January 02, 2014
A security deposit is the standard collection technique for commercial landlords. A security deposit is a cash deposit that a tenant provides to a landlord as security for the tenant’s performance of its obligations under the lease. If the tenant fails to perform an obligation under the lease, then the landlord has the right to apply all or a portion of the security deposit towards the damage resulting from such non-performance. As an example, if the tenant fails to pay its rent for the month of June 2013, the landlord has the right to take an amount equal to the June 2013 rent out of the security deposit.
The primary benefit of a security deposit is that, with certain exceptions (see below), the landlord has immediate access to cash on hand and can remedy damages caused by a tenant’s non-performance quickly. Another benefit of using a security deposit is that it is a straightforward collection technique, and – outside of issues of amount and duration (see below) – it is easy to negotiate and include in a lease.
The primary disadvantage of a security deposit is its finite nature. If the damages resulting from a tenant’s non-performance(s) are greater than the security deposit amount, then a landlord may need to utilize other collection techniques in order to deal with the shortfall. One way to address this disadvantage is to require the tenant to replenish the security deposit in the amount of that removed by the landlord following non-performance. This requirement should be a covenant in the lease (and most leases contain such a covenant). However, this requirement is also problematic in that it assumes the tenant has the cash available to replenish the security deposit by the time set forth in the lease (and before the landlord needs to access those funds again). If the landlord has to access the security deposit because the tenant has failed to pay its rent, then should the landlord reasonably expect that the tenant has available cash to replenish the security deposit? As discussed further below, this problem can be resolved by supplementing the security deposit with another collection technique, such as a letter of credit.
The threat of bankruptcy highlights another disadvantage of relying upon a security deposit – if the tenant declares bankruptcy before its landlord has the opportunity to apply the security deposit to unpaid payments, the automatic stay in bankruptcy may prevent the landlord from doing so.
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Due Diligence Checklist for Commercial Real Estate
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When drafting a security deposit provision in a lease, a landlord should consider the size and duration of a security deposit:
Size of the Security Deposit.
The amount of a tenant’s security deposit is subject to agreement between the landlord and the tenant. While there is no industry standard, the landlord should ensure that the security deposit amount in effect at all times during the lease term is in an amount sufficient for the landlord to feel its interests are secured adequately. As with all of the other collection techniques described in this teleconference, the landlord’s desired security deposit amount should be based on the results of the landlord’s due diligence regarding the tenant. The landlord may be comfortable with a smaller security deposit if the tenant is a well-established company with strong financials in a stable industry. Conversely, the landlord may require a larger security deposit from a tenant who is starting a new business, from a tenant with weak financial statements, or from a tenant who is in a weak or declining industry. Of course, if the tenant’s financial position is weak, then the tenant may not have additional money to provide towards a security deposit, but, as previously discussed, the landlord may choose to supplement the security deposit with another collection technique.
Duration of the Security Deposit.
The landlord should also consider how long it wants to keep the security deposit intact and whether or not it would consider a “good behavior” refund or reduction in the security deposit. A “good behavior” refund or reduction is when the landlord refunds all or a portion of the security deposit to the tenant, provided that the tenant has complied with all of the lease terms (including timely lease payments) for a probationary period (such as two years following the lease’s commencement date). In theory, by the time the “probationary period” is over, the tenant’s business is operationally solid enough that the landlord doesn’t need the full security deposit. However, many landlords who added a “good behavior” refund to their leases in the mid 2000s became a victim of timing – the refunds kicked in just as the economic downturn got under way.
Authors: Kelly C. Spicher, Foley & Lardner LLP; Jill L. Nicholson, Foley & Lardner LLP; Dean M. Victor, Foley & Lardner LLP
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