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COVID-19: Should Landlords Apply Security Deposits to Unpaid Rents?
Many landlords of shopping centers and other commercial buildings have been asking whether landlords can begin eviction proceedings or exercise other lease or legal remedies now that tenants have missed April rent payments. While there are currently several bills in various stages of being passed into law in several states as of early April, which would restrict, on a temporary basis, the eviction of commercial tenants from their leased premises for failure to pay rent, the current restrictions only apply to residential tenants throughout the country.
Just recently, the Massachusetts state senate passed a bill that prohibits all non-emergency evictions for small businesses and prohibits evictions and foreclosures for residential properties for at least 120 days after the bill is signed by the governor. The legislation also prohibits late fees or negative credit reporting for non-payment of rent if the lack of payment if the lack of payment is due to financial impact related to COVID-19. Several other states are passing similar bills on a temporary basis. Whether these bills get signed into law and survive judicial scrutiny remains to be seen. And since most judicial proceedings have come to a standstill, eviction or other proceedings do not seem to be a wise choice at this time.
The question then logically follows whether, instead of taking the severe remedy of evicting a commercial tenant, or applying late charges, a landlord may enforce the security deposit section of its lease and take the deposit should the tenant miss a rent payment.
Again, as of mid-April, there are not any states that have passed laws which would restrict the right of a landlord to apply the security deposit to unpaid rent in a retail or other commercial lease.
However, before taking this course of action, it is imperative the landlord review the security deposit section of the lease. Many leases require there to be an "Event of Default" which event can only occur following a notice and opportunity to cure. In these cases, the landlord should send a notice to the tenant, asserting that the rent or other payment was not timely made and following the cure period set forth in the lease, the landlord will apply the security deposit to the unpaid rent. Even without this requirement, it is recommended that the landlord notify the tenant that the landlord is taking this action. If the security deposit is applied, the landlord would also send a notice requiring the tenant to restore the security deposit to the original amount. Often the lease specifies a time period for the tenant to do so.
This action would not run against any laws that states may adopt restricting evictions of commercial tenants or prohibiting late charges, since the landlord is not seeking to do either of these two actions. The landlord may, in its notice to the tenant, specifically mention that the landlord is not seeking either of these two remedies, even though it would be permitted to do so in the lease.
However, the decision to take the security deposit must be looked at on a case by case basis. Is this a tenant that is still fully operating its business and merely using the pandemic in an effort to reduce its operating costs? The landlord should also determine whether this is a tenant that has chronically been late and for which the landlord has given several breaks in the past. Or is it a tenant that has always paid rent on time and missed its April payment for the first time because of COVID-19? More leniency might be given in the latter situation. But since tenants may talk to each other, an issue can arise that the landlord is treating certain tenants differently, and this could have a negative impact in the future relationship with the tenant whose security deposit was taken. Is this a tenant the landlord wants to keep in the shopping center or building? Is the landlord concerned about how this would be seen if it gets out to the public? For this reason, instead of taking the security deposit of tenants who didn't pay April rent, many landlords are seeking to enter into lease amendments with their tenants to defer unpaid rent for some short period of time, and perhaps requiring the tenants to pay only reduced or percentage rent (if a retail tenant who is still open for business) and operating expenses and taxes. This could be seen as an opportunity to improve the landlord's position on some other lease issues (such as waiving an early termination right or removing a co-tenancy provision), or perhaps extend the term of the lease on the back end. In the lease amendment, the parties could agree that the landlord may apply the security deposit to unpaid rent and provide for the restoration at a later date. The landlord may also use this as an opportunity to require a guaranty of the lease obligations by an individual or parent or affiliate company that is not as greatly impacted by reduced operations.
For the reasons stated in the above paragraph, there may be reasons why the landlord does not want to simply apply the security deposit to unpaid rent. The risk that a landlord takes, however, in delaying the application of the security deposit, is that if the tenant may eventually file for bankruptcy protection, and if the landlord hasn't yet taken the security deposit, it might not be able to do so under applicable bankruptcy laws. This might not be the case should the security deposit be in the form of a letter of credit, in which case the landlord would have more rights to draw on the letter of credit at a later date.
So while taking a security deposit may be an available remedy for a landlord to take, the decision to do so must be made on a case by case basis, looking at the language of each lease and the relationship between the landlord and the tenant.
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Ira Fierstein, a member of this newsletter's Board of Editors, is a partner in the real estate group at Seyfarth Shaw LLP.
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