Landlords: is the security deposit from your tenant really secure? (Selected Topic).

Landlords routinely demand and generally receive large security deposits to back long-term commercial leases. A large security deposit is often the backbone of a commercial lease transaction; however, landlords and their counsel may be dismayed when they learn that the security deposit is far less protected than it may seem, particularly with respect to future collection against the failure of a tenant's business.

The use of a security deposit for commercial landlords is governed by California Civil Code Section 1950.7. (1) The statute begins by broadly defining a security deposit to include "Any payment or deposit of money the primary function of which is to secure the performance of a rental agreement including an advance payment of rent, made to secure the execution of a rental agreement..."

The advanced payment of rent or the deposit of money is held by the landlord for the benefit of the tenant. While the tenant is typically not entitled to interest on the advanced payment of rent or the deposit of money, under Section 1950.7(b) (2), the claim of a tenant to such a payment or deposit of money receives priority over the claim of any creditor of the landlord, except a trustee in a bankruptcy case.

Section 1950.7(c) limits the application of a security deposit to retrospective damages, which include "those amounts as are necessary to remedy tenant defaults in the payment of rent, to repair damages to the premises caused by the tenant, or to clean the premises upon termination of the tenancy, if the payment or deposit is made for any or all of those specific purposes."

The distinction between retrospective damages and prospective damages are codified in Section 1951.2 of the Civil Code. This Section of the Civil Code specifies the damages a landlord may be permitted to recover based on the early termination of a lease. Rent accrued but unpaid (retrospective damage) prior to the termination of the lease, is automatically allowed under Section 1951.2(a)(i). Future rent loss (prospective damage) is only allowed under Section 1951.2(a)(3) and only if "the amount by which the unpaid rent for the balance of the term... exceeds the amount of such rental loss that the lessee proves could be reasonably avoided" and if the lease so provides.

Section 1950.7(c) also contains an ironclad requirement that a landlord must return the unused portion of the advanced payment of rent or the deposit of money to the tenant within no more than thirty (30) days after the landlord receives possession of the premises. Under the statute, where the claim of the landlord is only for defaults in rent arrearages, then any remaining portion of the payment of rent or deposit of money is due and payable to the tenant no later than two (2) weeks after the date the landlord receives possession of the premises. Where, however, the landlord's claim includes amounts reasonably necessary to repair damages to the premises caused by the tenant or to clean the premises, then any remaining portion of the payment of rent or deposit of money is due and payable to the tenant at a time mutually agreed by the parties, but no later than thirty (30) days from the date the landlord receives possession of the premises.

It is important to note that landlord's obligation under Section 1950.7(c) to return the unused portion of the advanced payment of rent or the deposit of money is without regard to landlord's potential prospective damages defined in Section 1951.2 of the Civil Code, which is typically mirrored in the lease agreement under default provisions.