Maximize Default Protection with Strong Security Clause

If one of your tenants has defaulted on its lease or damaged its space, you know the importance of having both a security deposit amount large enough to cover expensive problems and a clause in the lease that will protect you from having to spend your own money rectifying them. But be prepared for a tough negotiation—especially in this economy, when many tenants have a hard time coming up with the cash for a deposit and fear that they will lose it if they have to go dark.

Include the following key points—which show you how to hold, spend, and return a deposit—in your security deposit clause to stop the tenant from limiting your ability to fix problems caused by the tenant with its—not your—money.

Essential Security Deposit Provisions

Be aware that big, national tenants with good credit may refuse to give you a security deposit. But insist on getting one from smaller franchised and local tenants. Make sure that, like our Model Lease Clause: Get Maximum Security Deposit Protection, your security deposit clause says:

Tenant must pay deposit at lease signing. Require the tenant to pay the security deposit when it signs the lease, advises New Jersey real estate attorney Marc L. Ripp [Clause, par. a]. Try to get it even sooner—when the tenant accepts the letter of intent. Either way, don't agree to let the tenant give you the security deposit at a later point in time after it is already occupying the space, or after you've finished any buildouts. By that time, you'll have lost some of your negotiating power on an important issue that the tenant will fight for.

Access to deposit will be triggered by any tenant default. Say in the clause that you can access the security deposit whenever the tenant defaults—whether it's a monetary or non-monetary default [Clause, par. b]. But expect the tenant to insist that you agree to give it notice and a chance to cure—that is, fix—the violation before you can access the security deposit.

A savvy tenant may object to letting you access the security deposit if it commits a non-monetary default—especially a minor one—because it's difficult to place a value on non-monetary defaults. As a compromise, ask the tenant to agree that you can access the security deposit for monetary defaults and only non-monetary important “material” defaults.

Reasons for applying deposit. To avoid arguments with a tenant about the circumstances under which the security deposit can be applied, Ripp suggests getting the right in the lease to apply the security deposit to the following:

• Any unpaid amounts the tenant owes you under the lease, such as base rent or additional rent;

• Any payments that the tenant fails to make to others, as required under the lease, such as insurance premiums;

• Any loss or damages you suffer as a result of any tenant default—for example, a rodent problem resulting from the tenant's failure to throw out its garbage; and

• Costs you incur in connection with taking back the space early, such as attorney's fees and reletting costs [Clause, par. b].

Deposit won't affect remedies. Protect your right to draw from the deposit at your discretion when the tenant defaults under its lease. Make it clear that drawing on the security deposit isn't a prerequisite to resorting to your lease remedies (such as suing for damages or evicting the tenant) [Clause, par. c]. These terms will stop the tenant from arguing that you must sue it before drawing from the deposit. And they will ensure that you can resort to your lease remedies without losing your right to draw from the deposit later, says Ripp. That way, the tenant can't argue that by, for example, filing a lawsuit against it, you gave up your right to draw from the deposit, he explains.

PRACTICAL POINTER: It may make more sense for you to draw from the security deposit than to take other legal action against the tenant in the following situations: if you're having cash-flow problems and need money immediately; if the tenant is desirable but just suffering from a temporary financial setback; or if you're worried that a lawsuit against a tenant would give potential buyers and lenders a bad impression of your building or center.

Deposit isn't cap on damages. If you discover that the security deposit ends up not being enough to cover the damages the tenant caused, you'll want to be able to sue it for the difference. Protect your right to sue for the balance of what the tenant owes you after you have deducted its security deposit by clarifying in the clause that the security deposit isn't a cap on your damages.

And specify that the security deposit can't be used to pay “liquidated damages—the preset amount that the tenant has agreed to pay you if it violates the lease [Clause, par. d]. That way, the tenant won't be able to argue that the security deposit is the full amount of damages you can collect for any lease violation, he says.

Deposit isn't advance payment of rent. Sometimes departing tenants think that they can use the security deposit to pay their last month's rent. State in the clause that the security deposit isn't an advance payment of rent [Clause, par. e]. You need this protection because you never know what kind of damage a tenant will do to your space during its tenancy, and then move out, leaving you without funds to fix the space.

Tenant must replenish drawn deposit money. Say in the clause that if you draw on some or all of the security deposit during the lease, the tenant must replenish the deposit to its original amount. Otherwise, there may not be enough left in the deposit to protect you. Set a replenishment deadline—for example, within five days after your demand, says Ripp. Also, say that failure to replenish the security deposit will be considered a lease default, he adds [Clause, par. f].

Tenant must fully comply with lease to get back deposit. Don't simply agree to return the security deposit as soon as the lease ends, warns Ripp. Require the tenant to fully comply with the terms and conditions of the lease in order to get back its deposit, he says. That way, you'll be able to keep part or all of the deposit if the tenant fails to: pay all of the rent and any other charges—such as operating expenses—and all third-party invoices relating to the space (such as utility charges); repair any damage it caused to the space; and return the space to you in the condition required by the lease. It's crucial to specify that you—not the tenant—will make the determination of whether it met the conditions [Clause, par. g].

When deposit must be returned. Give yourself time after the lease ends to return any unused portion of the security deposit—for example, 20 days to 60 days after the lease ends—if the tenant has complied with the lease terms and conditions [Clause, par. g]. Be prepared for the tenant to negotiate to recoup its money as fast as possible.

Deposit can be returned to assignee. Generally, the security deposit will be returned to the tenant. However, if the tenant assigned the lease, the assignee may claim that it's entitled to the deposit. But the fact that the tenant assigned its lease doesn't necessarily mean it assigned the security deposit, too.

To avoid getting caught in a battle between an irate tenant and assignee over who's entitled to the security deposit—and getting sued if you hand over the money to the wrong party—require the assignee to provide sufficient evidence that it is entitled to the deposit.

Also say that you have the right to give the deposit to either the assignee or the tenant, as you choose. Specify that you'll be released from all liability for the return of the security deposit to the tenant if you return the deposit to the assignee [Clause, par. h].

Deposit can be transferred if building/center is sold. If you decide to sell your building or center before the tenant's lease ends, you'll want to transfer the security deposit to the new owner (or to the lender after a foreclosure). Make sure the lease gives you this right, advises Ripp. And ensure that after the transfer, you'll have no further responsibility for the deposit and that the tenant must look only to the buyer for the security deposit's return at the end of the lease [Clause, par. i]. Otherwise, you'll remain responsible for the security deposit. Expect the tenant to demand some assurance that the buyer will assume responsibility for the security deposit.

Payment of security deposit doesn't make lease effective. There may be times when you'll decide not to sign the lease after you've collected the security deposit. If this happens, the tenant might argue that your acceptance of the security deposit was an acceptance of the lease. To prevent such an argument, say in the clause that your acceptance of the security deposit from the tenant won't put the lease into effect and that the lease won't become effective until you sign it and deliver it to the tenant, says Ripp [Clause, par. j].

To attract tenants, you may have to be flexible and willing to compromise with regard to the security deposit. Before agreeing to forgo collecting a cash security deposit, explore other alternatives, such as getting a letter of credit, security interest in its personal property, or personal guaranties or indemnities.

Insider Source

Marc L. Ripp, Esq.: Senior Associate General Counsel, Mack-Cali Realty Corp., Mack-Cali Centre II, 650 From Rd., Ste. 220, Paramus, NJ 07652-3517; (201) 967-0324; mripp@mack-cali.com.

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