Security deposits are a fundamental landlord protection under leases with the expectation of tenants that the deposits will be returned upon the expiration of the lease. While landlords frequently consider how to protect their rights in the security deposit should the tenant file for bankruptcy, a recent decision highlights the risk to tenants if the landlord is, instead, the debtor in a bankruptcy proceeding. The issue arises due to the broad scope of what is included in “property of a bankruptcy estate” and under what circumstances the non-debtor (here, the tenant) has a property right in the cash security deposit or is simply a creditor with a prepetition unsecured claim against the debtor-landlord. Notably, under Section 541(d) of the Bankruptcy Code, property held by a debtor in trust for a non-debtor does not become property of the debtor’s bankruptcy estate to the extent of the non-debtor parties’ beneficial interest in such funds. Trust rights can arise by virtue of statute or agreement. A recent court ruling in New York has highlighted the importance of including express language in the lease document to ensure that a tenant will receive back its cash security deposit upon lease expiration.

In 10FN, Inc. v. Cerberus Business Fin., LLC et al., Case No. 21-CV-5996-VEC (S.D.N.Y. Oct. 18, 2022), the U.S. District Court for the Southern District of New York (the Court) held that the non-debtor-tenant’s $271,000 security deposit was tantamount to an unsecured loan where neither the commercial lease nor the applicable state law expressly required the commercial landlord to hold the security deposit in trust for the benefit of the tenant. Consequently, the tenant was precluded from seeking recovery against the secured lenders (who had swept the bank accounts in which the security deposit was held). The only avenue for recovery available to the tenant was as a general unsecured creditor against the landlord’s Chapter 7 bankruptcy estate.

Background

In 2016, Network Innovations, dba Nitel Inc. (theTenant) entered into a commercial sublease (Sublease) with Rocket Fuel Inc. for office space located in Chicago, IL, and gave a $271,000.00 cash security deposit (theSecurity Deposit). The terms of the Sublease provided that it was governed by Illinois law and that the Tenant had a right to have the Security Deposit returned within 30 days of the expiration of the Sublease (provided that the Tenant was not in default on rent payments), and upon a default, the landlord could draw from the Security Deposit. However, the Sublease was silent as to the landlord’s obligations with respect to the disposition of the Security Deposit during the term of the Sublease.

While the Sublease was in effect, Sizmek DSP Inc. (theDebtor) acquired Rocket Fuel, which was financed by loans from Cerberus Business Finance LLC and PEPI Capital L.P. (together, theSecured Lenders). As part of the transaction, the Debtor executed certain account control agreements, authorizing the Secured Lenders to control and sweep the Debtor’s accounts.

Shortly before the bankruptcy filing, the Secured Lenders swept all cash from the Debtor’s accounts, including some or all of the Security Deposit.

In March 2019, the Debtor commenced a Chapter 11 bankruptcy case, which was later converted to Chapter 7, In re Sizmek Inc., No. 19-10971 (Bankr. S.D.N.Y. filed Mar. 29, 2019). The Debtor rejected the Sublease 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 complaint against the Secured Creditors, asserting claims for conversion and unjust enrichment. The complaint was subsequently amended to include claims for conversion and negligence against several executives of the Debtor (theExecutive 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, which the plaintiff opposed.

Court Rulings

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 with respect to determining whether the elements of the three tort claims were properly plead, but that Illinois law applied for purposes of interpreting the provisions of the Sublease. The Court proceeded to analyze each claim within this framework.

With respect to the conversion claim, the Court ruled that the Tenant failed to adequately establish the Tenant’s possessory right or interest in the Security Deposit — a key element of a conversion claim. The Court began its analysis by noting that the conversion claim relied on the Tenant’s assertion that the Landlord was required to hold the Security Deposit in trust for the benefit of the Tenant. Because the Sublease imposed no such obligation on the Landlord, the Court turned to Illinois law. Although Illinois law imposes this obligation on residential landlords, the Court found that no such requirement exists with respect to commercial landlords.

Rather, the Court interpreted Illinois law — and more specifically, dicta set forth in a Seventh Circuit Court of Appeals decision — to mean that the Security Deposit is tantamount to an unsecured loan by the Tenant to the Landlord. This conclusion was based on the absence of the commercial landlord’s obligation to segregate the Security Deposit — both at state law and in the Sublease — combined with the terms of the Sublease expressly authorizing the Landlord to draw upon the funds if the Tenant defaults. Therefore, the Debtor-Landlord’s refusal to return the Security Deposit to the Tenant was analogous to a borrower’s refusal to repay a loan to a lender (here, the Tenant). Consequently, the Tenant was limited to seeking recovery of the Security Deposit as a general unsecured creditor in the Landlord’s bankruptcy.

The claim for negligence against the Executive Defendants likewise failed. To state a claim for negligence, a plaintiff must allege, inter alia, that the defendant breached a duty owed to the plaintiff. Since the Court had already concluded that there was no duty to segregate the Security Deposit and hold it in trust, the claim for negligence likewise failed.

The final claim for unjust enrichment against the Secured Lenders also failed. A claim for unjust enrichment is generally barred when there exists a valid, enforceable agreement governing the subject matter of the dispute (even if the claim is asserted against a non-party to the agreement). Here, the Sublease governed the dispute over the Security Deposit.

Why This Case Is Interesting

This case serves as a warning for 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 loan to the landlord in the bankruptcy. In other words, the debtor-landlord merely has an obligation to repay the security deposit, no different than any other general unsecured claim that a vendor, supplier or other contract party may have against a debtor and its 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 is property of the bankruptcy estate — would not apply. Thus, if the debtor-landlord has filed for bankruptcy, the tenant will have a difficult time getting repaid its security deposit.

As a result, this decision highlights the importance of setting forth, in express terms, the treatment and disposition of and parties’ obligations with respect to security deposits (or other payments obligations) under a lease agreement, particularly when the applicable law is silent on the issue. And even if applicable state law provides for funds to be held in trust, adding trust language to the applicable lease mitigates the risk of the funds being part of the debtor’s estate subject to the rights of the debtor’s secured lenders.

Note that this case and guidance do not directly apply 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 a landlord-debtor under its control. Any draw under the letter of credit is subject to meeting the conditions to do so, as well. However, if the landlord-debtor has any residual interest in the letter of credit proceeds, or has drawn on the letter of credit but not applied the funds, then the cash proceeds drawn by the landlord would be subject to the same risk as a cash deposit.