Of Security Deposits and Reserve Accounts
Looking at the details of rent-to-own transactions can be a useful exercise. At the least it can remind dealers of the compliance issues that surround the industry. At best it may yield insights into developing better ways of doing business, better transactions and better customer relations.
Two items that bear a faint resemblance to one another are front and center in this piece: security deposits and reserve accounts. Although traditional brick and mortar RTO dealers might have never used either in their agreements, both exist in the industry—especially in some of the emerging RTO channels, and are therefore worth a look.
While security deposits are ubiquitous in some parts of the consumer rental universe, in real estate leases for example, they have only rarely been employed in brick and mortar TV, appliance and furniture RTO stores. One reason is that dealers deemed it a marketing advantage to allow customers to go home with the product having paid as little up-front as possible. “$10 delivers” has been a popular advertising campaign from time to time. That strategy made for a lot of deliveries, and when employees were given bonuses based on deliveries, everybody was happy except for the delivery folks who ended up going back out and picking up most of those $10 deliveries, often after only a week or two, when the real rental rate kicked in. Customers who got product with little or no personal investment often didn’t get very far along in the deal.
Whatever was included in the initial payment—first rental payment, processing or administrative fee, delivery, and any other optional services the customer chose—loading a security deposit into first payments only makes the deal harder to close, because the customer must dig deeper and come up with more money. It’s easy to close a $10 deal. It’s harder when it is a $110 deal.
Security deposits are, of course, payments customers make to secure their obligations under the agreement. If a dealer has been able to get a security deposit from the customer, it is not revenue for the company, but it is money the dealer can grab if the deal ends with the customer owing back rent or if the property is returned damaged beyond normal wear and tear.
If the customer returns the product in perfect condition and does not owe any back rent or any other amounts on the account, then the dealer must return the deposit in due course. Security deposits are almost always refundable, and should be labeled and explained as such. If they for some reason are non-refundable, then the deposit would have to be added into the total RTO cost for ownership and be subject to any limits on that amount. In addition, payments would become unequal, the first being larger than subsequent payments because of the deposit, which if nonrefundable becomes a payment, and that could create issues under the Internal Revenue Code definition of RTO transactions, which call for level payments.
There are few rules in the RTO statutes governing security deposits. The California law limits the size of any security deposit to one month’s rental payment. The law goes on to require dealers to return the security deposit, less any amounts the customer may owe, within two weeks after the return of the property. Finally, the dealer must give the customer an “itemized and detailed” statement of any amounts being withheld from the deposit. This is akin to landlord-tenant laws regulating security deposits in most states.
Other state RTO statutes acknowledge the possibility of a dealer taking security deposits without attempting to regulate them in any way. Some state RTO statutes do not reference security deposits at all. The absence of any security deposit language in the RTO statute has given rise to a class action lawsuit in West Virginia. Plaintiffs are arguing that because they are not specifically authorized in the statute, security deposits in RTO transactions are prohibited in the state.
A similar issue arose in South Carolina several years ago when the Department of Consumer Affairs challenged a rental company’s use of optional liability damage waivers (LDW). The state argued that fees for LDW were not specifically authorized in the statute and were therefore prohibited. The case went all the way to the South Carolina Supreme Court where the rental company won. The Department threw some Latin at the Court, “expression unius est exclusion alterius,” which means “to express one thing implies the exclusion of another or the alternative.” This doctrine does indeed exist in the law, which is why contracts listing things to be included in the deal often read, “… including, but not limited to….” The South Carolina RTO statute does have a list of “other charges” with fee limits for each, but nowhere does the statute provide that the fees listed are the only ones that may ever be offered or assessed in an RTO transaction. West Virginia has a similar list of permissible fees, but once again the law does not state that those are the only fees that can be charged. In fact, the West Virginia statute says that an RTO transaction may not “require any initial payment for the first rental period except the payment for the first rental period, taxes, insurance or delivery fees and other disclosed fees or fees authorized by this chapter.” The plain reading of this provision indicates that in addition to the fees and charges enumerated, dealers can also charge other fees as long as either they are disclosed in the agreement or authorized in the statute.
Since the security deposits in question were disclosed in the agreement, the rental company should ultimately prevail. As of this writing, the matter is still pending. That class has not yet been certified.
Outside of the RTO statute themselves, a couple of states have laws regulating security deposits taken by lessors of personal property. New York State has a statute requiring a lessor to keep security deposit money in a separate account, and the interest earned, if any, belongs to the lessee. If the deposit is $750 or more, the money must be placed in an interest-bearing account in a New York State banking institution (NY CLS Gen Oblig. Section 7-101). Illinois enacted the Consumer Deposit Security Act of 1987 (815 ILCS 165/1), which law only applies to consumer lease with an initial term longer than four months. Finally, there is a West Virginia statute that applies to out-of-state lessors who take a deposit from a West Virginia resident before the property is delivered to the customer. Think of special order furniture with the ultimate delivery scheduled for several months in the future. The out-of-state lessor may require a deposit that the customer would lose if he were to change his mind before the property was delivered. That deposit, by law, must be kept in a separate account in a West Virginia bank until the property is delivered (WV Code, section 45-1-7).
Security deposits are more prevalent in the musical instrument and portable building rental businesses than in the TV, appliance and furniture rental world. Some music merchants offer customers a choice of either agreeing to allow recurring charges for rental payments on a credit or debit card or provide money up-front such as a security deposit if the customer does not want recurring charges on a card. In the shed rental world, dealers will often get a security deposit equal to one month’s rent. A few dealers have been labeling those funds, “first and last months’ rent” which is a misnomer and a bad idea, since, of course, the customer in an RTO transaction is never obligated to make the next payment, much less the “last payment,” and the use of such language cold be confusing to customers. It is often a challenge in the shed rental industry to keep clear the distinction between buying a shed and renting a shed. Sloppy language can add to the challenge. Better to call the extra payment what it is, a refundable security deposit, and explain when and how the deposit is to be refunded.
Now, in the immortal words of Monty Python, for something completely different: up-front deposits to reduce total lease cost. Apparently, shed dealers had at least a few customers who wanted to pay some money up-front on a rental deal and get their rental payments reduced. For example, suppose the cash price for the shed is $3000 and it rents for $140 for 36 months under an RTO transaction with a total cost of $5040, if the customer goes to term. The customer has $1000 cash that he wants to put in the deal up-front. Shed dealers have been carefully schooled that there are no “down payments” in RTO. They nonetheless wanted a way to take the money the customer was offering and were willing to lower rental payments accordingly. The answer seems to be creating a reserve account for the customer and holding the $1000 in reserve. Since the amount in the reserve is one-third of the cash price, the shed dealer is willing to reduce rental payments by that amount, and so rental payments drop from $140 to $93 per month. Paying $93 per month and then finally tendering the amount in reserve to the dealer to ownership of the shed results in lowering the total cost from $5040 to $4348. So, the customer saves money month by month, and also pays less overall to obtain ownership of the shed. The risk to the dealer, of course, is that if the shed comes back, in which case the dealer must return the money in the reserve account to the customer, less any amounts past due. If that occurs the dealer loses $47 for every month that the shed is out on rent. That has been a risk worth taking for most shed rental dealers, since, in their view, a customer who puts up real money in reserve has real personal investment in the deal and will work hard to keep up payments and acquire ownership. Reserve accounts have worked well and still work well, seemingly, everywhere but in Indiana. In Indiana, the Department of Financial Institutions, with regulatory authority of RTO companies, audits every rental store in the state every year. The Department grew frustrated trying to audit reserve accounts due to inadequate bookkeeping and as a result in 2015 it was able to get the RTO statute amended to prohibit the use of reserve accounts in RTO transactions. Life has continued swiftly in Indiana.
One may rightfully ask why a customer with a spare $1000 lying around would want to rent a shed. Why not just buy the thing outright and pay less? The answer is probably that the customer still needs to come up with another $2000 to buy the shed and for any number of reasons, he or she may not have that much at their disposal and there may not be anybody out there who wants to loan them that kind of money. These kinds of reserve accounts may not work everywhere, but they seem to fit comfortably within the RTO statute in any number of states. Shed dealers do generally disclose the regular rental rate, the rental rate with money put into reserve, and by how much the total cost is lowered. Shed dealers are simply booking reserve funds in order to hold the money in the customer’s account as opposed to booking them for revenue.
Importantly, there is a huge difference between security deposits and reserve accounts. The lessor can require the former in any amount that the traffic will bear. Lessors cannot require that customers put money into reserve. That choice lies entirely with the customer. Otherwise, any type of required reserve account payment may seem like a down payment and therefore can give the transaction the appearance of a disguised credit sale.
There is in the consumer leasing industry a provision for capitalized cost reduction, think vehicle leases, which is an up-front payment that lowers lease payments. In Regulation M, section 1013.2(f), capitalized cost reduction is defined as “the total amount of any rebate, cash payment, net trade-in allowance, and noncash credit that reduces the gross capitalized cost (the “cash price”)”. But in a consumer lease there is a contractual obligation to make payments for a period of anywhere between 24 to 72 months, over which time the amount of the capitalized cost reduction can be amortized. There is no long-term contractual obligation in an RTO transaction and therefore no period over which an initial payment, however denominated, can be amortized. This means there can be no capitalized cost reduction or any other kind of down payment in a true RTO transaction. Dealers are reminded that long-term leases are not automatically exempt from the Truth in Lending definition of “credit sale,” just because the transaction is labeled a lease. Vehicle leases, for the most part, with or without capitalized cost reductions are true leases because they have such large final balloon payment options at the end of the lease term before ownership can transfer. In an RTO transaction, without the contractual obligation to keep making payments, any kind of up-front payment, beyond an initial rental payment, delivery, processing, and the like, that is non-refundable would likely be challenged as a penalty, and take the transaction out from under Regulation Z’s exclusion of RTO transactions from the credit sale definition. Most RTO dealers understand this. If there are dealers out there who do not understand or who willfully choose to ignore the economic truths surrounding RTO, they are finally in another business and may one day end up being regulated differently from traditional RTO.