Under many leases, a landlord will require a tenant to provide security to secure the performance of the tenant’s obligations under the lease. If the tenant breaches the lease or becomes insolvent/bankrupt, the landlord may call on the security to recover all, or some, of its loss suffered as a result.

Usually, security can be provide by way of:

1. Bank guarantee; or
2. Security deposit.

You may think all types of security are equally secure, however, that is not necessarily the case. We explain below the difference between types of security and what steps you can take to further protect your interest in security. You might be surprised to discover that unless and until you ‘perfect’ your interest in a security deposit, it is not secure in the event that your tenant becomes insolvent or bankrupt.

What is a security deposit and how is it different to a bank guarantee?

A security deposit is a cash amount of money paid upfront by the tenant to the landlord as a guarantee against potential losses, damages, or non-performance of the tenant’s obligations under the lease. A security deposit is usually a cash bond deposited directly into a landlord’s bank account or it can be held on trust by an agent or law firm for the landlord’s benefit.

A bank guarantee is a promise by a bank to cover the liabilities of its customer (the tenant) if the tenant fails to meet its obligations under the lease. No money is transferred upfront, instead the bank provides a written guarantee to the landlord on behalf of the tenant.

What is better, a security deposit or a bank guarantee?

There are two primary considerations when deciding what security is best for you:

1. how easily it can be called on (i.e. used) to recover loss; and
2. whether you have a right to call on the security if the tenant becomes insolvent or bankrupt.

Ease of calling on the security

Typically, a security deposit is easier to call on than a bank guarantee because it is a cash amount held by, or on behalf of, the landlord.

Where the security deposit is held by the landlord, the cash can be easily applied to recover loss suffered by the landlord as a result of the tenant. However, there can be disputes regarding whether the landlord properly applied the security (i.e. the tenant could argue it was not in breach and/or the landlord had not suffered loss because of the tenant). Whether these types of disputes arise, and are successful, will often depend on the wording of the security provisions in the lease.

Where the security deposit is held by a third party on behalf of the landlord (like an agent or a law firm), it can be more difficult to call on, depending on who that third party is and the terms of the lease. The third party holding the deposit might refuse to return it for various reasons, leading to potential legal issues or delays in recovering funds.

On the other hand, a bank guarantee may be more difficult and time consuming to call on, because the landlord has to contact the bank and usually satisfy certain conditions before the bank provides the money to the landlord (depending on the wording of the bank guarantee and relevant provisions of the lease). Having said that, provided any conditions are met, the bank is legally obligated to pay the amount on demand.

What happens to security when the tenant becomes insolvent or bankrupt?

When a tenant becomes insolvent or bankrupt, there is often a range of parties who are owed money by the tenant, called creditors. The creditors may be ‘secured creditors’ or ‘unsecured creditors’.

A secured creditor is someone who has been granted security over the entity’s assets. They will have priority to claim amounts owed in insolvency or bankruptcy proceedings. An unsecured creditor is someone who has not been granted security over the entity’s assets and can only claim amounts it is owed after all the secured creditors have been paid. Unfortunately, it is not uncommon that by the time the unsecured creditors are able to be paid out, there is little to no money left. This will depend on the total assets held by the entity at the time of insolvency/bankruptcy and how many creditors there are.

The best way to ensure you are paid what you are owed in these circumstances is to be a secured creditor. So, how do you become a secured creditor?

Becoming a secured creditor

To become a secured creditor, the interest in the security needs to be ‘perfected’ which can be achieved by the nature of the security itself or taking steps to ‘perfect’ the interest in the security.

As outlined in the table below, a bank guarantee is ‘automatically’ perfected by the very nature of the security. The landlord does not need to take steps to become a secured creditor. The enforceability of a bank guarantee is based on the terms of the guarantee itself and the contractual relationship between the parties. So, if a tenant goes into liquidation or bankruptcy, generally only the landlord can claim an interest in, and enforce, the bank guarantee.

In contrast, a security deposit is not ‘automatically’ perfected, meaning, unless and until the landlord takes steps to perfect it, the landlord is an unsecured creditor in a tenant’s bankruptcy/ insolvency.

So, what do you need to do to ‘perfect’ an interest in a security deposit?

A security deposit is classified as ‘personal property’ under the Personal Property Securities Act 2009 (Cth) (PPSA). Under the PPSA, there are two ways to perfect an interest in a security deposit:

1. Registration: registering a security interest on the Personal Property Securities Register (PPSR) (often referred to as ‘perfection by registration); or
2. Possession: having actual or apparent possession of the security deposit (often referred to as ‘perfection by possession’).

The best way to perfect an interest in security is to register a security interest on the PPSR. Provided the security interest is registered within the specific timing requirements under the PPSA, it is much more difficult for someone to dispute your interest in the security compared to relying on perfection by possession.

Where you rely on perfection by possession, you need to have actual physical or apparent possession of the security deposit. Without going into the nuisances of ‘possession’, although its ordinary meaning is easy to understand (i.e. if you hold something in your hand, you have possession of it), ‘possession’ for the purpose of the PPSA is not always as straightforward.

Where the security deposit is held by the landlord (i.e. in its own bank account), arguably the landlord has physical possession of the security deposit. However, there is limited case law providing guidance on whether holding a security deposit in a bank account constitutes possession for the purpose of the PPSA. Whether an argument can be made against possession will depend on the terms of the lease and the circumstances in which the landlord holds the security deposit.

Where the security deposit is held on trust (by an agent or law firm), the landlord will not have actual possession over the security deposit. As such, the only way to ‘perfect’ an interest in the security deposit is to register a security interest on the PPSR.

What should I do?

If you have not taken steps to perfect your interest in a security deposit, if the tenant becomes bankrupt or insolvent, you will be an unsecured creditor. In the proverbial line-up for money, you stand behind all the other secured creditors (such as banks) with all other unsecured creditors. Particularly if there are many creditors in line for money, the chances of there being anything left when it’s your turn, is likely to be low.

For security deposits, we recommend you:

1. take the most conservative approach and convert it to a bank guarantee (if the terms of the lease permit); or
2. register a security interest over the security deposit particularly if it is held by a third party for your benefit; or
3. if you hold the security deposit personally, seek legal advice on whether you likely have actual physical possession of the security deposit to constitute perfection by registration.

Before you deal with security, you should:

1. consider the terms of the document governing the contractual relationship between the parties – some leases will only allow for a specific form of security – if it’s not too late, get it amended;
2. ensure you are within the timing requirements to register a security interest – if you fail to register within the prescribed time, you may lose your priority as a secured creditor; and
3. seek independent legal advice.

If you would like guidance on how to best protect your interests in security, including reviewing the terms of the lease concerning the rights to have security, please contact Mahoneys commercial Partner, Antony Harrison on (07) 3007 3777 or aharrison@mahoneys.com.au

Written by Antony Harrison

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