer financial problems or go bankrupt.

In the litigation described in this article, the landlord was actually a tech company that was a sublandlord, not a property owner. The tech company entered into the sublease because it didn’t need all the space it had leased. It was shrinking. Those facts alone probably should have set off alarm bells for the subtenant that put up the substantial security deposit. Today, however, any office tenant should ask similar questions about the future solvency of its landlord, given the present economic pressures on office buildings.

More generally, in any state where the law treats a security deposit as an unsecured loan to the landlord, that might create an issue for any lender – a true lender, such as a bank – to consider in negotiating a credit agreement with a landlord. The financial definitions in that credit agreement might intuitively carve out “security deposits” from the definition of the landlord borrower’s liabilities. At the same time, the definitions governing the landlord borrower’s assets might allow the borrower to treat the cash “borrowed” from the tenant as just another asset. Such an anomaly could make the landlord’s financial condition look better than it really is.

Endnotes

1. Sole principal, Joshua Stein PLLC (www.joshuastein.com). The author’s three-volume book on ground leases (www.groundleasebook. com) is scheduled for publication late this year. Mr. Stein has written five previous books and over 400 articles on commercial real estate law and practice, many of which appear on his website. He received his law degree from Columbia Law School, where he was a Harlan Fiske Stone Scholar and a managing editor of Columbia Law Review. Copyright (c) 2023 Joshua Stein. An earlier version of this article appeared on Forbes.com.