When negotiating a commercial lease, landlords must often determine the credibility of the proposed tenant and determine what security can be given for the tenant’s performance under the lease. The most often used methods of security in the case of commercial leases are security deposits and prepaid rent. However, the Pennsylvania Landlord and Tenant Act restricts the amount of security deposit and transactions that require tenants to expend large amount of cash and are often refused or rejected. Therefore, the landlord should use other means to secure the tenant’s obligations.
The most common alternative form of security is to obtain and perfect a security interest in the tenant’s personal property (i.e. assets other than real estate), which may include furniture, fixtures, equipment, inventory, securities and accounts receivable. This article provides an overview of the process of perfecting a security interest in a tenant’s assets and addresses related issues that are often overlooked in the lease negotiation process.
Generally, perfecting a security interest in a tenant’s personal property provides the landlord with a right to take that personal property, subject to prior liens, in order to satisfy the tenant’s obligations under the lease. However, before entering into this type of transaction, it is important to address two significant issues. First, the landlord should determine whether the personal property is valuable. This can be done informally or formally. A landlord can determine the value of the tenant’s personal property by reviewing a list of such personal property provided by the tenant and making a determination based on the landlord’s knowledge of the personal property to be collateralized. On the other hand, a more formal appraisal may be conducted. Assuming that the personal property is valuable, the landlord must next determine whether the personal property subject to prior liens. If the personal property is subject to prior perfected liens, those prior liens will take priority over the landlord’s lien, and therefore, a landlord must determine whether the junior lienholder position is sufficient to secure the landlord’s interest. Assuming that the assets are valuable and are not subject to prior liens or there is sufficient equity in the assets that the landlord is comfortable with a junior lienholder position, several steps must be undertaken to perfect a security interest.
First, the landlord must include, in the lease, provisions akin to a security agreement that grant the landlord a security interest in the tenant’s personal property. To be enforceable against the tenant, the tenant must receive something of value, the tenant must have the right to grant the interest in the collateral, and the personal property must be described in detail. The description of the collateral must be very specific, enumerating all items of collateral to be subject to the security interest. It is important to note here that a general description, such as “all assets,” is insufficient for purposes of creating a security interest in the tenant’s personal property. The tenant must sign the security agreement or a lease that includes language akin to a security agreement. Automatically upon the satisfaction of the conditions listed above, a security interest in favor of a landlord will attach to the personal property.
Assuming that the security agreement is properly attached to the collateral, the landlord then must “perfect” its security interest. A security interest that is not perfected will be junior to all perfected interests and all prior recorded unperfected interests. A security interest that is perfected has priority over all unperfected creditors, all unsecured creditors and all later-filed, perfected security interests.
There are several ways in which a landlord can perfect a security interest in a tenant’s personal property. For example, the landlord may file a financing statement, commonly known as a UCC-1, with the Pennsylvania Department of State, or take possession or control of certain personal property. The manner of perfection will depend on the type of collateral in which the security interest has been granted. Upon perfection, the landlord’s order of priority will be held for a period of five years. Perfection will lapse after five years unless the landlord takes certain acts to continue its perfection. In order to continue its perfection, the landlord must file an amendment to its financing statement, commonly known as a UCC-3, with the Pennsylvania Department of State. If perfection lapses, the landlord’s security interest is deemed to have never been perfected. Therefore, even a creditor who has obtained a security interest after the landlord perfected its security interest will have priority over the landlord if the landlord’s perfection lapses.
In an event the landlord takes possession of the collateral in order to perfect its security interest, the landlord has certain duties that must be undertaken for the benefit of the tenant. First, the landlord has a duty to exercise reasonable care in the custody and preservation of the collateral in the landlord’s possession. Second, in certain circumstances, a landlord may be required to provide an accounting of all of tenant’s personal property held in the landlord’s possession.
Upon satisfaction of the underlying indebtedness or obligation, the landlord has a duty to file an amendment to its financing statement terminating its perfected interest. Assuming the landlord has properly perfected its security interest and maintained that perfection in the tenant’s collateral, then the landlord has certain remedies that would otherwise not be available in the case of a tenant’s default under the lease. In the event the tenant commits a monetary default under the lease or any other default that requires the payment of money to the landlord or any third party, the landlord may take possession of the collateral in which the security interest was granted and perfected, provided the landlord does not breach the peace in doing so. The landlord may sell and dispose of the collateral and use the proceeds of that sale or disposition to satisfy any indebtedness to the landlord. In the event the collateral is cash or cash equivalents (for example, accounts receivable), the landlord has a right to collect such cash or cash equivalents and apply those amounts to any indebtedness of the tenant.
The foregoing is a summary of the process through which a landlord may perfect a security interest in a tenant’s personal property as security for a tenant’s performance under a lease. Although the process seems simple as described below, it is actually quite nuanced. More importantly, a landlord who wishes to perfect a security interest in its tenant’s personal property must strictly comply with all provisions of the applicable Commercial Code to acquire the rights and remedies described above.
- Confirm title to the tenant’s personal property is free and clear of any liens or encumbrances.
- Confirm the tenant’s legal name and require that the tenant provide notice of any name change.
- If the tenant is a business entity, confirm the tenant’s state of formation.
- Require that the tenant maintain an accurate accounting of the collateral and provide a copy of the accounting to the landlord upon written landlord’s request.
- Require that the tenant disclose the location of the collateral and prohibit the tenant from changing that location at any time.
- Require that the tenant provide notice to the landlord of any casualty affecting the collateral.
- Restrict or prohibit the disposition of the collateral by the tenant.
- Require that the tenant maintain the collateral in good condition and working order and preserve the value of the collateral.
- Prohibit the tenant from granting any other security interest in the collateral to any other parties.
- Require that the tenant insure the collateral.
- Require that the tenant pay taxes that may affect the collateral as and when due.
- Grant the landlord the authority to file financing statements as and when appropriate in order to perfect and maintain its security interest.
- Grant the landlord the right to audit and inspect tenant’s books and collateral to confirm the value and amount of the collateral.
While security deposits and prepaid rents are often sufficient security for a landlord, those landlords who enter into leases with significant monetary values or tenants with less than excellent credit should acquire and perfect a security interest in its tenant’s collateral to secure the tenant’s obligations to the landlord. In the event the security deposit and the prepaid rent are not sufficient to recoup a landlord’s costs over the terms of a lease, the right to the collateral may do so. In addition to the cash that may be derived from the collateral, the threat of taking such collateral provides a significant bargaining tool for a landlord that wishes to maintain compliant and cooperative tenants.