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Rights of Tenant to Security Deposit When Landlord Files for Bankruptcy
As we debate whether there will be a "soft" or "hard" landing of the economy and the resulting effect of different landings on the volume of bankruptcy filings, it is helpful to review how a bankruptcy filing affects not only rights between a creditor and the debtor, but also the respective rights of creditors against property held by the debtor. These rights may be determined by in what capacity the debtor is holding the property. For example, Section 365 of the Bankruptcy Code, which governs the disposition of executory contracts, has specific provisions regarding the disposition of commercial real estate leases in bankruptcy. These provisions address, among other things, the rights of a tenant to remain in possession of the leased premises when the landlord files a bankruptcy case and rejects the lease. But what rights does a tenant have with regard to the security deposit delivered by the tenant to the landlord to secure the tenant's performance under the lease when the landlord files for bankruptcy and rejects the lease?
This issue was recently considered by the U.S. District Court for the Southern District of New York in the case of 10FN v. Cerebus Business Finance, Case No. 1-CV-5996 (VEC) (Oct. 18, 2022). In that case, a subtenant's security deposit was swept from the master tenant's bank account by its secured lenders just prior to the master tenant's bankruptcy filing. The subtenant sued the secured lenders and some of the master tenant's executives, arguing that the lenders and executives all knew the security deposit was in the account and the master tenant held the security deposit in trust for the subtenant. The subtenant alleged that by sweeping the account, the secured lenders unlawfully took the funds, and the master tenant executives were negligent in letting that happen. The court held the security deposit was not held in trust either under the terms of the sublease or by operation of state and local law, and it was merely an unsecured loan by the subtenant to the master tenant that was subject to set-off if the subtenant defaulted under lease. Consequently, the subtenant was reduced to the status of an unsecured creditor in the master tenant's bankruptcy case for the amount of the security deposit and could not assert claims against the secured lenders or the master tenant's executives.
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