Insight
Security deposits are a fundamental landlord protection under leases, with tenants expecting the deposits to be returned when the lease expires. Although landlords frequently think about how to protect their rights to the security deposit if the tenant declares bankruptcy, a recent decision highlights the risk for tenants if the lessor is instead the debtor in bankruptcy proceedings. The question arises because of the broad scope of what is included in the “ownership of a bankruptcy estate” and under what circumstances the non-debtor (here, the tenant) has an ownership interest in the security deposit. in cash or is simply a creditor with a prior unsecured claim against the debtor-lessor. Notably, under section 541(d) of the Bankruptcy Code, property held by a debtor in trust for a non-debtor does not become the property of the debtor’s bankruptcy estate to the extent of the beneficial interest of non-debtor parties in such funds. Trust rights may arise by statute or by agreement. A recent court ruling in New York highlighted the importance of including explicit language in the lease document to ensure that a tenant will receive their cash security deposit when the lease expires.
In 10FN, Inc. c. Cerberus Business Fin., LLC et al., Case No. 21-CV-5996-VEC (SDNY Oct. 18, 2022), the U.S. District Court for the Southern District of New York (the court) ruled that the nondebtor tenant’s $271,000 security deposit amounted to an unsecured loan where neither the commercial lease nor applicable state law expressly requires the commercial landlord to hold the security deposit in trust for the benefit of the tenant. Consequently, the tenant was unable to seek recourse against the secured creditors (who had swept away the bank accounts in which the security deposit was held). The only avenue of recovery available to the tenant was as a general unsecured creditor against the landlord’s Chapter 7 bankruptcy.
Background
In 2016, Network Innovations, dba Nitel Inc. (the tenant) entered into a commercial sublease (sublease) with Rocket Fuel Inc. for office space located in Chicago, IL, and paid a security deposit in cash of $271,000.00 (the security deposit). The terms of the sublease provided that it was governed by Illinois law and that the tenant had the right to recover the security deposit within 30 days of the expiration of the sublease (provided that the tenant is not in default of payment of the rent), and in the event of default, the landlord could deduct from the security deposit. However, the sublease was silent as to the landlord’s obligations regarding the disposition of the security deposit during the term of the sublease.
While the sublease was in effect, Sizmek DSP Inc. (the debtor) acquired Rocket Fuel, which was funded by loans from Cerberus Business Finance LLC and PEPI Capital LP (together, the secured lenders). As part of the transaction, the Debtor signed certain account control agreements authorizing the Secured Lenders to control and sweep the accounts of the Debtor.
Shortly before the bankruptcy filing, the secured lenders withdrew all money from the debtor’s accounts, including some or all of the security deposit.
In March 2019, the debtor commenced Chapter 11 bankruptcy proceedings, which was later converted to Chapter 7, In re Sizmek Inc., No. 19-10971 (Bankr. SDNY filed March 29, 2019). The debtor rejected the sublet in June 2019, after which the tenant made several unsuccessful attempts to recover the security deposit in the bankruptcy case. In June 2021, the tenant filed a lawsuit against secured creditors, asserting claims for conversion and unjust enrichment. The Complaint was later amended to include conversion and negligence claims against several of the Debtor’s officers (the Executive Defendants).
In April 2022, the Secured Lenders and Executive Defendants filed motions to dismiss the Amended Complaint pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, to which Plaintiff objected.
Court decisions
Ultimately, the Court granted the motions to dismiss in their entirety, dismissing each of the Tenant’s claims on the merits.
As a preliminary matter, the Court ruled that New York law would apply to determine whether the elements of the three tort actions had been properly pleaded, but that Illinois law applied for purposes of interpreting the provisions of the sublease. The Court has analyzed each request in this context.
With respect to the conversion application, the Court ruled that the tenant failed to adequately establish his right of possession or interest in the security deposit – a key element of a conversion application. The Court began its analysis by noting that the application for conversion rested on the tenant’s assertion that the landlord was required to hold the security deposit in trust for the benefit of the tenant. Since the sublease imposed no such obligation on the landlord, the Court turned to Illinois law. Although Illinois law imposes this obligation on Residential owners, the Court concluded that no such requirement exists with respect to commercial owners.
Rather, the Court interpreted Illinois law – and more specifically, dictated stated in a decision of the Court of Appeals for the Seventh Circuit – to mean that the security deposit is equivalent to an unsecured loan from the tenant to the landlord. This conclusion was based on the commercial owner’s lack of obligation to separate the security deposit—both in state law and in the sublease—combined with the terms of the sublease expressly allowing the owner to draw on the funds if the lessee defaults. Thus, the refusal of the debtor-landlord to return the security deposit to the tenant was analogous to the refusal of a borrower to repay a loan to a lender (here, the tenant). Therefore, the tenant was limited to seeking recovery of the security deposit as a general unsecured creditor in the landlord’s bankruptcy.
The negligence action against the Executive Defendants also failed. To make a claim for negligence, a plaintiff must allege, among others, that the defendant has breached a duty to the plaintiff. Since the Court had already found that there was no obligation to separate the security deposit and hold it in trust, the negligence action also failed.
The final unjust enrichment claim against the secured lenders also failed. An action for unjust enrichment is generally barred where there is a valid and enforceable agreement governing the subject matter of the dispute (even if the action is brought against a third party to the agreement). Here, the sublet governed the security deposit dispute.
Why this case is interesting
This case serves as a warning to commercial tenants: if the commercial lease and/or applicable law does not require the landlord to segregate and hold the security deposit funds in trust for the benefit of the tenant, the security deposit may be treated as an unsecured deposit. loan to owner in bankruptcy. In other words, the debtor-lessor simply has an obligation to repay the security deposit, which is no different from any other general unsecured claim that a seller, supplier or other party to the contract may have against a debtor and his bankruptcy estate. The special protections of Section 541(d) of the Bankruptcy Code – which limit a debtor’s right to assert that property held in trust for the benefit of a non-debtor belongs to the bankruptcy estate – does would not apply. Thus, if the debtor-lessor has filed for bankruptcy, the tenant will have trouble getting his security deposit reimbursed.
Accordingly, this decision underscores the importance of setting out, in express terms, the treatment and disposition of the parties’ obligations with respect to security deposits (or other payment obligations) under a rental, particularly where the applicable law is silent on the issue. And even if applicable state law provides for the funds to be held in trust, adding trust language to the applicable lease mitigates the risk of the funds becoming part of the debtor’s estate subject to the rights of the lenders. debtor’s guarantees.
Note that this case and these tips do not apply directly to a security deposit in the form of a letter of credit, because the tenant is the “account debtor” for the letter of credit and the letter of credit is an obligation of the issuing bank, rather than the property of an owner-debtor under its control. Any drawing under the letter of credit is also subject to compliance with the conditions for doing so. However, if the owner-debtor has a residual interest in the proceeds of the letter of credit, or if he has drawn on the letter of credit but has not used the funds, then the cash proceeds drawn by the owner would be subject to the same risk as a cash payment.
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