What are the bankruptcy implications of the treatment of a tenant’s security deposit following a payment default?  Many non-residential tenants are now or are likely in the future to be unable to pay rent and landlords will consider their options for dealing with the security deposit in situations where they either do not intend to terminate the lease, perhaps in connection with a workout, or are barred from doing so by an eviction moratorium. A landlord may fear that a tenant is or is likely to become insolvent and so consider declaring that the amount of the security deposit equal to the defaulted rent has become the property of the landlord and that, if provided in the lease, the tenant is required to replenish the security deposit. The landlord may instead enter into a lease amendment abating and/or reducing the rent and, as part of the consideration for the amendment, the parties agree that the security deposit has been applied to past due rent and that it will be replenished under a payment schedule.

In addition to considering the likelihood of the tenant’s eventual bankruptcy, other considerations include the specific provisions of the lease, provisions in any applicable loan documents relating to tenant defaults and security deposits, and the restrictions on landlords’ actions in applicable local and state eviction and related moratoria.  As a practical matter, in the commercial context security deposits are only a balance sheet liability and there is no separate cash deposit account, so as described below, the preferred course of action is not to declare that the security deposit is applied to a rent arrearage.

Many landlords hold security deposits under lease provisions such as:

“Following an event of default by Tenant under this Lease, Landlord may use, apply or retain all or any portion of the Deposit for the payment of any rent or other charge in default, or the payment of any other sum to which Landlord may become obligated by Tenant’s default, or to compensate Landlord for any expense, loss or damage which Landlord may suffer thereby.”

In a tenant’s bankruptcy the landlord has potentially three separate claims: (i) for arrearages owed or accruing prior to the bankruptcy petition date; (ii) for amounts accruing after the petition date and prior to the effective date the bankruptcy estate rejects the lease; and (iii) for damages resulting from rejection of the lease.  Only claim (iii) is subject to any limit, which is the greater of “rent reserved” under the lease (which can include CAM and other periodic charges) for one year or 15% of the remaining term of the lease (up to a maximum of three years of rent reserved).

Subject to application of the security deposit towards the landlord’s claim (discussed below), claims (i) and (iii) would be treated as “general unsecured prepetition claims” in the tenant’s bankruptcy case, which would be paid consistent with other prepetition unsecured trade creditor claims (typically at a fraction of amount owed).  Claim (ii) is treated as an “administrative expense claim” which (at least in the absence of an agreement to the contrary) must be paid 100% before unsecured prepetition claims receive any payment.

If the landlord has not applied the security deposit to rent arrearages prepetition, then the landlord should be entitled to do so (i.e., apply it to claim (i)) after the bankruptcy is filed through stipulation/motion for relief from stay or by netting it in connection with its proof of claim filing process.  If the security deposit is not applied to rent arrearages prepetition, it technically will become part of the tenant’s bankruptcy estate, but will remain subject to the landlord’s security interest (perfected by having possession of the subject funds), rather than being available for payment of claims of other creditors and therefore will leave the landlord in the same financial position as it would have been in if it had applied the deposit towards the rent arrearage pre-bankruptcy.

If the landlord applies the security deposit towards rent arrearages and within 90 days thereafter the tenant files bankruptcy, then the landlord’s action may be “avoided” (undone) as a preferential transfer and/or setoff that improves the landlord’s net secured position during the 90-day pre-bankruptcy period pursuant to Bankruptcy Code Section 553(b).  The landlord presumably would have defenses to such claims, including that the application is not a preference because it did not result in the landlord receiving more than it otherwise would have if it had not been undertaken.  Although the landlord is likely ultimately to be allowed to apply the security deposit to the tenant’s debt, the cost of defending such litigation is likely to be higher than the cost of preparing the motion/stipulation to obtain stay relief to effectuate a setoff post-petition.