TYGlobe

The two cases recently handled by the author both involve the issue of whether a landlord shall refund the rental deposit. Such issues usually arise from contracts that are not duly performed in full, that is, residential lease contracts terminated before the completion of performance, including termination by agreement (subletting) or termination for breach of contract. Under such circumstances, almost all landlords confiscate the deposit in a one-size-fits-all manner, and may also claim high liquidated damages from the tenant at the same time. Then, should the rental deposit be refunded after all? Even if the tenant has settled all relevant fees and charges when surrendering the leased premises, is the tenant bound to leave the deposit at the arbitrary disposal of the landlord?

In response to this issue, the author has conducted extensive legal research and case retrieval, and found that there is no explicit legal provision on the nature of deposit. Whether the deposit shall be refunded cannot be generalized; instead, the nature of the deposit shall be analyzed in combination with the stipulations on deposit specified in the housing lease contract concluded between the landlord and the tenant. In practice, it mainly falls into the following circumstances:

I. The deposit is in the nature of liquidated damages.

Under such circumstances, lease contracts generally provide as follows: "Where the lessee commits a breach of contract, it is agreed that the rental deposit shall be forfeited, and the lessee shall pay a specified amount of liquidated damages." Or the contract may stipulate that: "Where the lessee commits such breaches as early lease termination, unauthorized sublease, damage to the leased premises or rent payment default, the lessor shall be entitled to forfeit the rental deposit. If the deposit is insufficient to offset the losses sustained by the lessor, the lessee shall make compensation for the shortfall."

For example, in Case (2018) Hu 02 Min Zhong No. 3981, the court held that: "Although Jinshengfa Company failed to pay the deposit, the stipulation in the lease contract that the method of bearing liability for breach of contract upon rescission of the contract is forfeiture of the deposit shall be deemed as an agreement on the amount of liquidated damages, that is, if the contract is rescinded due to one party's breach of contract, the breaching party shall pay RMB 20,000 in liquidated damages to the other party."

In the case (2022) Yue 01 Min Zhong No. 27148, the court held that: "Pursuant to Paragraph 3, Article 5 of the contract, Qu Yuqiang shall double refund the deposit of RMB 8,800 to Fan Youquan and pay the investment loss of RMB 10,000. With regard to the loss of rental profits, as mentioned above, the double return of deposit and compensation for investment profit loss agreed by the two parties in the house leasing contract actually set out the liability for breach of contract and compensation for losses in the event of the lessor's breach of contract."

Does it mean that the landlord shall have the right to directly forfeit the deposit once the deposit is determined to be of the nature of liquidated damages? The answer is negative. Where the deposit is characterized as liquidated damages, whether the landlord may forfeit the full amount of the deposit, or whether the landlord may concurrently claim liquidated damages after forfeiting the deposit, shall be determined in light of specific circumstances.

It is generally recognized that liquidated damages perform dual functions: first, the compensatory function, that is, to compensate the non-breaching party for losses incurred by the other party's breach of contract; second, the punitive function, that is, to urge the parties to perform the contract in good faith. While the people's court respects the party autonomy of the parties (i.e., the liquidated damages clauses stipulated in the contract), a relevant party may request the people's court to adjust the liquidated damages downward if they are excessively high. In judicial practice, the determination of whether liquidated damages are excessively high shall be mainly based on the following factors: the actual loss of the non-breaching party, the degree of fault of the breaching party, expected interests, and the performance status of the contract. Specifically in disputes over housing lease contracts, if both forfeiture of the security deposit and payment of liquidated damages as compensation are agreed under the contract, the liability for breach of contract to be assumed by the tenant may be excessively high. Upon the request of the tenant, the people's court will usually make adjustments in accordance with the actual circumstances.

For example, in Case (2018) Hu 01 Min Zhong No. 1648, the court held: "Expo Bailian Co., Ltd. requires Yunhao Co., Ltd. to bear the liquidated damages for contract termination, which are calculated based on the amount of 6 months' rent and property management fees, and such requirement complies with the stipulations of the contract. Yunhao Co., Ltd. raises the defense that the liquidated damages are excessively high. In this regard, the court holds that whether the amount of liquidated damages is excessively high shall be determined by taking into account comprehensive factors including the performance of the contract, the degree of fault of the parties and expected interests. At present, on the premise that Expo Bailian Co., Ltd. has forfeited the relevant rental deposit, the court of first instance has discretionarily adjusted the liquidated damages to RMB 585,520.84."

II. The deposit is by nature a security for the performance of the lease contract.

Under such circumstances, the lease contract generally stipulates that: "Upon expiration of the lease term, after the lessee settles all payable expenses, or after the outstanding expenses are deducted from the rental deposit, the lessor shall refund the rental deposit in a lump sum without interest on the date of lease surrender." That is to say, under such stipulations, the lessor has no right to deduct the deposit directly. Where the corresponding reasonable expenses have been deducted or the lessee has borne the liability for breach of contract, the lessor has lost the contractual basis for continuing to possess the deposit and shall refund the deposit accordingly.

For example, in Case (2017) SPC Civil Retrial No. 53, the court held that: "On the issue of deposit return. Pursuant to the agreement reached by both parties, the Woolen Mill shall refund the deposit within one month after the expiration of the contract provided that Jinli Laiyuan Company has no arrears in rent, utility expenses and other relevant fees. In terms of nature, the deposit involved in this case has the attribute of securing Jinli Laiyuan Company's timely performance of contractual obligations such as rent payment. In view that this Court has confirmed the termination of the *Commercial Building Lease Contract* signed by the two parties, and meanwhile ordered Jinli Laiyuan Company to perform the obligation of paying the outstanding rent to the Woolen Mill and bear the corresponding liability for breach of contract, the Woolen Mill has no contractual basis to continue retaining the deposit paid by Jinli Laiyuan Company. Therefore, this Court upholds the retrial claim of Jinli Laiyuan Company requesting the Woolen Mill to return the deposit."

In the case (2023) Jing 03 Min Zhong No. 4019, the court held that: "The lease term agreed by the two parties under the contract is from September 17, 2020 to September 16, 2021. Du Xichen vacated the leased premises on March 15, 2021. Du Xichen moved out of the house within the contract term due to his self-purchase of a residential property, which violates the contractual agreement and constitutes a breach of contract. However, the agreement signed by the two parties does not stipulate that the deposit shall not be refunded under such circumstances, nor does it stipulate that the deposit shall be collected by the lessor as liquidated damages. As Du Xichen has paid off all relevant expenses incurred during the lease term, Xu Qing shall refund the deposit of RMB 5,700 to Du Xichen. Therefore, the litigation claim filed by Du Xichen for Xu Qing to refund the deposit of RMB 5,700 is upheld by the court."

III. The nature of the deposit is a performance bond.

Except for the aforesaid circumstances, where the landlord and the tenant fail to stipulate the nature of the deposit or the disposition of the deposit on some occasions, the deposit shall generally be deemed as performance security, which refers to a certain sum of money paid by the tenant and held by the landlord to guarantee the performance of the tenant's obligations. Where there is any remaining amount after the deposit is used to discharge the relevant debts owed by the tenant, the remaining amount shall be returned.

For example, in Case (2016) Min 06 Civil Final No. 2433, the court held that: "In the present case, the RMB 10,000 security deposit paid by Han Moumou to Wang Moumou is in the nature of a performance bond, which is intended to ensure that Han Moumou performs his obligations in accordance with the contract during the lease term. The original judgment characterized the aforesaid RMB 10,000 security deposit as earnest money, which constitutes an incorrect determination of its nature. Furthermore, the lease term agreed upon in the involved contract has not yet expired, and it remains uncertain whether Han Moumou will commit any breach of contract during the remaining performance period. It is improper for the original judgment to directly order Wang Moumou to return the RMB 10,000 security deposit upon the expiration of the contract. Pursuant to the stipulations of the contract, the security deposit shall be returned by Wang Moumou after Han Moumou fully performs his contractual obligations upon the expiration of the contract term. However, since Wang Moumou did not file an appeal, This Court will not alter the handling of the RMB 10,000 security deposit as rendered in the original judgment."

In Case (2018) Su 01 Min Zhong No. 3033, the court held that: The security deposit agreed upon in the lease agreement is in nature a security for the performance of the lease contract, whose scope of security covers unpaid rent, relevant expenses and the liability for breach of contract to be assumed. Since both parties to this case have filed separate lawsuits concerning the unpaid expenses and liability for breach of contract, and neither party has claimed to offset the aforesaid amounts against the security deposit, the appellee's claim for return of the security deposit shall be upheld.

In Case (2016) Yue 06 Min Zhong No. 1675, the court held that: "With regard to Tang Moumou's claim for Zeng Moumou to refund the deposit of RMB 6,000: as the two parties did not make specific stipulations on the handling of the deposit in the contract, Zeng Moumou's claim to forfeit the entire deposit on the ground of Tang Moumou's breach of contract lacks contractual basis. Meanwhile, in the absence of special stipulations between the parties, the nature of the deposit under an ordinary lease contract is a certain amount of money prepaid by the lessee to the lessor to guarantee the performance of his contractual obligations. In the event that the lessee breaches the contract, the deposit shall be used to discharge the lessee's unfulfilled monetary debts and compensate for the losses caused to the lessor. Where the deposit is insufficient to discharge the lessee's debts, the lessee shall pay off the remaining debts. Where there is a surplus after the deposit is used to discharge the lessee's debts, the lessor shall return the surplus to the lessee."

Based on the foregoing analysis, the author holds that the landlord is not entitled to directly deduct the security deposit in all circumstances. Where the parties do not stipulate that the landlord has the right to forfeit the security deposit, the landlord shall return the security deposit to the tenant after the tenant settles all relevant fees. Where the parties stipulate that the security deposit is in the nature of liquidated damages, if the amount of such liquidated damages is excessively high, the tenant may request a downward adjustment of the liquidated damages to minimize their own losses to the greatest extent possible. The author hereby also reminds the public that special attention shall be paid to clauses on security deposit, liquidated damages and other related terms when signing a lease contract. The stipulation of the security deposit clause determines whether the tenant can ultimately claim the refund of the security deposit from the landlord. In the meantime, the public is reminded that when paying rent, security deposit, water and electricity fees, they shall clearly specify the nature of each payment in the remarks section, and properly retain relevant payment vouchers to avoid falling into deposit traps.

Links to Relevant Legal Provisions:

Article 584 of the Civil Code of the People's Republic of China provides that where a party fails to perform its contractual obligations or the performance of its contractual obligations does not conform to the agreement, thereby causing losses to the other party, the amount of compensation for losses shall be equivalent to the losses incurred as a result of the breach of contract, including the benefits obtainable upon the performance of the contract; however, such amount shall not exceed the possible losses caused by the breach of contract that the breaching party foresaw or ought to have foreseen at the time of the conclusion of the contract.

Article 585 of the Civil Code of the People's Republic of China stipulates that the parties may agree that where one party commits a breach of contract, it shall pay a certain amount of liquidated damages to the other party in light of the circumstances of the breach, and may also agree on the calculation method for the amount of compensation for losses arising from the breach. Where the agreed liquidated damages are lower than the losses incurred, the people's court or arbitration institution may increase the same at the request of the concerned party; where the agreed liquidated damages are excessively higher than the losses incurred, the people's court or arbitration institution may appropriately reduce the same at the request of the concerned party.