List Eight Potentially Costly Events that Allow Security Deposit Increase
You depend on a security deposit to give you protection if a tenant doesn't meet its lease obligations. But if certain events occur during the lease, you may discover too late that the amount of the security deposit is too small to adequately protect you. For example, you may agree during the lease to let the tenant change its use, and discover only after the tenant moves out that this change caused damage to the space. If the security deposit is too small, it won't cover the full cost of the repairs.
To better protect yourself, CLLI, with the help of Toronto attorney Harvey M. Haber, San Francisco attorney Richard C. Mallory, and New Jersey attorney Marc L. Ripp, has put together a list of eight events that should trigger an increase in the security deposit. Plus we address how much the security deposit increase should be, when it must be paid, and what you can do if the tenant refuses to pay it. There's a Model Lease Clause on p. 3 that you can adapt and use for your leases that will give you the right to increase the security deposit.
Get Increase Right for Eight Events
Give yourself the right to increase the security deposit if any of the following eight events occurs:
Tenant changes use. The lease is amended because the tenant wants to make a “material”—that is, important—change to its use clause, says Mallory [Clause, par. a(i)]. For instance, instead of an accounting office, the tenant wants to use the space for a print shop. But that new use might result in additional damage to the space (for example, the tenant's heavy printing equipment may cause excessive wear and tear to the floors). So you may need extra money in the security deposit to repair the damage, he explains. Make sure that you alone get the right to determine whether the use change is material, adds Mallory.
Tenant alters space. The tenant performs alterations to the space, says Ripp [Clause, par. a(viii)]. You'll need extra money in the security deposit in case any construction liens are filed on the space or its fixtures or if you need to fix any damage to the space caused by the work, he explains.
Tenant requests transfer of lease or sublet to financially weaker party. The tenant requests your approval of an assignment or a sublet, and you determine that its prospective assignee or subtenant is financially weaker than the tenant, says Mallory [Clause, par. a(ii)]. You'll want extra money in the security deposit because a financially weaker assignee or subtenant is more likely to fail to cover all of its financial obligations to you, he explains.
Tenant's net worth drops. You discover that the tenant's net worth drops below an amount that's acceptable to you, says Ripp [Clause, par. a(iii)]. If the tenant's net worth drops, it may be a sign that the tenant is having financial problems, he warns. To alleviate your concerns about its financial stability, the tenant should give you more security, he says. Then you've got more protection if the tenant later becomes financially shaky, explains Ripp.
Guarantor's or indemnitor's net worth drops. You discover that the guarantor's or indemnitor's net worth drops below an amount that's acceptable to you or the guarantor or indemnitor goes bankrupt, violates the guaranty or indemnity, or dies, says Ripp [Clause, par. a(iv)]. Since the purpose of the guaranty or indemnity is to provide additional security, an increased security deposit can act as a substitute for the guaranty or indemnity if the guarantor or indemnitor can no longer be relied upon, he explains.
Tenant chronically violates lease. The tenant violates the lease more than once during a 12-month period, says Haber. Even if the tenant cures—that is, fixes—its lease violations, increasing the security deposit will teach the tenant that it must pay for its behavior, he explains. That may deter such behavior in the future, he adds.
How many violations must occur within the 12-month period before you can increase the security deposit? Haber usually starts out by saying that a second violation within 12 months triggers the increase [Clause, par. a(v)]. But he'll often agree to a three-default trigger.
Practical Pointer: Don't give in if the tenant argues that your right to increase the security deposit should be triggered only if the tenant doesn't cure the lease violation, says Haber. One reason for using this strategy is to stop the tenant from repeatedly violating the lease and then curing the violation before you can do anything, he explains. Also, don't limit the provision to only material violations, he says. You and the tenant could end up arguing over which violations are material and which aren't, he warns.
Tenant expands space. If you give the tenant an option to expand its space and it exercises the option, say that your security deposit should likewise expand, says Ripp [Clause, par. a(vii)]. Otherwise, the security deposit may be inadequate to protect you, he warns.
Tenant renews lease. If you give the tenant an option to renew and it exercises the option, make sure you increase the security deposit in proportion to any renewal rent hike, says Ripp [Clause, par. a(vi)]. Otherwise, the security deposit may be inadequate to protect you.
How Much Should Security Deposit Increase?
When deciding on how much to increase the security deposit in the previous situations, consider these two approaches:
Hardball approach: Unlimited increase. Start off your negotiations with the tenant with the hardball approach, says Ripp. That is, don't put a specific dollar amount increase in the lease, he says. Instead, get the right to increase the security deposit as much as you see fit if any of the eight events occurs, he says.
To use this hardball approach, say in the clause that you can increase the security deposit by an amount that you've determined, in your sole discretion, is necessary to protect your interests, says Ripp [Clause, par. b].
Practical Pointer: As a precaution, ask your local attorney if the amount of the security deposit increase that you select will be enforceable, says Haber. Otherwise, for example, you and the tenant could later get into a dispute over your demand for a security deposit increase, and a court could rule that your increase is so high that it's an unenforceable penalty, he warns.
Compromise approach: Limited increase. Expect a savvy tenant to balk at the hardball approach because there are no controls on how much you could increase the security deposit, says Haber. The tenant will probably demand some limit on the increase, he says. In response, Haber suggests offering to compromise: After a triggering event, you'll increase the security deposit to a set amount. He suggests that the set amount be three times the original security deposit or three months' minimum rent, whichever is higher.
A savvy tenant may try to negotiate a smaller increase, notes Haber. But keep in mind that you'll want enough security to cover lease violations, rent or space increases, or extra wear and tear to the space if there's a use clause change or alterations damage, he cautions.
When Should Increase Be Paid?
When you're negotiating how quickly the tenant must pay the security deposit increase, consider these two approaches:
Hardball approach: Require immediate payment. Start off your negotiations with the hardball approach, says Haber. Say in your clause that the tenant must pay the security deposit increase immediately, upon your demand, he says [Clause, par. b].
Compromise approach: Give tenant time to pay. A tenant may balk at the hardball approach, claiming that it's unreasonable to require immediate payment, says Ripp. So try this compromise: Give the tenant a few—say, 10—days to make the payment, he says.
Practical Pointer: What form should the security deposit increase take—cash or letter of credit? You may want to require the tenant to pay you in cash if the existing security deposit is in cash, says Ripp. But keep in mind that if a tenant goes bankrupt, you'll have easy access to a letter of credit, but not to a cash security deposit, he warns.
Get Termination Right if Tenant Doesn't Pay Increase
Make sure that you have the right to terminate the lease if the tenant doesn't promptly pay the security deposit increase, says Ripp. This will give the tenant a strong incentive to pay the security deposit on time, he explains. Have the lease terminate within a set time—say, 10 days—after you notify the ten-/ant of the termination. Also, require the tenant to move out of the space within that same time period and pay rent until the lease terminates, adds Haber [Clause, par. c].
CLLI Sources
Harvey M. Haber, QC, LSM: Partner, Goldman Sloan Nash & Haber LLP, 250 Dundas St. W., Ste. 603, Toronto, ON M5T 2Z5; (416) 597-3392.
Richard C. Mallory, Esq.: Managing Partner, San Francisco Office, Allen Matkins Leck Gamble & Mallory LLP, 333 Bush St., 17th Fl., San Francisco, CA 94104-2806; rmallory@allenmatkins.com.
Marc L. Ripp, Esq.: General Counsel, The Gale Company, 200 Campus Dr., Ste. 2000, Florham Park, NJ 07932; marc.ripp@thegalecompany.com.