A commercial tenant may expect that its security deposit will be segregated or held in trust by its landlord and therefore be available to be returned to it when the lease is terminated. As explained in a recent New York federal court decision,1 however, if a commercial lease does not require the landlord to segregate a security deposit or hold it in trust, the tenant has only an unsecured claim in the event the landlord files bankruptcy.
Tenant leased office space in Chicago from landlord’s predecessor. Pursuant to the lease, which was governed by Illinois law, tenant gave landlord a $271,000 security deposit. After entering into the lease, landlord borrowed money from secured lenders, granting them a first-priority lien on all of its assets and entering into account control agreements that authorized them to “sweep” landlord’s accounts, including the account containing tenant’s security deposit.
Shortly before landlord filed its chapter 11 bankruptcy case, secured lenders swept all cash in landlord’s accounts. After landlord filed bankruptcy and rejected the lease, and both landlord and secured lenders refused tenant’s demand to return the security deposit, tenant sued secured lender and landlord’s executives in bankruptcy court for conversion, negligence and unjust enrichment. Secured lenders prevailed on a motion to withdraw the reference of the lawsuit from the bankruptcy court to the district court, then they and landlord’s executives moved to dismiss tenant’s complaint.
The Court’s Decision
The court explained that tenant’s conversion claims rested entirely on tenant’s allegation that Illinois law required landlord to hold tenant’s security deposit in trust. The court found that it did not because (i) the lease itself did not require landlord to segregate the security deposit or hold it in trust, and (ii) Illinois law requiring residential landlords to hold security deposits in trust did not apply to commercial landlords. As a result, the court held that tenant was limited to recovery as an unsecured creditor in landlord’s bankruptcy and dismissed tenant’s conversion claims.
Having found that landlord was not required to segregate the security deposit or hold it in trust, the court held that neither landlord not its executives owed tenant a duty and dismissed tenant’s negligence claim against landlord’s executives. The court also dismissed tenant’s unjust enrichment claim against secured lenders because the disposition of the security deposit was governed by a valid contract – i.e., the lease.
Takeaways for Commercial Tenants
As this case demonstrates, unless a commercial lease expressly requires a landlord to segregate a tenant’s security deposit or hold it in trust, the landlord may pledge the funds and the landlord’s secured lenders may apply the funds to the landlord’s secured debt, leaving the tenant with a potentially uncollectable unsecured claim against the landlord. To guard against this risk, tenants should negotiate suitable protections into their commercial leases or investigate whether applicable law requires commercial landlords to hold security deposits in trust.
1 10FN Inc. v. Cerberus Business Finance LLC, 21-CV-5996 (S.D.N.Y. Oct. 18, 2022).