Tenant Security Deposit or Unsecured Loan? State Law Disparity Leads to Forfeiture

The plaintiff-tenant commenced the case after a $270,000 security deposit was removed from the debtor landlord’s bank account after the landlord filed for bankruptcy. After the tenant repeatedly attempted to obtain a refund of its security deposit, it filed tort claims against the landlord’s secured lenders for conversion and unjust enrichment and against the landlord for conversion and negligence.

In the case, choice of law was an important issue because while the lease included a provision stating that it “shall in all respects be governed by and construed in accordance with the laws of the State of Illinois”, that governing law provision was not sufficiently broad to encompass the tenant’s tort claims. In its holding, the Court referenced a Second Circuit case “which concluded that a provision stating that an agreement ‘shall be governed by and construed in accordance with the laws of the Commonwealth of Massachusetts’ was too narrow to encompass a fraud claim arising incident to the agreement.” See Krock v. Lipsay, 97 F.3d 640, 645 (2d Cir. 1996). The Court therefore applied New York law to the tenant’s negligence and conversion claims because federal courts typically apply a forum state’s choice of law rules. Nevertheless, the Court clarified that “[a]lthough the Court applies New York law to Plaintiff’s conversion claim, the Sublease (construed under Illinois law) governs the nature of Plaintiff’s interest in the Security Deposit.”

With regard to the tenant’s conversion claim, the Court held that because its claim “rest[ed] entirely on [the] allegation that, under Illinois law, the [landlord] was obligated to hold its Security Deposit in trust and that its failure to do so gives rise to a claim for conversion under New York law,” the tenant failed to state a claim because Illinois law does not require commercial landlords to segregate security deposits or hold them in trust. Instead, according to the Court, the tenant had to seek recovery of its security deposit as an unsecured lender in the landlord’s bankruptcy proceeding and could not proceed with a conversion action against the landlord and the landlord’s secured lenders.

Whereas Illinois law requires that security deposits be held in trust only by residential landlords, New York law requires that security deposits be held in trust by both residential and commercial landlords. See N.Y. Gen. Oblig. Law § 7-103(1). This distinction between Illinois and New York law was critical because if the Court had applied New York law rather than Illinois law (as it did with the tenant’s tort claims arising from the lease) to the tenant’s claim for return of its security deposit, the tenant would have likely prevailed. Cautious tenants should carefully consider the choice of law provisions that govern how their security deposits are held bearing in mind the outcome of this case.

Special thanks to real estate extern Sara Leston for her contribution to this publication.