§ 4A.02 Kinds of Security
| Jurisdiction | United States |
| Publication year | 2022 |
§ 4A.02 Kinds of Security
[1]—Introduction
Landlords usually obtain cash security from tenants, but occasionally accept other forms of security, which may include letters of credit, lease deposit surety bonds, pledges of accounts receivable, pledges of securities (e.g., stocks and bonds), and guaranties (although guaranties more commonly serve as supplemental, rather than substitute, security). Such substitute forms of security (such as letters of credit) are not always readily available, as a practical matter, to undercapitalized tenants. A start up tenant, for example, with no credit history and no long term relationship with a lender, will not be able to obtain a letter of credit as security for a landlord unless it posts cash in an amount equal to the letter of credit with the issuing bank to secure its obligation to repay the bank if the letter of credit is drawn down. However, more established tenants, such as chain store tenants, typically have established bank lines of credit that allow them easily to obtain letters of credit. Even start up tenants, however, may be able to provide supplemental security—especially in the form of a guaranty from a parent company or other principal(s) of the tenant. This Section will compare the different forms of security generally used in lease transactions.
[2]—Cash Security
Cash is the best-loved form of security for landlords because it is in the landlord's control, is generally easy to administer, and is instantly available if the tenant defaults (unless the tenant files for or is placed in bankruptcy). Even cash security, however, raises a number of issues for both landlord and tenant.
[a]—Segregation of Cash Security
Tenants view security as their own property and expect to have it refunded to them at the end of the term of the lease. As already noted,1 that view may be overly optimistic if the landlord fails to transfer security to a new landlord or to a foreclosing lender.
Another risk tenants often fail to appreciate is the risk that the tenant's security deposit will become subject to the claims of the landlord's creditors in a landlord bankruptcy. Property to which the bankrupt holds legal or equitable title is part of the bankrupt's estate. If under state law tenant security deposits are owned by the tenants, such deposits are not part of the bankrupt landlord's estate unless and until applied against the tenant's obligations.2 However, once the security is commingled with the landlord's general funds, the result is probably different and the tenant may become one of many general creditors seeking to recover against the bankrupt's remaining assets.3
Some, but not all, states require segregation of security deposits.4 In a state that requires segregation, failure to segregate may result in criminal penalties or loss of the landlord's status as a secured creditor with respect to the security if the tenant.5 Even if segregation is required by statute, it is best practice to include in the lease a requirement that the landlord segregate the security.
In a state that does not require segregation, tenant's counsel should ask the landlord to segregate the security deposit and to hold the security deposit in trust for the tenant. The segregation of security both increases the probability that it will be deemed the tenant's property in a landlord bankruptcy, and decreases the possibility that the landlord will be unable to repay the security at the end of the term of the lease.
In those states in which the landlord is not required by law to segregate commercial rent security deposits, landlords may resist segregation. This may arise from a simple reluctance to increase the landlord's administrative burden, but may also stem from a desire to use the security to, among other things, fund the tenant's construction allowance, repay the departing tenant's security deposit, or add to the landlord's operating funds. The risks to the tenant of failure to segregate are obvious, especially if the landlord is insulated from liability with a standard exculpation clause (limiting the landlord's liability under the lease to its interest in the real property), if the landlord files for bankruptcy, or if the building is foreclosed and the landlord does not transfer the security to the foreclosing lender. Accordingly, if the landlord will not segregate the security and the security deposit is substantial, the tenant may seek to have a principal of the landlord guaranty the return of the security or request copies of the account statements.
Assuming the landlord is willing to segregate the security, the landlord should determine whether its bank has the ability to establish a central security deposit account with separate subaccounts for individual security deposits.
[b]—Interest and Earnings on Cash Security
Although state laws often require landlords to deposit security on residential leases in interest bearing accounts and to pay the interest to the tenants, such is not generally the case for commercial leases. New York straddles the line in that it does not require a landlord to deposit security for a commercial lease in an interest bearing account; however, if the security is actually deposited in an interest bearing account, the landlord must pay the interest to the tenant (although the landlord is allowed to deduct an administrative fee no greater than 1%).6
If the security is of sufficient size to make earnings on it a significant factor, the tenant generally requests the landlord to deposit the security in a segregated, interest bearing account, with the interest paid to the tenant. The tenant may want the interest paid to it annually; and the landlord may want to hold the interest as part of the security deposit until the end of the lease. The resolution will depend on the amount of interest at stake and the tenant's leverage. If the amount of the security increases as the base rent increases, an easy compromise is the application of the annual interest against the tenant's obligation to increase the security.
If the security is held in an interest-bearing account, the landlord will want to be compensated for its administrative efforts, and thus may charge an annual fee. Unless the tenant has significant leverage, the landlord will usually deposit the security in a bank savings account, yielding a minimal return, with other security deposits, and, in fact, may be required by the terms of its mortgage to deposit security with the lender bank. If the tenant has leverage and the security is a substantial sum, the tenant may bargain to have the security deposited in a mutual fund, money market fund, certificate of deposit, or other relatively high yield account. Before acceding to such a request, the landlord needs to consider whether the building's mortgagee requires the landlord to deposit tenant security with the lender and, in the case of an account (such as a money market account) that may decline in value, whether the landlord is capable of and willing to monitor the account.
The landlord should not agree to any investment vehicle that does not provide ready access to cash, or which cannot be cashed without penalty (such as a certificate of deposit) unless the security is increased sufficiently to cover any penalty. If the security is deposited in an account designated by the tenant, the tenant should bear the risk of loss due to depository failure or decline in market value, release the landlord from liability if the account loses value (through failure of the depository or market fluctuations), agree to replenish the security if the amount of the security is reduced through market fluctuations or because of depository failure, and give the landlord the authority to move the security, at the landlord's option, if the depository becomes unsatisfactory to landlord or if the security loses value.
If the security is deposited in an FDIC insured account and the amount of the security exceeds the limit of FDIC insurance, tenant and landlord should consider dividing the security among a number of banks, to reduce the risk of loss due to depository failure.
[c]—Cash Security—The Bankruptcy Problem
As noted in § 4A.01[1] infra, cash security is best viewed as a source of immediately available cash to cover the landlord's initial expenses in the event of a tenant default (e.g., landlord's construction allowance), to provide a rental cushion for the period it takes the landlord to re-let after the tenant defaults, and/or to cover the landlord's re-letting expenses. In short, cash security is excellent as an immediate source of cash to cover the landlord's damages, although it will rarely cover all of the landlord's damages.
In bankruptcy, however, cash security loses its liquidity advantage because the automatic stay imposed by Bankruptcy Code § 362 will prevent the landlord from accessing the security until the bankruptcy court orders the automatic stay vacated.7 A possible solution to this dilemma is the letter of credit (described below).
[3]—Letters of Credit
[a]—What Is a Letter of Credit?
A letter of credit is a commitment, usually made by a bank (the issuer), to make a payment to the beneficiary named in the letter of credit upon presentation of the documents specified in the letter of credit. In the context of a lease, the tenant is the applicant (or account party) for the letter of credit, the tenant's bank is the issuer, and the landlord is the beneficiary. If the tenant defaults under the lease, the landlord/beneficiary determines the amount due it from the tenant and draws upon the letter of credit by submitting to the issuer bank a "sight draft" in that amount together with such other documents as may be required by the letter of credit.8
For a small tenant, a letter of credit may be more expensive than cash security because the tenant generally will be required by the issuing bank to secure the letter of credit with an equivalent amount of cash (which will be held...
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