Notes & Comment
Vol. 2005, No. 7
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Commercial Real Estate
Letter of Credit Security Deposits in California
In the good old days of the internet bubble, a common feature in commercial office leases was the landlord's requirement for substantial security deposits, often in the form of cash (one or two months' rent) and a substantial standby letter of credit (LC). The LC was put in place as the landlord's hedge against lost rent (past and future) should the lessee fail before the office lease expires.
But what happens if the lessee does founder, there is substantial time and unpaid downstream rent remaining under the lease, and a large security deposit balance remains under the LC? Under California law, may a landlord use the LC to offset the failed lessee's future rent obligations?
A case from that by-gone era recently handed down by the California Court of Appeal says that those answers depend on the lease language and how the landlord handles things. 250 L.L.C. v. Photopoint Corporation (USA), et al. (No. A105231, First Appellate District, July 28, 2005).
The Facts
250 L.L.C. (250) signed a five year office lease with Photopoint Corporation (USA) (Tenant) in April 2000. The lease required a cash security deposit of one month's rent ($49.5K), and a further deposit of $890K (a sum equal to 18 months' rent) in the form of an irrevocable LC that would decline 20% in value each year during the five year lease term. In March 2001, the LC amount was reduced to $712K, but Tenant immediately ran into financial trouble and failed to pay rent for April, May, June and July 2001.
250 drew against the LC for the equivalent of three months' past due and unpaid rent, and in June 2001, Tenant made a general assignment to Sherwood Partners, Inc. (Sherwood), resulting in a technical default under the lease. In July 2001, 250 drew against the remaining $563K under the LC, and in August, 250 gave Tenant a "notice of abandonment" and a "notice to quit" and began eviction proceedings. In November, Sherwood (Tenant's assignee) sued 250 for return of the security deposit, including the LC funds drawn down that July ($563K). 250 changed its eviction lawsuit into a lawsuit for damages against Tenant for breach of the lease.
The trial court held that 250 did not return the security deposit, as required by the lease and by California law, but also found that 250 was entitled to "set off" its damages for future lost rent against the balance of the LC. The appellate court reversed, ruling that 250 was not entitled to such a set off, and under the circumstances of the case, that both the lease and California law required it to return the balance of the LC.
Return of Commercial Lease Security Deposits under California Law
California Civil Code Section 1950.7 governs treatment of security deposits in commercial office leases. Basically, that law says that security deposits in commercial lease deals must be returned to the tenant within thirty days after the landlord receives possession of the premises, unless they are applied by the landlord to remedy tenant defaults in the payment of rent, to repair damages or to clean the premises. 250 argued that future rent obligations can be swept into this; that even if the tenant was technically not yet required to pay the rent, the landlord was entitled to apply the LC funds against future damages for such unpaid rent. Sherwood argued that the statute (and the lease itself) allowed the security deposit to be used only against current defaults in the payment of rent.
The Court sided with Sherwood, holding that because a security deposit must be returned relatively quickly after tenant's possession ends, the deposit cannot be retained to offset future rent that might come due later. The Court reasoned that future unpaid rent under the lease is either not yet due or is too speculative to calculate. "[I]t is not permissible", the Court wrote, "for a landlord to keep a security deposit beyond the statutory time limit, even if an additional amount [of future rent] is certain to be determined to be due to the landlord thereafter, [nor is it] permissible…to apply the deposit to an unliquidated amount [of rent] that may subsequently become due."
What Could the Landlord Have Done?
The problem caused by California Civil Code Section 1950.7, the Court held, could have been avoided had the parties waived that statutory remedy in the commercial lease. In other words, had 250 and Tenant specifically agreed that 250 could retain the balance of the LC to offset future unpaid rent, the statute wouldn't have applied. However, the lease language tracked almost precisely the wording of California Civil Code Section 1950.7.
The Court also held that 250 could have retained the LC to offset Tenant's future rent obligations as they arise had it not terminated the lease and regained possession. Under California Civil Code Section 1951.4 and provided the lease wording tracks the remedies under that statute, a landlord may basically ignore the tenant's default and abandonment and choose to keep the lease in effect, including the right to recover rent as it becomes due. Had 250 not evicted Tenant and not recovered possession of the premises, had it treated the lease as still in effect, Section 1950.7 (requiring return of a deposit shortly after possession is recovered) would not have come into play and the LC could have been retained and drawn against as unpaid rent became due.
Conclusion
250 L.L.C. v. Photopoint Corporation (USA), et al. and California Civil Code Section 1950.7, the governing statute here, don't prevent commercial landlords from taking substantial deposits in the form of irrevocable LCs and using those instruments to offset future unpaid rent. What the case and the statute say is that commercial landlords must proceed carefully; they must thoroughly evaluate their statutory and lease obligations and consider all options before they take action.
Had the lease specifically authorized 250 to do what it did, the Court would not have had an issue with 250 applying the LC proceeds against unpaid future rents.
Alternatively, had 250 not terminated the lease or retaken possession, thereby invoking the security deposit return provisions of the statute -- had they chosen, instead, to leave the lease in force and collect unpaid rent against the LC as it became due -- the Court also would not have had an issue. While it may be emotionally satisfying to terminate a commercial office lease when the tenant is in default, that may not always be the wisest course to take.
© Matthew Joseph 2005. Law Offices of Matthew Joseph, San Mateo, California, practices in the areas of intellectual property licensing, commercial real estate leasing, and corporate and business transactions. No legal advice is intended by the information provided herein and recipients should independently consult counsel before taking any action related to this subject matter.