Security Deposits – Fugetaboutit (From A Tenant’s Perspective)

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A tenant derives no particular benefit from posting a security deposit other than its use as a means to conclude lease negotiations. A security deposit is merely part of that package of rights and duties we call a lease. Every single term and condition of a lease is economic in nature, and it takes no giant intellectual step to recognize that security deposits are merely a matter of dollars and cents. For a landlord—it is dollars; for a tenant—it makes no sense.

Being a “landlord” issue, security deposit clauses in leases are almost always drafted by the landlord, in its favor. Like most other lease provisions prepared for a landlord’s benefit, the proposed language may be only a starting point for a fair and balanced outcome. Knowledge being power, the following exploration of security deposit issues should serve as useful armament for a tenant willing and able to do battle with a landlord over this often ignored area.

What is left to discuss once it is agreed that a deposit will be posted? Even setting aside any question of dollar amount, the answer is “plenty.” Not all security deposits are created equal. To begin the analysis, a tenant should ask —”what is the deposit intended to secure?” While the initial landlord response is — “all of the terms, covenants, and conditions of the lease,” this is merely an opening position. Alternative possibilities include: monetary terms only; damage to the premises only; post termination claims only; or a blend of one or more of the approaches. The simpler the standard, the easier it will be to resolve disputes down the road.

If, as is most favorable to a tenant, the deposit secures only defaults in the payment of basic rent, the arena for disputes is limited. Although there can be some exceptions, tenants and landlords generally agree as to whether the rent has been paid. Extending the net to cover items of additional rent is only slightly more problematical. To the extent that the lease already includes a means to resolve disputes over the calculation of items of additional rent, the landlord’s right to draw upon the security deposit should be available only after the underlying dispute has been resolved. Otherwise, if a landlord can apply the security deposit upon its own allegation that an event of default has occurred, the tenant will fall victim to its landlord’s “self-help” remedy. Consequently, any tenant believing that if it holds a tight checkbook, its landlord will be forced to come to the table, will be in for a surprise.

In almost all cases, a landlord’s right to invade the security deposit is triggered by an event that also constitutes a default under the lease. Perhaps, it should only be upon an “Event of Default.” The answer, of course, is relegated to the negotiating process. Whatever the trigger might be, does application of some or all of the security deposit also serve to cure the default? Obviously, express language within the lease will provide a direct answer. In the absence of such language, however, a tenant could (and should) maintain that a default no longer exists and therefore the landlord’s right to terminate the lease or exercise some other remedy has been lost. Depending on the lease language itself, the argument may be directly posed or, in other cases, may be a part of a tenant’s position that landlord has made an election of remedies.

Put differently, in negotiating the remedies provision of the lease, a tenant should keep in mind the future possibility of raising these two arguments: (a) that the landlord has cured the default by application of the security deposit; and (b) the landlord has already elected its remedy. A carefully crafted remedies provision can hinder a landlord seeking to terminate a lease or seeking to evict its tenant, especially where the local courts readily apply principles of equity or are pragmatic in their application of law.

Where does this leave a tenant that has agreed to the common lease clause requiring replenishment of any deficit in its security deposit account? Fortunately, not in a particularly disadvantageous position. It does not necessarily mean that a tenant has jumped from the “default” frying pan into the “default” fire. Typically, a lease will provide a cure period allowing the tenant time to remedy any alleged breach. Therefore, it is quite conceivable that once a landlord has taken the “self-help” remedy of applying the security deposit, the tenant then gains an additional ten or more days (depending on the lease itself) to cure what has now become a derivative default. Even if a tenant is unable to finesse the lease language to avoid a replenishment provision, the tenant may still be able to structure an extended grace and cure period, avoiding the application of drastic remedies by the landlord in those circumstances where the landlord has applied the deposit to cure what would otherwise have been a default.

A related, but distinctively separate approach that can be taken by a tenant is to negotiate a provision requiring landlord to first move against the deposit before placing the tenant in “default” by reason of a breach of lease provision that money alone can cure. In the course of negotiating security deposit provisions, the tenant should never forget that the deposit itself is an asset of the tenant and a liability of the landlord. With this in mind, the tenant should endeavor to utilize this asset to maximum advantage. Logically, if the tenant retained control over the security deposit, i.e., had the money in its own bank, the tenant would be able to cure a potential monetary default merely by writing a check. That is what people do with their cash assets. They use them to pay their expenses. In the landlord/tenant context, it is reasonable to think of the security deposit as a restricted bank account, owned by the tenant, but controlled by the landlord. Under the lease, a landlord and tenant have agreed to restrict the use of this particular asset of the tenant for the sole purpose of meeting the tenant’s lease obligations. Accordingly, it is entirely reasonable for a tenant to insist that its landlord release this asset for exactly the purpose intended. If the tenant can’t retain control of the funds, it still should be able to use them to cure a monetary default and avoid the drastic consequences that it would face if it didn’t pay rent or additional rent on time. Therefore, tenants would be wise to take the position that a landlord is first obligated to apply the security deposit toward delinquent rent and additional rent before landlord may elect any other remedy.

If no restrictions were imposed within the lease, a tenant’s security deposit would constitute the ultimate self-help remedy. Without standards governing when and why the landlord may use the funds, a tenant may find that its landlord has spent the tenant’s money without the tenant’s consent and perhaps without its knowledge. Commonly, leases provide agreed-upon notice provisions and opportunity to cure provisions before the happening of an “event of default.” A tenant should be cautious not to leave the rear door open by allowing its landlord resort to the security deposit before applicable notice and grace periods have lapsed. Also, it is not a “given” that a landlord should be able to apply the security deposit automatically and without notice. Even if prior notice is not given, a tenant should insist that notice of the application of the funds be given within a relatively short period of time after the action has taken place. This gives the tenant an opportunity to seek immediate redress, in the courts if needed.

A related issue is a tenant’s interest in limiting application of the proceeds to cover narrowly specified purposes only. Frequently, landlords will advance the position that their primary interest in holding a security deposit is to assure that the funds are available when needed. What this does, however, is to shift the burden from landlord to tenant wherein a tenant must chase its landlord for return of the monies. If the true purpose of the deposit is “security,” then a landlord should be willing to agree that the money will not become available until after a judgment or arbitration award is obtained in its favor. After all, this would serve the purpose of “securing” a ready source of tenant’s funds to pay what would in effect be an undisputed debt.

The most common substitute for a cash security deposit is a letter of credit. Although simple in concept, the terms of a letter of credit security deposit clause can be quite complex. The landlord and its tenant must agree on the type of letter of credit to be used, the conditions under which a full or partial draw may be made, the strength of the issuing bank, renewal conditions, transfer rights, allocation of bank fees, and more. In addition, all of the concerns regarding the conditions under which the landlord may have access to the security deposit are equally applicable to letters of credit and cash. Nonetheless, for financial reasons, some tenants prefer to deposit a letter of credit with their landlord and many landlords, especially larger ones, are willing to accept, indeed insist upon, such instruments as security under a lease.

A letter of credit is an undertaking of payment by a bank upon the satisfaction of pre-established conditions. Always in writing, it is a promise by the issuing bank to the beneficiary (landlord) at the request, and on the instructions, of the applicant (tenant) to pay no more than a stated amount of money, before a given date, and against stipulated documents. As a conditional undertaking, the landlord has the right to demand payment only if it meets all of the requirements described in the letter of credit.

Common terms used in leases to describe letters of credit include: “unconditional,” “clean,” “irrevocable,” and “transferable.” An unconditional or clean letter of credit requires only presentation of a draft or demand of payment, and no other documents. Therefore, it is the type most frequently requested by landlords. In the banking trade, another name for a clean letter of credit, appropriately selected, is a “suicide” or “guillotine” letter of credit. The prudent tenant should not agree to deliver an unconditional or clean letter of credit. At a minimum, a tenant should insist that its landlord deliver an affidavit of default as part of the draw documents.

In contrast to a revocable letter of credit that may be amended or cancelled by the issuing bank without prior notice to landlord, an irrevocable letter of credit can neither be amended nor cancelled without the agreement of the issuing bank and the landlord. For this reason, a landlord properly can insist that the tenant’s letter of credit be irrevocable. A transferable letter of credit is one under which the landlord may transfer the rights to draw drafts or make demands for payment under the credit. Lastly, the type of instrument that is commonly used to satisfy a lease’s security deposit requirement is called a “Standby Letter of Credit.” This term is used to distinguish it from a “Commercial Letter of Credit,” and is generally issued to pay the beneficiary (landlord) if the applicant (tenant) fails to perform under the lease and usually requires presentation of only a draft or demand for payment.

A few (we’d venture a handful of) readers may recognize some of today’s posting as coming from a much longer article that was published quite some time ago. Well, yes, we repurposed such an article, not purely out of laziness, but because we thought it was time we put on our tenant hat and because in the approximately 215 prior postings, we haven’t said much about security deposits.

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Comments

  1. Ira, great job covering an important item in a lease negotiation!

    Howard Applebaum
    Corporate America Realty & Advisors

  2. A very good primer on a topic even most brokers don’t focus on (except when it comes to that letter of credit!)

  3. A great and thought provoking post, the next retail lease will be read with a few more questions in mind.

  4. Alan Betus says:

    Question: If a tenant is fortunate enough to negotiate that the security deposit can only be used for monetary defaults, can a landlord seek to invade the deposit in the following example: Tenant is required to do something (such as repair damage it causes), and if it doesn’t, landlord can exercise self-help rights at tenant’s cost and seek payment. If tenant fails to repair such damage, landlord cures and bills tenant, and tenant fails to pay, can landlord invade the deposit?

    In other words, can a landlord invade the deposit if the underlying obligation is non-monetary in nature and only converts to a monetary default because landlord exercised self-help rights and billed the tenant. Just curious. Thanks.

    PS, another great post.

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