Conflict Resolution Between Landlords and Tenants: Strategies for Commercial Landlords

THE REAL ESTATE COUNSELORS NATIONAL CONVENTION
DISNEYLAND HOTEL
ANAHEIM, CA
NOVEMBER 2, 1994

I. INTRODUCTION

II. Commercial Landlord Strategies in Tenant's Market

A. Focus: Alternatives in negotiations or disputes with existing tenants, where tenant stops paying rent and abandons, or threatens to abandon, on the ground that it is paying above-market rent.

B. First Response: Evaluate tenant's situation

1. Review all lease documents to determine "effective" rate

a. Rent structure (was it lower in the beginning with graduated step-ups".)

b. Amount of free rent.

c. Tenant improvement allowance

d. Any other economic concessions?

2. Check lease for:

a. Time left on base term

(1) If significant time left, maybe landlord will be less motivated to "deal" (if tenant is collectible).

(2) If within 18 months of expiration of term, consider negotiating extension.

3. Request updated financial information from tenant and guarantor (financial statements, last two years' tax returns, identification of address and account number for all checking, savings and deposit accounts, last three months' statements from each account) and update credit report for both.

a. Request up-front as a condition to considering request, "as a matter of policy"; when Tenant is requesting favor from landlord, more likely to cooperate on providing this information than after settlement discussions break down.

b. May lay foundation for fraud claim if there are material unexplained inconsistencies between original information and updated information or if it later turns out that tenant misrepresented or concealed information in order to induce landlord to agree to reduced rent.

c. May delay (in good faith) having to deal with tenant's request while it assembles all the information. In the meantime, tenant required to continue paying rent.

d. May identify potential personal or real property to use as collateral to secure tenant's obligations (past or future) or to attach in future legal action.

e. Will assist in evaluating collectability of any future judgments in any future litigation.

4. Evaluate landlord's situation

a. Other potential tenants for space?

(1) Other tenants want to move or expand?

(2) Any potential new tenants?

(3) Economics of any substitute deal

b. Effect of vacancy on project or other tenants? 5. After evaluating tenant's claim and situation and landlord's situation, landlord may be left with tenant who cannot or will not pay full rent, but whom it makes more sense to keep than terminate. Now what? C. Preparing for Tenant "Work-Out" Negotiations

1. Check loan documents or ground lease (if applicable) for:

a. restrictions on landlord's ability to amend lease.

b. restrictions on loan to value.

c. Landlord's breach could trigger default and acceleration.

2. Preface any discussions with statement of confidentiality and make on-going confidentiality an express condition precedent to effectiveness and enforcement of any compromise.

3. Review lease and all amendments to determine what changes would benefit landlord.

a. Review all original landlord concessions and determine if there are any that would be beneficial to "take back".

b. Call attorney to make sure there are no new statutes or cases which would make any modifications desirable. For example,

(1) Subordination, attornment and non-disturbance clause (Dover)

(2) Americans with Disabilities Act compliance obligations

(3) Inclusion of all available statutory remedies

c. Consider asking for extension of lease term.

(1) Will help determine tenant's attitude about future and, accordingly, likelihood of long-range collectability;

(2) Will avoid having to go through another renegotiation when present lease term would otherwise expire;

(3) Could assist in future sale or refinance of property; and

(4) Even if tenant ultimately defaults, increases period of time for which landlord can collect rent.

D. Compromise alternatives

1. Agreement to defer, rather than to forgive

2. Agreement to provide for stipulated judgment to secure payment of back rent

a. file immediately, or

b. hold and file upon default

3. Agreement to require collateral or guaranties

a. deed of trust, or

b. fixture filing

c. before accepting, investigate condition of title, any senior liens and physical condition of any property which might be foreclosed upon.

4. Barter (check with tax advisor re reporting requirements)

5. Percentage rent (primarily for retail)

a. if not already in lease, add

b. if already in, consider lowering minimum rent in exchange for increase in percentage rent

6. Make sure all concessions revoked upon tenant default

7. What if landlord and tenant cannot reach compromise? Evaluate legal remedies.

F. Litigation: The Last Resort

1. When to consider

a. If tenant threatens to abandon or has abandoned

b. If tenant negotiating in "bad faith"

c. If no compromise reached after 30 days of mutual good faith negotiations

2. Preliminary steps

a. Project damage claims

(1) Past rent due

(2) Estimated future rent (until re-let or termination of lease)

(3) Difference between lease rent and market rent through remainder of lease term

(4) Unamortized tenant improvements and broker commissions

(5) Tenant improvements, brokers' commissions and free rent on new deal

b. Have attorney prepare litigation budget

c. Consider value of time of all landlord personnel to administer and participate in litigation

d. Anticipate affirmative defenses and cross-claims of tenant

(1) Fraud (misrepresentations, false promises, concealment)

(2) Breach of quiet enjoyment

(3) Constructive eviction

(4) Breach of contract

(5) Negligent management

e. Evaluate insurance coverage for potential cross-claims

f. Evaluate effect of vigorously enforcing/defending, or not, claims against, or which may be asserted by, other tenants.

g. Perform cost/benefit analysis

3. Advantages

a. Demonstrates landlord's seriousness

b. Avoids loss of time pending compromise discussions

c. Allows landlord to negotiate from stronger position

d. Court-imposed deadlines keeps momentum of discussions from slowing down

e. Positions landlord to seek prejudgment attachment to make sure there's something to collect if wins judgment. Caution: claims must be fore amount which is fixed or readily ascertainable.

4. Disadvantages

a. Requires tremendous expenditure of time, money, effort and emotions

b. May side-track compromise discussions, at least temporarily

c. May irreparably damage landlord-tenant relationship

5. Choice of Remedies

a. CRITICAL: CONSIDER BEFORE SERVING NOTICE TO PAY RENT OR QUIT!!!!

b. Traditional "Get-Tough Remedies

1. Three-day notice (or longer if set forth in lease)

2. Eviction

3. In low vacancy, rising rental market, this made sense

4. In today's high vacancy, declining market, may be mistake

c. If tenant has not yet abandoned premises, but is unilaterally reducing rent payments, consider periodic collection actions

d. If there is some risk that tenant will abandon, or if it has already abandoned, service of 3-day notice can destroy valuable remedies of landlord under Civil Code § 1951.4: ABILITY TO CONTINUE COLLECTING ABOVE-MARKET RENT WITHOUT ANY DUTY TO MITIGATE DAMAGES!!

COMPARISON OF TERMINATION VS. CONTINUATION OF TENANT'S
RIGHTS TO POSSESSION OF THE PREMISES
ConsequenceTermination
CC § 1951.2
Continuation
CC § 1951.4
Landlord has a duty to mitigate damages.Yes.No.
Tenant may re-take possession.No.Yes.
Tenant may submit proposed subtenants and assignees.No.Yes.
If the tenant files a bankruptcy petition, the lease becomes property of the bankruptcy estate.No. However, under certain circumstances the right to relief from forfeiture under state law becomes property of the bankruptcy estate.Yes.
The landlord can recover all of the damages caused by the tenant's breach of the lease and abandonment of the premises in a single action.Yes, including rent and other damages accruing after the date of the judgment.No, unless the lease term ends before the date of the judgment. The landlord can only recover for the rent due prior to the date of the judgment. The landlord may need to file multiple actions.

e. Requirements for landlord to take advantage of Civil Code § 1951.4.

(1) Remedy needs to be provided in lease

(2) Lease must also include language giving tenant right to assign or sublet with landlord's reasonable consent (landlord cannot refuse within sold and arbitrary discretion)

f. Other landlord considerations under 1951.4

(1) Tenant's right to re-take premises

(2) Effect of continuing vacancy

(3) Collectability of tenant or guarantor

III. ANALYSIS OF DOVER DECISION

A. The Dover Decision

1. Facts: Tenant enters into lease containing provision that lease would automatically be subordinate to all fixture financing, unless the lender under such financing notified tenant that the lease should be superior to the lender's lien. Landlord thereafter gets new financing with New Lender for premises occupied by Tenant. New Lender does not notify Tenant that it elects to treat its lease as superior to New Lender's deed of trust. New Lender forecloses and New Owner purchases property at foreclosure sale. Tenant continues to pay rent under lease to New Owner. Tenant tries to negotiate rent reduction with New Owner. After six months of failed discussions, tenant gives New Owner 30-day notice of its intent to vacate even though there are 3 years left on its lease. Tenant vacates and stops paying rent. New Owner files suit against Tenant for back and future rent.

2. Tenant's argument: Foreclosure automatically extinguished Tenant's lease, thereby converting to a month-to-month tenancy.

3. Landlord's argument: Upon foreclosure New Owner had an option, a unilateral right, to pick and choose which leases it wanted to extinguish. Also, tenant's continuing payments served either to ratify the old lease or create a new lease on the same terms of the old lease.

4. Holding: Judgment in favor of Tenant.

5. Rationale: The automatic subordination clause in the lease was enforceable and self-executing without any further act by Tenant or New Lender. Following the non-judicial foreclosure sale, the lease was extinguished and the tenant's interest in the property became a month-to-month tenancy. Moreover, the mere fact that the Tenant continued paying rent under the lease for several months after the New Owner acquired the property could not support the conclusion that Tenant entered into a new lease with the New Owner or that Tenant ratified the old lease.

B. Significance

1. Generally: This result is noteworthy because:

a. it is contrary to previous belief that a purchaser at a foreclosure sale (usually the lender itself) could unilaterally choose which leases it wanted to keep while terminating those leases it deemed undesirable. Under Dover, purchasers at foreclosure sales can no longer "pick and choose" which tenants may remain.

b. Title insurance industry generally would not insure a lender's lien as being prior to a lease based on an automatic lease subordination provision. With Dover, now they might. But industry trend is presently against.

2. For Property Owners.

a. To gain leverage in work-out discussions with lenders:

(1) If property includes above-market leases with subordination clauses, lenders may no longer be able to control decision of which leases to affirm or terminate. Dover could let tenants with above-market leases off the hook. This could make foreclosure remedy less attractive to lender and more inclined to consider work-out alternatives with property owner.

(2) Caveat: Language of lease provision critical. If like Dover, it may give lender right to unilaterally elect to have lease superior to lender's lien and, thus, eliminate any lender concerns on this point.

b. Alternate Method of Effecting Subordination of Leases:

(1) Often difficult, time-consuming and expensive to get tenants to agree to and sign subordination agreements. With Dover, landlords can put automatic subordination provision in their lease and not have to make this a negotiating point with tenants.

c. To terminate below-market leases: In Dover, the tenant used the automatic subordination language as a "shield" against enforcement of their above-market leases. However, this case could help purchasers of property at foreclosure sales. That is, a new owner could try to use the case as a "sword" to terminate a below-market lease after foreclosure. This specific issue was not before the Dover court and, therefore, it did not rule on this issue. However, it did include language in its decision which would support to such a position in future cases.

(1) Caveat: Title company may not insure lender's priority with such a provision if no independent subordination agreement signed by tenant.

(2) Caveat: If include such a provision, should include non-disturbance language or Court may refuse to enforce.

d. To make sure its leases are financeable:

(1) May need to include language so that lender can retain unilateral right to terminate.

(2) May need to include language which, at a minimum, provides for continuance of an approved lease so long as tenant is not in default.

e. Recommended Action:

(1) If property owner is anticipating or conducting work-out discussions with lender, review lease language of tenants to see if it supports a Dover argument.

(2) On all lease renewals, modifications, amendments or extensions, make sure appropriate subordination, attornment and non-disturbance language is included.