California Commercial Tenant Security Deposits in a COVID-19 World

Security Deposits in the Lease Context

Unless a tenant is of such financial wherewithal that it can argue no security deposit should be required of it, or has other bargaining leverage to avoid some sort of credit enhancement to support its lease obligation, most tenants will be required to establish a security deposit with the landlord as part of entering into a commercial lease. The deposit usually takes the form of cash but may also be in the form of a letter of credit issued by a bank and naming the landlord as a beneficiary. The amount of the deposit usually correlates to the monthly rent obligation, sometimes including estimated operation expense pass-through amounts, and is often based on the amount of the last month’s rent due under the lease to include annual increases that may be part of the lease. The latter approach is often a function of some tenants treating the security deposit as a form of payment of the last month’s rent due under the lease even though the deposit is usually stated as not intended for such purpose, as security deposits also cover the restoration obligations of the tenant with respect to the leased premises upon lease expiration and vacation. In cases where the landlord provides an allowance for the improvement of the premises for the tenant’s use, and such tenant improvements are extensive or unique, a security deposit may be quite large and related to the landlord’s recovery of such amounts through rent payments over the term of the lease. Such security deposits may be subject to a “burn-off” or reduction over time if the tenant does not default under the lease terms. In almost all cases, the security deposit is due upon execution of the lease.

California Law and Security Deposits

California non-residential lease security deposits are subject to certain restrictions on their use by the landlord under California law. California Civil Code Section 1950.7 limits the use of security deposit amounts to the cure of defaults in the payment of rent, repair of damages to the premises, and cleaning the premises upon lease expiration or termination. The statute also requires that the landlord refund to the tenant any amounts that have not been applied by the landlord to such defaults within 30 days of the landlord recovering possession of the premises. Importantly, these provisions are waivable by the tenant, and most commercial leases include such a waiver, giving the landlord the right to apply such amounts to any default by the tenant under the lease, including future rent damages.

Notwithstanding such a waiver, a security deposit is still intended to secure performance of the tenant and even the ability to apply the security deposit to a broader range of tenant lease breaches does not absolve the landlord of the obligation to refund amounts not so applied to the tenant upon lease expiration or earlier termination. Some leases may also impose accounting on the landlord for amounts expended that can be challenged by the tenant as appropriate and require that the remainder be returned within a specified period of time. Otherwise, the security deposit is susceptible to a re-characterization as prepaid rent. Since the landlord retains other rights under the lease for a tenant default (unlawful detainer and damages actions, for example), it is typically not viewed as liquidated damages and therefore not subject to the reasonableness and other requirements of California Civil Code Sections 1671 to 1681.

Impact of Prohibitions on Evictions and Security Deposits

In the current COVID-19 crisis, there are restrictions that have been imposed on commercial evictions in many jurisdictions by state or local order. However, these restrictions have not generally to date restricted commercial landlords from applying security deposits in the event of a tenant’s failure to timely pay installments of rent or perform other obligations under the tenant’s lease. Following a proper application of the security deposit to a rental default, most commercial leases provide that the tenant must replenish the depleted security deposit, sometimes “immediately” or within a specified period of time set forth in the lease. The failure to timely replenish the security deposit in accordance with the lease terms will also typically trigger a separate default by the tenant, but in the absence of a lift on the prohibitions on evictions, no further actions (other than perhaps a demand on a lease guarantor) would be available.

In the case of letters of credit posted by the tenant as security deposits, a default in payment of rent typically permits the landlord to draw down the letter of credit. If the letter of credit is for an amount greater than the rental payment that is the basis for a default, after a draw, the landlord often has the right under the lease document to draw down the full amount of the letter of credit if the tenant does not cause the issuing bank to reissue the letter of credit in its full amount. That reissuance can be problematic if the tenant is undergoing financial stress and is unable to reimburse the issuing bank for a draw made by the landlord. This failure to reimburse would typically be a defense by the bank to reissuing the letter of credit in the required full amount.

Potential Landlord Concerns in Accessing Security Deposits in Current Environment

Security deposits are an attractive option for landlords facing a tenant default and unable to exercise other remedies due to the current prohibitions on tenant evictions in many jurisdictions. Landlords should bear in mind that resorting to such security often requires consent from the landlord’s lender under its loan documents. Drawing on a security deposit may also accelerate the decision by a tenant experiencing wider cash flow or solvency issues toward a preemptive bankruptcy filing on the theory that there is no opportunity to work with the landlord, resulting in potentially larger issues for the landlord with respect to the lease. As a practical matter, unless the landlord has been preserving the cash security deposits as a separate account or otherwise segregating security deposits from its general accounts, there may be no real cash flow advantage to it in accessing the security deposit other than as a balance sheet entry since those funds may have already been spent in the ordinary course of operations.

For security deposits in the form of a letter of credit, drawing down on the letter of credit can have its own set of challenges for a landlord. Draws under letters of credit have certain documentary requirements that must be met and typically require submission of the draw request to the issuing bank using predetermined forms with specific language that must be included in the draw request in order to be valid. There also may be a requirement that the original of the letter of credit be produced as part of the draw. Additionally, the letter of credit terms may require that a draw request be presented at a designated physical location of the issuing bank, accompanied by all required draw documents. Even if an electronically transmitted draw request is permitted, the letter of credit terms may nonetheless grant the issuing bank the discretion to require that original documents be submitted as a condition to honoring the draw. Complying with these requirements can be an issue given that current “shelter in place” orders in effect in many jurisdictions may restrict access opportunities, as well as the possible closure of the bank location specified in the letter of credit.

Some Bankruptcy Considerations

For tenants that are insolvent or have filed for bankruptcy protection, the requirements of federal bankruptcy law govern a landlord’s rights in the case of both cash security deposits and letters of credit. On a pre-bankruptcy basis, landlords are sometimes advised to take the cash security deposit and apply it to the delinquent rent to the extent permitted by the lease and not prohibited by applicable state law, although having that application characterized as a preference under bankruptcy law is sometimes a tenant defense. On a post-bankruptcy filing basis, resort to the security deposit is generally prohibited due to the automatic stay. However, if the deposit is in the form of a letter of credit, the automatic stay typically would not apply and the landlord can take and apply the draw to the extent permitted under the lease and applicable law. An examination of these requirements and their impact on the parties’ rights and remedies is beyond the scope of this article but are important topics for consultation with experienced legal counsel.

General Concerns

The application by a landlord of a tenant security deposit may result in a cascading series of defaults that, in the context of the economic duress resulting from the current COVID-19 pandemic, make the likelihood of the tenant’s recovery and reoccupation of the leased premises less likely even following a recovery of economic equilibrium. Although resort to a tenant security deposit can be a useful remedy available to a landlord in the absence of eviction and recovery of the premises, its use in the current marketplace should be evaluated carefully by the landlord, ideally in consultation with counsel. Similarly, tenants undergoing financial duress in the current economic environment would do well to understand their rights and remedies as regards their commercial lease security deposits.

For more information, please reach out to your regular Pillsbury contact or the author of this client alert.

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