A decision by District Judge Valerie Caproni of New York teaches real estate lawyers an important lesson: If the lease does not require holding a security deposit in trust, the tenant can become an unsecured creditor in the landlord’s bankruptcy.
The tenant leased commercial space from the debtor in Chicago and gave the landlord-debtor a $270,000 security deposit. Shortly before the debtor’s chapter 11 filing in New York, the landlord’s secured lenders swept the debtor’s bank accounts, including whatever might have been left of the security deposit.
The debtor rejected the tenant’s lease. When the tenant demanded the return of the deposit as required by the lease, the debtor said there was none to refund following the lenders’ sweep.
The chapter 11 case converted to chapter 7. The tenant sued the lenders and the debtor’s principals in bankruptcy court to recover the security deposit. The complaint made claims for conversion, negligence and unjust enrichment.
The defendants prevailed on a motion to withdraw the reference, allowing Judge Caproni to preside over the defendants’ motions to dismiss for lack of jurisdiction and failure to state a claim. She granted them in full in an opinion on October 18.
Jurisdiction
The defendants contended that the federal court lacked subject matter jurisdiction. The argument failed.
Judge Caproni alluded to dicta from the Supreme Court suggesting that jurisdiction may be broader in chapter 11 than in chapter 7. She said that the Second Circuit has issued no “distinct standard” for “related to” jurisdiction in chapter 7 other than to employ the “conceivable effect” test in a case involving the Securities Investor Protection Act.
So, Judge Caproni employed “conceivable effect” and found several.
If the tenant were to prevail, the tenant’s claim in the debtor’s bankruptcy would decrease, and the lenders’ claim would increase. And if the tenant prevailed against the debtor’s principals, they might have indemnification claims against the debtor.
The court had subject matter jurisdiction.
Claims Dismissed on the Merits
Judge Caproni said that the tenant’s conversion claim rested entirely on the idea that Illinois law requires holding security deposits in trust.
True, an Illinois statute requires landlords to hold residential security deposits in trust, but there is no similar rule for commercial leases. Judge Caproni interpreted Illinois law to mean that the tenant made an unsecured loan to the landlord because there was no requirement about holding the deposit in trust.
Although Illinois governed the condition in which security deposits must be held, Judge Caproni said that New York law governed the tenant’s conversion claims. In New York, conversion requires unauthorized exercise of control over property by someone who is not the owner.
Because the tenant made an unsecured loan, the conversion claim failed. For whatever consolation it might be, Judge Caproni said that the tenant had an unsecured claim against the landlord.
The claims for negligence and unjust enrichment failed for the same reason. Negligence requires a duty, and there was none since the tenant made an unsecured loan. Judge Caproni said that a claim for unjust enrichment will fail if there was a valid contract governing the subject matter.
Judge Caproni dismissed the unjust-enrichment claim because there was a governing lease and therefore no wrongful retention.
A decision by District Judge Valerie Caproni of New York teaches real estate lawyers an important lesson: If the lease does not require holding a security deposit in trust, the tenant can become an unsecured creditor in the landlord’s bankruptcy.
The tenant leased commercial space from the debtor in Chicago and gave the landlord-debtor a $270,000 security deposit. Shortly before the debtor’s chapter 11 filing in New York, the landlord’s secured lenders swept the debtor’s bank accounts, including whatever might have been left of the security deposit.
The debtor rejected the tenant’s lease. When the tenant demanded the return of the deposit as required by the lease, the debtor said there was none to refund following the lenders’ sweep.
The chapter 11 case converted to chapter 7. The tenant sued the lenders and the debtor’s principals in bankruptcy court to recover the security deposit. The complaint made claims for conversion, negligence and unjust enrichment.
The defendants prevailed on a motion to withdraw the reference, allowing Judge Caproni to preside over the defendants’ motions to dismiss for lack of jurisdiction and failure to state a claim. She granted them in full in an opinion on October 18.