Creating A Security Interest In Your Tenant Security Deposits
By James M. H. Feuille, Associate Attorney
Creditor’s Rights Section – White Paper – September 2018
In the words of Michael Scott, the infamous over-spender on NBC’s The Office: “I declare bankruptcy!” As a commercial landlord, those three words can be terrifying, but they do not need to be. Word of a tenant’s bankruptcy can fill a landlord with fear of the unknown – namely, what rights does the landlord have once the tenant files for bankruptcy protection and the automatic stay of 11 U.S.C. § 362 is in effect? While there are many issues that arise due to a tenant’s bankruptcy filing, one simple way to protect yourself as the landlord is by shoring up your lease language to explicitly create a security interest in the tenant’s security deposit and inventory.
With the appropriate lease language, federal bankruptcy courts consistently characterize the interest of the holder of a security deposit as a security interest. Timothy Dean’s, Inc. v. White (In re Timothy Dean Rest. & Bar), 342 B.R. 1, 8 (Bankr. D.D.C. 2006) (“The Hotel [a commercial tenancy landlord] possesses a perfected security interest in the security deposit”). One bankruptcy court in Pennsylvania has held “as a matter of law, that the Security Deposit is subject to some sort of encumbrance that amounts, or that is at least akin, to a perfected security interest.” ITXS, Inc. v. F & S Hayward, LLC (In re ITXS, Inc.), 318 B.R. 85, 89-90 (Bankr. W.D. Pa. 2004).
According to the Court in Timothy Dean’s, Inc., a landlord who takes possession of a security deposit pursuant to a lease (a) creates a security interest in the security deposit and (b) perfects the security interest. Timothy Dean’s, Inc. v. White (In re Timothy Dean Rest. & Bar), 342 B.R. at 8. In Timothy Dean’s, Inc., the court applied the Uniform Commercial Code’s requirements for attachment and perfection to a security interest in a security deposit: “Pursuant to former Section 9-203 of the UCC, a security interest attaches to collateral when three requirements are met: (1) the creditor gives value to the debtor; (2) the debtor has rights in the collateral in which it is conveying a security interest; and (3) the debtor has signed a Security Agreement that contains an adequate description of the collateral or the secured party has possession of the collateral. The debtor’s security deposit consisted of a money deposit to the [landlord] that was later placed in an account maintained at Harris Bank . . . The [landlord] clearly satisfied all of the requirements under Section 9-203 with respect to the money deposited by the debtor with the [landord]. The [landlord] gave value (in the form of the debtor’s rights under the Lease) in exchange for collateral [the security deposit] belonging to the debtor. Moreover, the [landlord] had both signed a Security Agreement (the Lease) and as recited by the Lease, was in initial possession of the security deposit money . . .. The [landlord] also perfected its security interest in the money. With exceptions of no relevance here, a security interest in money can only be perfected by obtaining possession . . .. Accordingly, by taking possession the [landlord] both created and perfected a security interest in the money deposited by the debtor.” Timothy Dean’s, Inc. v. White, 342 B.R. at 11 (emphasis added) (citations omitted)
It is crucial that the landlord meet two requirements: (1) the lease clearly states that the landlord holds a security interest in the security deposit funds, and (2) the landlord retains possession of the security deposit funds. In other words, the lease should explicitly state that by depositing the security deposit with the landlord, the landlord holds a security interest in the deposit. Additionally, while most commercial leases permit the landlord to dip into the security deposit should the tenant miss a payment, doing so may leave the landlord undersecured. Therefore, if you are going to apply a portion of the security deposit prior to the termination of the lease, be sure to include in the lease the requirement that the tenant replenish the security deposit to the full amount. Moreover, once you have applied a portion of the security deposit to a late or missed payment by the tenant, be sure to actually demand and recover from the tenant the amounts applied.
By protecting yourself and creating a security interest in the security deposit, you will have some amount of protection should the tenant file for bankruptcy. In most cases, if a third party holds the property of the debtor, upon filing for bankruptcy, the debtor or the bankruptcy trustee has the right to demand that the third-party return the property to the debtor’s bankruptcy estate. If a landlord does not create and hold a security interest in the security deposit, the landlord would be obligated to return the security deposit to the debtor’s bankruptcy estate. However, with a properly perfected security interest, the landlord is not required by bankruptcy law to return the security deposit and can retain the security deposit up to the amount of the landlord’s claim against the debtor. Without a properly perfected security interest, the landlord will be faced with the choice of returning the security deposit to the tenant’s bankruptcy estate and being treated as an unsecured creditor—potentially getting pennies on the dollar for its claim—or face a claim that the landlord has violated the automatic stay and is subject to penalties. In fact, the same is true for an equipment or personal property lessor. So, if you are in the business of leasing anything, it would be wise to have a creditor’s rights/bankruptcy lawyer review your lease documents and advise you on how to ensure that you have properly perfected your security interest in the security deposit in case your lessee threatens you with those infamous words: “I declare bankruptcy!”