A decision from the U.S. District Court for the Southern District of New York should spark the attention of secured lenders whose borrowers hold commercial lessee security deposits.1 The opinion issued by Judge Valerie Caproni, 10FN, Inc. v. Cerberus Business Finance, LLC,2 dismissed a commercial tenant's (the "Tenant" or the "Sub-Lessee") claims of conversion and negligence against the bankrupt sub-lessor's (the "Debtor" or the "Sub-Lessor") executives and unjust enrichment and conversion against the Debtor's secured lenders (the "Secured Lenders") after concluding the Tenant's security deposit was an unsecured loan to the Debtor.
I. 10FN, Inc. v. Cerberus Business Finance, LLC
In 10FN, Inc., the Debtor's predecessor was a lessee under a commercial lease in Chicago, Illinois. The predecessor entered into a sub-lease agreement (the "Sub-Lease") with the Tenant in 2016, pursuant to which the Tenant provided a security deposit of $271,092.87. After the predecessor and Tenant entered into the Sub-Lease, the Debtor purchased the predecessor, and in connection with the acquisition, borrowed funds from the Secured Lenders.3 Under the lending arrangement, the Debtor granted the Secured Lenders "first-priority liens on 'substantially all [of] the Debtor's assets'"4 and executed account control agreements permitting the Secured Lenders to sweep the Debtor's accounts.5 The Debtor subsequently filed a Chapter 11 bankruptcy petition on March 29, 2019. Prior to the Debtor's bankruptcy petition, however, the Secured Lenders swept funds, including "some or all of" the Tenant's security deposit, from the Debtor's accounts pursuant to the cash sweep provisions of the account control agreements. After the Debtor's bankruptcy petition, the Debtor rejected the Tenant's Sub-Lease as permitted under the Bankruptcy Code.6
After the Debtor rejected the Sub-Lease, the Tenant unsuccessfully tried to recover its security deposit.7 On February 18, 2022, the Tenant filed an amended complaint against the Secured Lenders on theories of conversion and unjust enrichment and against the Debtor's executives for conversion and negligence. The court quickly rejected the Tenant's negligence claim against the Debtor's executives after concluding the executives did not owe any duty to the Tenant, an essential component of a negligence claim.8 While the 10FN, Inc. court also analyzed subject matter jurisdiction and certain conflict of laws issues, the court's analysis and discussion of the Tenant's conversion and unjust enrichment claims provide the most impactful lessons for secured lenders.
A. The Court Dismissed the Tenant's Conversion Claim Because Neither State Law Nor the Sub-Lease Required the Debtor to Hold the Security Deposit in Trust.
In its consideration of the Tenant's conversion claim, the 10FN, Inc. court ruled that, although New York law governed the claim, Illinois law controlled the Tenant and Debtor's Sub-Lease.9 Under New York law, the court described conversion as "any unauthorized exercise of dominion or control over property by one who is not the owner of the property which interferes with and is in defiance of a superior possessory right of another in the property."10 The court described the two key elements of conversion as "(1) the plaintiff's possessory right or interest in the property and (2) the defendant's dominion over the property or interference with it, in derogation of the plaintiff's rights."11 To determine whether the deposit could form the basis for a conversion suit, the court looked to the nature of the Tenant's interest in the security deposit, which required an analysis of the Sub-Lease's terms.
The Sub-Lease permitted the Debtor to draw upon the deposit after the occurrence of a default by the Tenant under the Sub-Lease and did not, by its terms, require the Debtor to segregate the Tenant's security deposit or hold it in trust, diminishing the Tenant's arguments that the deposit was held in trust. For additional support, the court next looked to both Illinois state law and the Chicago Municipal Code. The court noted that courts applying local law have found that lessors must hold residential tenants' security deposits in trust, but it did not find any authority stating that commercial tenants' security deposits were subject to similar requirements.12 To the contrary, the court found persuasive authority holding that a lease or state law treating security deposits as loans from the lessee confers upon the lessee the status of unsecured creditor when the lessor declares bankruptcy.13 Here, as the Sub-Lease did not require the Debtor to hold the security deposit in trust and permitted the Debtor to draw on the Tenant's security deposit upon the occurrence of a default by the Tenant under the Sub-Lease, the court held that the Tenant gave the Debtor an unsecured loan.14 As the Tenant was the Debtor's unsecured creditor, the Tenant's only avenue for recovery was to file a claim in the Debtor's bankruptcy case. Accordingly, the court rejected the Tenant's conversion suit against the Secured Lenders.15
B. The Court Dismissed the Tenant's Unjust Enrichment Claim because the...
