New Market Means New Legal Issues

Financial fallout alters the importance of legal formulas commercial practitioners once took for granted.

September 1, 2009

All the old sources of legal controversy about commercial properties—from commission disputes to late rent payments—are still keeping commercial real estate attorneys occupied. But the industry's lack of liquidity is putting a new spin on many legal provisions real estate brokers and managers once considered standard.

"Transactions done five years ago didn't foresee today's financial environment. There was an assumption that at some leverage ratio, a property owner would be able to get financing. Today, many borrowers simply cannot roll over their debt into new loans," says Michael Sawyer Smith, who heads the real estate practice at Baker & McKenzie LLP from the firm's Chicago office.

Smith predicts that future loan documents will incorporate extendable due dates so that borrowers won't automatically be thrown into default if a loan comes due when credit markets are locked up.

Cash-strapped limited partnerships are another place where once-boilerplate contract provisions are causes a heightened level of legal friction.

"The penalties in a partnership agreement for not cooperating with a capital call can be quite draconian and allow the partner who can pay to seriously dilute the ownership interest of other parties that can't," says Rick Kranz, a business trial lawyer with Cox, Castle & Nicholson in Los Angeles.

In these economic times, partners sometimes just don't have the extra cash when it's needed for refinancing or operations, so there's "a great deal of controversy," over a clause few expected to invoke, Kranz says.

To lessen the likelihood that partners may try and hold the general partner responsible for cash shortfalls, operating partners should inform all parties early on of any decrease in revenues and keep careful records of how funds are spent. "Partner disputes are ugly battles with no winners. Open and honest communication is the best way to avoid litigation," says Kranz.

Even such routine lease issues as payments for tenant improvements are getting more attention, says Brad Kaplan with Ulmer & Berne LLP in Cincinnati. While provisions requiring landlords to post letters of credit or bonds to cover build-out cost have been common, "they're getting a lot more in the forefront of everyone's mind" because of concerns that owners may not have the funds to pay, says the attorney, who also the editor of The Real Estate Advisor Law Blog at www.realestateadvisorlawblog.com.

Perhaps the ultimate manifestation of the credit crisis in the legal arena is the increasing number of company officers and owners who are risking personally liable for the "deepening insolvency" of their companies, says Smith.

Brokers involved in selling either personal or business real estate for such owners need to be certain that they don't get involved in fraudulent transfers where assets are sold at much less than market value to avoid possible seizure. In such cases, brokers should protect themselves by getting a fair opinion of value and providing comparables to support the sale price.

They should also make sure that the actions of the officer they are working for has been approved by the company's board of directors, advises Smith. Otherwise, the broker could be drawn into any post-insolvency litigation.

The Challenge of Getting Paid

The cash shortfalls facing many sellers and owners of commercial property owners are trickling down to real estate practitioners who represent them—jeopardizing commission payments. If a lender does not fund a loan or maintain a letter or credit, there may not be any money to pay out when that lease commission comes due, says Janis Schiff, chair of Holland & Knight's real estate department in Washington, D.C.

Unfortunately, brokers don't have great options for redress, she says. While many states allow commercial brokers to file a lien on the property for an unpaid commission, "lenders often won't release financing without good title," so filing a lien—which clouds the title—may actually prevent an owner from receiving the funding needed to pay the commission, she explains.

The timing of commission payments in leasing agreements may also change, suggests Smith: "Developers aren't going to assume that the tenant is taking occupancy and so won't want to pay the majority of a leasing commission until the tenant moves in."

These new commission issues are already becoming a basis for dispute between brokers and clients. "It used to be that procuring cause was the main issue in commercial commission disputes. Now our research indicates that many more cases are arising out of the back-end issues—tenants who aren't taking occupancy or who are leaving early," says Andre Sahlin of the Legal Research Center Inc.

The Minneapolis firm recently completed the "Institute of Real Estate Management 2009 Legal Scan," which combines survey data and legal research about 2007 and 2008 court cases affecting commercial leasing and property management. Sahlin found that almost half of the survey respondents consider commissions to be among the top three legal challenges they face. Even such perennial legal disputes as slips and falls on properties are getting a new legal spin thanks to the weak economy. Real estate managers responding to the IREM survey expect to see slip and fall disputes increase as more tenants and visitors to leased property seek settlements as a source of funds in tough times.

Struggling to Get Tenants to Pay Up

Another major issue highlighted in the 2009 Legal Scan is debt collection. Nearly 69 percent of survey respondents stated that collections were a significant current source of disputes with tenants, and more than 84 percent expected that the issue would become more important in the next two years. "It's never been one of the top-ranked legal issues among managers before, and suddenly it's No. 1," Sahlin says.

Deciding just how to go about exercising rights to unpaid tenant debts is also becoming more challenging as it becomes harder to replace tenants who default on rent, says Ed Quigley, an attorney specializing in real estate with Cox, Castle & Nicholson in Los Angeles.

Because filing an unlawful detainer against a tenant behind on the rent terminates the lease, many managers are instead choosing to sue for breach of lease, seeking damages rather than possession. At the same time, managers are pursuing lease guarantors for payment. "That's often a very effective strategy, although getting money from guarantors is also getting harder," Quigley says.

On the reverse side of the negotiation, many retail tenants are looking for any breaches in preleasing agreements that will let them avoid opening a new store, Quigley says. Since the absence of a major tenant can also provide an out for smaller retailers, the impact can be significant and can result in the owners' being in violation of mortgage loan covenants.

The importance of timing in lease default filings for tenants considering bankruptcy also adds to the complexity of collecting unpaid rents, says Smith. If a commercial tenant declares bankruptcy and then rejects the lease, a landlord's judgment for unpaid rents against that tenant is limited by statute to one year's rent or 15 percent of the rent owned during the term of the lease (with a three-year maximum). If a tenant breaches the lease and terminates it before bankruptcy, however, and the landlord files a damage claim, that limitation doesn't apply, greatly increasing the debtor's liability and the owner's chance of collecting, says Smith.

Anticipating the Legal Fallout

It may be months or even years before cases growing out of the current financial turmoil reach the courts. Many may not get that far since the high cost of litigation are prompting parties to look for more out-of-court settlements in these financially challenging times, Schiff says.

"Everyone acknowledges that the asset value has to justify litigation, and these days, a strip center may just not be worth it, agrees Kaplan. Reaching a compromise sooner also has the advantage of securing a settlement while there are still funds available to pay it.

But sue or settle, smart commercial owners and their agents and attorneys are also rethinking and rewriting contracts to mitigate the risks of legal fallout from future financial problems, wherever they may come from.

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