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Handling commercial security deposits.

Handling commercial security deposits

Commercial landlords often overlook the statutory obligations imposed on them when they hold and transfer tenants' security deposits, with potentially serious consequences. A commercial landlord holds security deposits subject to Article 7 of the New York General Obligations Law ("GOL"). Failure to comply with the GOL may, in some cases, result in the landlord's forfeiting its rights to the deposit even if the tenant has defaulted on a lease obligation. By setting up its accounts properly, a landlord can protect its right to apply the funds for their intended purpose.

Landlord's Requirements

Section 7-103 of the GOL, which applies to both security deposits and prepaid rent, requires that, until repaid to the tenant or applied against a tenant's lease obligations, security deposits and prepaid rent be kept in a segregated account and not be commingled with "personal moneys" of the landlord. Personal moneys includes general bank accounts used for the landlord's business operations.

There is no requirement that the landlord maintain separate accounts for each tenant's security deposit or prepaid rent, nor are they required to be kept in interest-bearing accounts. However, if the terms of the lease require the funds to be kept in an interest-bearing account, or if the landlord otherwise does so, the landlord holds interest in trust for the tenant. Unless the lease specifically gives the landlord the right to maintain the interest as part of the security, interest shall paid annually to the tenant, subject to the landlord's right to retain a one percent (1 percent) administrative fee.

If the landlord deposits the security deposits with a bank, the GOL further requires that the bank must be located either within New York State or outside of New York State (as long as the out-of-state bank has a duly authorized office within New York State). In practice, however, landlords generally hold the funds wherever convenient, and this requirement is not enforced. Nevertheless, the landlord must notify the tenant in writing of (a) the name and address of the bank and (b) the amount of the deposit. Moreover, it may be prudent for a landlord to strictly comply with the statute so as not to give a court any basis to disallow its claim for a security deposit or prepaid rent merely because of a technical violation of Article 7 of the GOL.

A tenant cannot waive any of the provisions of Section 7-103 of the GOL. Such waiver is absolutely void.

Result of Noncompliance

As long as the landlord complies with the GOL, it may apply the security deposit or prepaid rent in accordance with the terms of the lease upon a tenant's default. Of particular importance to the landlord in today's economic environment, is the landlord's right to apply the security of a bankrupt tenant against unpaid rent. Generally, if a tenant makes an assignment for the benefit of creditors or files for bankruptcy, the landlord has the right to (a) set off amounts held as security against the tenant's lease obligations and (b) reject the demands of the assignee and the trustee in bankruptcy for the return of the security deposit or prepaid rent. In the Matter of Pal-Playwell, Inc., 334 F. 2d 389 (Second Cir. 1964); In the Matter of Perfection Technical Services Press, Inc., 18 N.Y. 2d 644, 273 N.Y.S. 2d 71 (1966); Glass vs. Janbach Properties, 73 A.D. 2d 106, 425 N.Y.S. 2d 343 (Second Dep't. 1980).

However, if the tenant files for bankruptcy and the landlord has commingled the funds in violation of Section 7-103 of the GOL, such commingling transforms the landlord from a protected or "secured" creditor to an unsecured creditor of the tenant, and in such case, courts have granted the assignee or trustee the right to recover such funds from the landlord, In re Spinelli, 36 Bkcy. Rptr. 819 (E.D.N.Y. 1984); In re Radiant Systems, 253 F. Supp. 776 (E.D.N.Y. 1965). It is important to note, though, that courts will respect the landlord's right of set-off with respect to security deposits or prepaid rent which were at one time commingled, but are later segregated by the landlord if (a) such segregation occurs Prior to an assignment for the benefit of creditors or the commencement of a bankruptcy proceeding and (b) the landlord's commingling was inadvertent as opposed to a deliberate disregard of the law. A court will not allow a landlord who segregates after such assignment or bankruptcy to oppose an assignee's or trustee's claim for return of such security. In re Spinelli, 36 Bkcy. Rptr. 819 (E.D.N.Y. 1984).

Given the relative ease of compliance with the requirements of Article 7 of the GOL, and the harsh consequences of forfeiture due to noncompliance, landlords should make sure tenants' security deposits and prepaid rent are handled properly.

Anthony Casareale is a partner, and Connie Kam is an associate, in the New York office of Pircher, Nichols & Meeks, a firm specializing in real estate transactions with offices in Los Angeles, New York and Chicago.
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Title Annotation:Insider Outlook
Author:Kam, Connie
Publication:Real Estate Weekly
Date:Jun 12, 1991
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