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.