Suspend ‘Burn Off’ of Security Deposit if Tenant Defaults

Issue to Negotiate

Your lease requires the tenant to give you a security deposit. Should you let the security deposit burn off—that is, decrease—over time so that it's eventually eliminated during the lease term?

Owner's View

You don't want the security deposit to burn off. You rely on it to protect your interests if the tenant defaults under the lease. A security deposit that keeps decreasing and then disappears can't protect you. So the security deposit must stay at its original amount, or greater, during the entire lease term.

Tenant's View

A tenant will argue that it needs money for its business operations, so the security deposit, which ties up vital resources, should be eliminated or burned off over time. Also, the tenant may point out two reasons why you would need a security deposit only at the beginning of the lease.

First, the tenant hasn't yet proven that it will make payments faithfully. But once it proves itself, there's no need for you to keep its security deposit, as it's unlikely that the tenant will suddenly turn into a deadbeat.

Second, you may have spent lots of money on tenant improvements that would be of little value to another occupant that takes the space after the tenant defaults. So you'd need the security deposit as a protection early in the lease term to avoid taking a big financial hit on the improvements if the tenant then defaults. But that protection isn't necessary as the lease term progresses, because the tenant will have repaid the amortized cost of the tenant improvements as part of its rent.

Compromise

To avoid disputes with the tenant on this issue, offer this compromise: Agree to let the tenant's security deposit burn off. But suspend the burn-off for a set period of time if the tenant defaults, suggests Orlando, Fla., attorney Stephen W. Snively. After the suspension period ends, the burn-off schedule will resume where it left off, he says. The more times the tenant defaults, the longer the resulting suspension period will be, he adds.

This compromise benefits the tenant because you're letting its security deposit burn off. And you benefit because the security deposit stops decreasing when you need it most—when the tenant has defaulted. This arrangement may also give the tenant an incentive not to default.

To properly and fairly set up this compromise in your lease, we'll give you a checklist of seven points to include in your lease's security deposit clause. Some of those points assume that the tenant will give you a letter of credit as a security deposit. All of the points are covered in the Model Lease Clause on p. 7 that you can adapt and use in your lease.

Include Seven Points in Security Deposit Clause

Set Out Security Deposit's Burn-Off Schedule

Start by setting out the schedule for the security deposit burn-off, including its elimination date, says Snively [Clause, par. a]. For example, a burn-off period could be 10 years, during which time the security deposit will be reduced by 10 percent of its original amount per year.

Suspend Burn-Off Schedule if Tenant Defaults

State in the lease that if you determine in good faith that you need to draw more than a set dollar amount—say, $10,000—from the security deposit to help cure a tenant's default, then the burn-off schedule will be suspended for a set period of time. Once the suspension period ends, the burn-off schedule will resume where it left off.

How long should the suspension period last? The answer depends on how many times the tenant has defaulted, says Snively. The first time the tenant defaults, the suspension period should last at least one year. Snively likes to measure the suspension period to the anniversary of the lease or rent commencement date. For instance, you could say in the lease that the suspension period will last until the second anniversary of the rent commencement date occurring after the default date [Clause, par. e(i)].

Example: The lease's rent commencement date is Jan. 1, 2006. The security deposit is $1 million, which will burn off by $100,000 per year. The tenant defaults in May 2007. If the tenant hadn't defaulted, the security deposit would have decreased on Jan. 1, 2008, to $800,000 [$1 million - (2 years x 100,000)]. But the tenant's default suspends that decrease, and the tenant must wait an additional year—that is, until Jan. 1, 2009—for the security deposit to decrease to $800,000.

The second time the tenant defaults, the suspension period should last at least two years, says Snively. For instance, you could say in the lease that the suspension period will last until the third anniversary of the rent commencement date occurring after the default date [Clause, par. e(ii)].

Example: Continuing our example, the tenant defaults for a second time in September 2010. The security deposit should have decreased on Jan. 1, 2011, to $600,000 [$1 million - (4 years x 100,000)], but the tenant must wait two extra years—that is, until Jan. 1, 2013—for the security deposit to decrease to $600,000.

Block Suspension if Minimum Amount Not Met

The tenant will likely want to block the suspension of the burn-off schedule if you've had to draw only a small amount of money from the security deposit to cure its default. So agree that the burn-off schedule won't be suspended if you draw less than a minimum amount (say, $10,000) from the security deposit, says Snively [Clause, par. e(iii)].

Let Tenant Substitute Letter of Credit as Security Deposit Decreases

Suppose the tenant gives you a letter of credit (L/C) to keep as the security deposit. If the security deposit has been burning off, the tenant will likely request the right to get back the original L/C and substitute a new L/C in the decreased amount, says Snively [Clause, par. b]. That's a reasonable request to agree to.

Hold Excess L/C Proceeds in Escrow

If you've drawn on the L/C because the tenant has defaulted and the proceeds from the L/C are more than you need to cure the default, get the right to hold the excess L/C proceeds in an interest-bearing escrow account, says Snively [Clause, par. c].

Return Portion from Escrow Exceeding Decreased Security Deposit

If the amount of excess L/C proceeds is greater than the amount of the security deposit required to remain at that time, give back to the tenant the portion that exceeds the required amount of the security deposit. For example, if you have $75,000 in escrow, but the security deposit burns off to $50,000, you'll give $25,000 ($75,000 - $50,000) back to the tenant, says Snively. But don't give back that portion if the tenant is in default, because you may need to use it to cure the tenant's default, he adds [Clause, par. c].

Return Remainder of Security Deposit at End of Burn-Off Schedule

Give back any remaining portion of the security deposit you still have when the security deposit is due to be eliminated, says Snively. But make sure you don't have to give back that remainder if the tenant is in default of the lease at that time, he adds [Clause, par. d].

CLLI Source

Stephen W. Snively, Esq.: Member, Holland & Knight LLP, Orlando, FL.