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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 that it may seem, particularly with respect to future collection against the failure of a tenant's business. At least one lower court in Santa Clara County, California, entered summary judgment in favor of tenant's assignee for the full amount of the unused portion of the security deposit. While landlords continue to demand and keep as much security deposit as possible, California law clearly restricts the use of security deposits to satisfy retrospective damages.

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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.

The only California appellate authority interpreting Section 1950.7(c) is Public Employees Retirement System ("PERS") v. Winston.3 In PERS, the Court of Appeals for the 1st District held that the statutory language unambiguously provides that the security deposit must be applied against rent arrearages two weeks after the date the landlord receives possession of the premises, notwithstanding the magnitude of landlord's expected prospective damages.

At least one lower court in Santa Clara County entered summary judgment in favor of tenant's assignee for the full amount of the unused portion of the security deposit. In Sherwood Partners, Inc., a California corporation, as Assignee for the Benefit of Creditors of Spinway, Inc. v. Stewart AP, Inc., a California corporation, Case No. CV 799827,4 Superior Court Judge Mary Jo Levinger, in a written but unpublished opinion, stated that "Civil Code Section 1950.7, subdivision (c), determines when and how much of a security deposit a landlord is required to return.As stated in the statute, `the triggering event is the date the landlord receives possession of the premises: There is no requirement that the landlord must take possession; a landlord must merely receive possession, and then any unused portion of the security deposit must be returned either within fourteen (14) days or thirty (30) days, depending upon for what the landlord uses the security deposit."

In Sherwood v. Stewart AP, Sherwood's assignor Spinway, Inc., in April of 2000, entered into a lease agreement with Stewart AP, the landlord. At Stewart AP's request, Spinway, Inc. at the time of the execution of the lease, deposited with the landlord the sum of $2,357,040 as a security deposit. When Spinway Inc.'s business ran into financial trouble in late 2000, Sherwood was brought in as the Assignee for the Benefit of Creditors of Spinway, Inc. Sherwood, as a fiduciary for the benefit of all creditors, demanded the return of the unused portion of the security deposit. Stewart AP refused. Sherwood, sued and brought a motion for Summary Adjudication based on its second cause of action for "Violation of Statutory Duty to Refund Security Deposit." Judge Levinger, based on "clear and unambiguous" statutory language and the holding of PERS, concluded that "there is no triable issue of fact, and the Court can state as a matter of law that a refund of the security deposit was owed and payable on January 7, 2001, in the amount of $1,750,906.13. Plaintiff's motion for summary adjudication is granted for these reasons."

While landlords continue to demand and keep as much security deposit as possible, California law clearly restricts the use of security deposits to satisfy retrospective damages. Especially in an economic downturn, it is not uncommon for landlord's prospective damages to be extensive and at times larger than the security deposit held by the landlord. However, under Section 1950.7, commercial landlords must act cautiously to avoid statutory damages pursuant to subsection (f) of the statute, pre-judgment and postjudgment interest, costs and potential attorneys fees. The bottom line is that the landlord has no legal right to retain the security deposit as collateral for its own prospective damages following the expiration of the statutory deadlines established in Section 1950.7(c). Indeed, the landlord is obligated to surrender the unused portion of the security deposit to the tenant.