Tenant Security Deposit Or Unsecured Loan? State Law Disparity Leads To Forfeiture

• Published date: 09 December 2022
• Subject Matter: Real Estate and Construction, Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy, Real Estate, Landlord & Tenant - Leases
• Law Firm: Shearman & Sterling LLP
• Author: Mr Malcolm Montgomery, Lisa Brill, Kris Ferranti and Jonathan Newman

Last month, Judge Caproni of the Southern District of New York issued a ruling stating that if a commercial lease does not require a landlord to hold a security deposit in trust and if there is no state statute generally requiring landlords to do so, the security deposit may not be recoverable by the tenant when the landlord files for bankruptcy. See 10FN Inc. v. Cerberus Business Finance LLC, 21-5996 (S.D.N.Y. Oct. 18, 2022). In its holding, the Court found that the security deposit at issue would receive the same treatment as an unsecured loan to the landlord because Illinois law requires that security deposits be held in trust only by residential landlords. Illinois law is silent on whether the same rule should apply to security deposits held under commercial leases.

The plaintiff-tenant commenced the case after a $270,000 security deposit was removed from the debtor landlord's bank account after the landlord filed for bankruptcy. After the tenant repeatedly attempted to obtain a refund of its security deposit, it filed tort claims against the landlord's secured lenders for conversion and unjust enrichment and against the landlord for conversion and negligence.

In the case, choice of law was an important issue because while the lease included a provision stating that it "shall in all respects be governed by and construed in accordance with the laws of the State of Illinois", that governing law provision was not sufficiently broad to encompass the tenant's tort claims. In its holding, the Court referenced a Second Circuit case "which concluded that a provision stating that an agreement 'shall be governed by and construed in accordance with the laws of the Commonwealth of Massachusetts' was too narrow to encompass a fraud claim arising incident to the agreement." See Krock v. Lipsay, 97 F.3d 640, 645 (2d Cir. 1996). The Court therefore applied New York law to the tenant's negligence and conversion claims because federal courts typically apply a forum state's choice of law rules. Nevertheless, the Court clarified that "[a]lthough the...