Real Estate Security Deposit Refund

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					                                                                                        REAL ESTATE
                                                                                          UPDATE
                                                                                        January 2006


            250 L.L.C. V. PHOTOPOINT: WHY SOME COMMERCIAL
                LANDLORDS ARE FEELING INSECURE ABOUT
                          THEIR SECURITY DEPOSITS
A recent California case entitled 250 L.L.C. v. PhotoPoint Corp., 131 Cal.App.4th 703 (2005), presents a
serious threat to the right of a commercial landlord to retain its security deposit post-default. The holding
of PhotoPoint places the mandate of section 1950.7 of the Civil Code1 – that a landlord return the unused
portion of a security deposit within two weeks to 30 days of retaking possession – in front of most other
rules and defenses it may have, even when the landlord’s damages exceed the amount of the security
deposit.

The situation in PhotoPoint was relatively common in the Silicon Valley market during early 2000. The
tenant was required to post a substantial security deposit, in part, in the form of an irrevocable letter of
credit equal to 18 months of base rent. The tenant failed to pay rent and executed a general assignment
for the benefit of creditors – both defaults under the lease. The landlord did not return any of the funds
drawn from the security deposit (about $600,000) and suffered total damages under the lease in excess
of $1.5 million.

The court in PhotoPoint held that the landlord violated section 1950.7 by retaining the security deposit to
cover its damages for future rent owed under the lease on the basis that section 1950.7 allows a security
deposit to be applied only against unpaid rent accruing prior to the date on which the deposit must be
returned pursuant to the statute. The court also held that the security deposit could not be offset against
future rent damages as that would allow the landlord to profit from its violation of section 1950.7.

The court’s decision turned on the statutory language contained in section 1950.7 that a security deposit
could be applied to a tenant’s “defaults in the payment of rent.” The issue was whether “rent” includes
only accrued, unpaid rent (as argued by the assignee for Photopoint) or future rent damages under
section 1951.2 as well as past due rent (as argued by the landlord). The court rejected the landlord’s
position that the statute allows future rent damages on the ground that the landlord cannot accurately
calculate future damages by itself after the tenant’s departure – it can retain the deposit only to cover any
unpaid back rent, but not future breach of lease damages.

Practically, this means that when a tenant defaults and abandons, leaving the landlord with a vacant
premises and no replacement prospect, the landlord is nevertheless required by section 1950.7 to return
the security deposit and separately pursue its damages under section 1951.2 by way of litigation. While
this result may have major economic implications in some current commercial landlord/tenant situations,
the significance of this rule is limited to those tenancies where the lessor holds a security deposit in
excess of any past-due rent obligations. The PhotoPoint court also endorsed a waiver of its holding so

 __________________________
                                                  y
 1 Unless otherwise indicated, all further statutor references are to the Civil Code.
that parties to a commercial lease are free to waive section 1950.7 to provide that a security deposit may
be held and applied against future rent damages.
                                                                REAL ESTATE GROUP
                                                                             UPDATE
For commercial landlords faced with the apparently advantageous position of holding a security deposit
in excess of the amount of past-due rent, there is at least one possible legal alternative for the landlord to
consider in trying to avoid a PhotoPoint type of catastrophe. A landlord may try to rely on section 1951.4
(to recover rent as it comes due without terminating the lease) rather than section 1951.2 as the basis for
holding on to the deposit. The term of the lease in PhotoPoint ended because the landlord terminated
the lease and proceeded under section 1951.2. Many leases provide the alternative remedy of suing for
the rent as it falls due, without terminating the lease, so that the landlord might effectively postpone its
duty to refund the security deposit by keeping the lease in force as long as possible. This strategy may
run into the practical problem of the letter of credit itself expiring before it can be fully drawn down, unless
at the last moment the remainder can be converted into cash and still held as a deposit.

If you have any questions regarding any real estate legal matter, in San Diego please contact Brian
Frasch (litigation) at bfrasch@gordonrees.com or Eric Young (transactions) at eyoung@gordonrees.com
or call us at (619) 696-6700.         In San Francisco, please contact Phil Wang (litigation) at
pwang@gordonrees.com or Bruce Boyd (transactions) at bboyd@gordonrees.com or call us at (415)
986-5900. This Real Estate Update was prepared by Phillip K. Wang of the firm’s San Francisco Office.




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