Excerpts from
REIN RETAIL REPORT
Legal Trends & Insights
by Fred Fathe of Mariscal, Weeks, McIntyre & Friedlander, P.A. (602) 285-5000

Assuming Conduit Loans
(Spring 2000 issue)

As we begin the second quarter of 2000, sales activity is increasing involving properties (both retail and commercial), which have been previously encumbered by so-called "conduit loans".  These loans became popular in the mid-to-late 1990’s as favorable interest rates and terms became available through large syndications of blocks of real estate loans through major United States securities markets.  Although the loans were placed locally through brokers and counsel, they were then "packaged" along with loans from all over the rest of the country and sold in large "blocks" as mortgage-backed securities through financial markets.

One feature of these loans that initially appeared to be quite attractive was an "assumability" feature.  That is, many of these loans, although including significant prepayment penalties, provided by their terms that they would be assumable by successors to the original Borrower in the context of future sales under certain conditions, including qualification of the assuming borrower (and its guarantors, if applicable) and payment of a fee.  Generally, this fee is in the range of one point. However, even though at first blush the prospective purchaser may view the assumption of the existing loan as a positive aspect of the proposed sale transaction, at least two issues have come to light regarding such assumptions of which all parties should be aware.

First, since Wall Street (and mainly the bond rating agencies) dictated many of the "non-business" terms of the loan documentation, a substantial number of the conduit loans were made to so-called “sole purpose entities”.  That is, the named Borrower must have as its sole function the holding and operation of the subject real property, together with the making and servicing of the loan.  The assuming Borrower will likewise be constrained.  Many times, loan documentation provides for rather strict conditions regarding sole purpose entity status.  These conditions include, without limitation, the provision of a very detailed legal opinion regarding the Borrower's structure and its relation to bankruptcy issues, the provision by the Borrower of an independent third party to act as a director, manager or other controlling party of the entity itself and/or the fact that only a single borrowing entity is permitted.  This latter issue sometimes becomes relevant in certain situations where the party wishing to purchase the property may consist of more than one cotenant "coming out" of a previously structured "Starker" transaction.  The first two concerns generally only come into play on very large loans (for example, in excess of $7,500,000.00), and in many cases are not ultimately relevant to the assuming buyer's evaluation of the transaction.  Nevertheless, they should initially be considered when viewing the proposed transaction.

Second, although most of the conduit loans were structured as non-recourse in nature, almost no loans are being made in the year 2000 without some exceptions to the non-recourse clause.  These exceptions include without limitation: concerns regarding environmental issues; bankruptcy; due on sale or other transfers; violation of the sole purpose entity covenants; waste; defalcation respecting insurance proceeds, rents and the like; and intentionally false representations and warranties.  However, since in most cases the Borrower is, by definition, a sole purpose entity with no assets other than the subject real property (which is already subject to the deed of trust), these so-called "carve-outs" would be meaningless without some backing by a solvent person and/or entity.  That is, there must be someone to sue (other than the Borrower who has no assets other than the property, which is already encumbered) if the "carve-outs" are violated.  Thus, many lenders will require a third party (natural person or entity) to guarantee the "carve-outs".  Similarly, in the context of an assumption, the assuming Borrower, which by definition will be a sole purpose entity, must provide replacement guarantors.  Consequently, the buyer should be ready to put before the lender financial statements of solvent parties to act as substitute guarantors.  Consideration should also be given to the fact that the lender may not release the existing guarantors from pre-assumption liabilities.  This issue should be discussed in the purchase agreement.

In conclusion, although conduit loans continue to present excellent opportunities for financing, the complexity dictated by Wall Street may make the assumption process more difficult than would be encountered in the context of a bank or insurance company alone.  Sufficient time should be allotted and competent advice should be sought and obtained to endeavor to complete such an assumption transaction.

Lot Split Issues- Some Caveats of Parcelizing
(Spring 1998 issue)

Most real estate professionals in Arizona are familiar with State subdivision laws. The "more than five" mantra when dealing with internal parcel subdivisions is usually scrupulously followed when parcelizing real property. For example, if a single restaurant pad is sold from a larger shopping center (usually after appropriate CC&R’s are executed), a state subdivision law issue will not arise and it may be thought that the conveyance can be completed on a meets and bounds description without approval of a plat or other similar instrument.

Unfortunately, the practitioner must be aware of local regulations dealing with lot splits. This author is familiar with lots with varying ordinances in the cities of Scottsdale, Mesa, Tempe and Phoenix. The general thrust of these ordinances is that when real property which was previously a single parcel is sold in portions, a lot split may occur which required either the approval of local authorities and/or the verification of an exception to the ordinance. In all potential lot split cases, local ordinances should be reviewed and local administrators may be helpful. There is one valley city where informal advice has been given in the past that if a lot split occurs prior to a formal platting process, but assuming the plat will follow in close order, the municipality will ignore the prior technical improper split and integrate the same into the plat approval. This appears to be an informal exception only and apparently is available only if the administrators are fully familiar with the proposed plans for the overall parcel and have a good idea as to the parameters of the proposed plat.

Some unexpected consequences can arise if local lot split ordinances are not properly followed. For example, there was a situation in Phoenix where a lot split had taken place numerous years prior to the acquisition of a property and no ready evidence revealed the prior allegedly illegal lot split. Nevertheless, when a building permit was to be issued, the City authorities discovered the purported lot split. Although no draconian penalties were exacted, an additional fee in excess of $1,000 (apparently representing the original application fee plus sundry other fees, interest, etc.) was imposed.

In another case of very recent vintage, a portion of a shopping center was acquired two or three conveyances removed from the original REO owner. Apparently, the original developer designed a larger center as a single parcel. However, after the improvements were constructed, the developer drew an arbitrary phase line which split the property. The phase line did not lie under any structures, but was located in relatively close proximity to a primary shopping center building. The developer then either sold the parcels separately or encumbered them separately to two separate lenders. The parcels became separated in fee title ownership and were generally treated as two phases of the same shopping center under different ownership. However, a municipality took the position that the drawing of the phase line and division of the property created a set back! Since the boundary was located within a foot or two of a building, the 10’ set back line lay under the building. The City also told the owner that the building could be maintained as a non-conforming use. Therefore, the removal of the building was not required, but it was very difficult to consummate a loan transaction involving the building. One possible solution would be to endeavor now to effect a proper split (perhaps with associated variance) and eliminate the "springing" set back line. It is further believed that had the lot split been properly under taken originally, this issue would not have arisen now.

Whether or not the developer is safe from liability under the state subdivision statutes, local lot split statutes should always be consulted when creating new parcels by meets and bounds conveyances.

End of Lease terms Issues- Dealing with Holdovers
(Summer 1997 issue)

Most of the time, meaningful discussions regarding occurrences and actions at the end of a commercial leasehold term do not occur during drafting, but only at or near the end of the term.

Most commercial leases provide that, at the end of the term, the tenant will turn the premises over to the landlord and has the right (or possibly the obligation (and possibly at the option of the landlord)) to remove the tenant's personal property/fixtures from the premises. Many commercial leases also provide that if the tenant does hold over, the lease converts to a month-to-month tenancy at some multiple of the original rental. There is some law in Arizona which indicates that all other charges which would otherwise be due under the Lease (CAM charges, taxes, insurance and sales tax) would also be due, prorata, during any holdover term.

If a tenant has an option to extend, that date should be calendared on the tenant's calendaring system. If a tenant fails to give timely notice of exercise, the tenant may have lost its option. Some tenants endeavor to include a clause in the lease which provides that the option will not expire until the landlord gives notice that the tenant has not exercised, but landlords generally resist so phrasing the option.

The tenant should arrange its affairs such that it promptly vacates the premises on the date which the lease is expiring. In theory, the tenant could be liable for damages to the landlord if some landlord bargain were breached due to the tenant's holding over and the landlord had notified the tenant of that potential.

Landlords should develop calendars of lease expiration dates. At least thirty (30) days prior to each expiration date, the landlord should give written notice to the tenant of the upcoming lease expiration and, unless desired otherwise, should explain to the tenant that the lease will be deemed terminated immediately upon such date and thereafter the tenancy will be at sufferance. This notice precludes the tenancy from becoming month-to-month so long as the landlord does not take any actions inconsistent with this position (such as acquiescing in continued possession and/or accepting rent for holdover periods). Immediately upon expiration of the term, the landlord could move to evict the tenant.

However, holdovers do occur and generally proceed on a month-to-month basis. Arizona Revised Statutes 33-341 (B) provides that a month-to-month lease may be terminated without cause by the landlord giving "at least 10 days notice" of termination. Therefore, if, in a month-to-month situation, the landlord wishes to terminate the tenant's legal right to possession, the landlord should do so in writing no later than 10 days prior to the monthly expiration date. If the notice is given any time within the first 20 days of any month, the tenancy may be terminated as of the end of that month. If the notice is given thereafter, the tenancy may be terminated only at the end of the next successive month.

In summary, if a landlord wishes to avoid a month-to-month tenancy because of a holdover, written notice of impending termination should be given in advance of expiration of the lease and actions consistent with an immediate termination of possession should be taken immediately upon expiration. Once the tenancy has become month-to-month, it can be terminated at the end of any lease month by giving written notice within the first 20 days of that month. Otherwise, the notice will only be effective as of the end of the next succeeding month.

Landlord Non-Recourse Clauses- A Way to Limit Your Liability
(Spring 1997 issue)

I write this month about a sometimes overlooked provision which generally appears near the end of most commercial leases in the lengthy miscellaneous section, the so-called "landlord non-recourse" clause. The general formulation of the clause states that notwithstanding anything in the lease or the law to the contrary, the landlord's liability to the tenant under the lease will be limited to the landlord's interest, if any, in the building, office complex, demised premises, etc. That is to say, if the landlord breaches the lease, the landlord is not personally liable for damages occasioned by the breach, but the tenant may only obtain a judgment and endeavor to execute on landlord's interest in the building, etc. A recent variation of this clause of which I became aware also included a proviso that the landlord’s interest in the premises would be deemed to be limited to the lesser of its actual interest in the premises or its remaining equity interest therein, if any, assuming that the premises were encumbered by an 80% loan-to-value mortgage. In other words, even if the landlord owned the premises free and clear, the tenant's rights would be further restricted.

Every form landlord lease should have such a clause contained in it somewhere. Every initial tenant's response to such a landlord lease proposal should be to eliminate the clause. Usually, there is a middle ground which is reached with respect to these particular negotiations. If the tenant has rental offset rights in the event of a landlord's failure to provide services or other bargained-for consideration under the lease, then it is arguable that the tenant's main concern is completion of the premises and/or the building if the same is the landlord's obligation. After completion of these "big ticket" items, the rent may be viewed to provide adequate security to the tenant in the event of a landlord breach. Thus, I have been involved with lease documents where the landlord's non-recourse clause "sprung into being" upon the completion of construction of the premises and tender thereof to the tenant. There may be certain lingering landlord exposure for warranty work and the like, but if the tenant has an adequate remedy against the rent, this type of "springing" non-recourse clause offers a compromise to the disparate positions of the landlord and the tenant.

Under some circumstances, the landlord non-recourse clause can also have an interplay with another clause of the lease which usually appears in the miscellaneous section, the subordination clause. If a tenant is able to negotiate an acceptable subordination clause, then the landlord's obligation to continue to lease the premises to the tenant free of the interference by any mortgages can be left to the effect of the non-recourse clause. However, if the lease is fully subordinated to existing or future financing encumbrances and the landlord breaches under those encumbrances, the mortgagee takes over possession of the building and evicts the tenant as the mortgage is superior to the lease. The tenant is totally left without a remedy. Elimination of the non-recourse clause would provide the tenant with a theoretical remedy, although if there is a default under the mortgage, the prospects of enforcing a judgment for breach of the lease against the landlord entity may be dim in that the landlord entity may be left assetless. Tenants should always strive to provide that the lease will be subordinate to existing or future financing only if the financing entity executes a non-disturbance agreement. Beyond this threshold issue, details of the subordination such as the successor landlord's liability for preexisting breaches are also matters of discussion.

When faced with issues regarding landlord non-recourse clauses, then, a common solution is to provide that the non-recourse clause only becomes effective upon build-out of the premises and/or the building or complexes of which premises are a part. Generally, as to subordination issues, most lenders are willing to accept the obligation to provide a non-disturbance agreement so long as the successor lender's liability for preexisting lease breaches is limited.

The foregoing is not an exhaustive discussion of these issues but highlights two clauses generally appearing near the end of the lease (when the reader is perhaps otherwise tired or inattentive) which merit review from the standpoint of both the tenant and landlord.

"Reps & Warranties" in Contracts- How Important are They?
(Summer 1996 issue)

Once many of the "basic" terms of a real estate purchase transaction- identity of the property, price, inspection and closing times and the like, are negotiated, the parties focus on drafting a purchase agreement. Most purchase agreements contain some representations or warranties (or express disclaimers) of the parties.

At an initial level, the Buyer and Seller will each desire representations from the other that the party has the requisite authority to execute, deliver and perform the purchase agreement, is a validly-formed entity, has authorized all of the foregoing and, sometimes, that the foregoing does not breach any agreements to which the Buyer or Seller is a party or by which, in the case of the Seller, the subject property is bound. These types of representations are usually non-controversial because, among other things, it is likely that the parties will have to prove the same items to the title company at closing before title insurance will be issued. Significant negotiations often occur, however, with respect to representations and warranties relating to the subject property itself. If the property is unimproved, Buyers may request warranties relating to such items as the absence of hazardous materials, the availability of utilities, the zoning and flood plain status of the property, soil conditions and compaction, the availability of access and general representations from the Seller dealing with the Seller's lack of knowledge of any adverse facts about the property and securities-type representations whereby the Seller is asked to represent that the Seller has not made any material misrepresentations of fact nor has omitted to state any material facts regarding the property. If the property is improved, in addition, Buyers may request representations as to the physical status of any improvements, the working nature of HVAC and other mechanical equipment, availability of parking and other services and entitlements and representations relating to the leases, if any, attendant to the property.

As a general matter, Sellers are reluctant to provide representations dealing with the status of the property. Generally, Sellers wish to sell property ‘AS-IS, WHERE-IS’ and that, after the property is sold, they wish to have no further involvement with, or deal with claims relating to, the property. One potential Buyer's response to this assertion is to request actual knowledge-type representations, so that the Buyer endeavors to know that the Seller is not "holding anything back."

Rather than viewing representations and warranties as being truths (or falsehoods, as the case may be), the parties could view representations and warranties as risk-shifting mechanisms. That is to say, whether or not a representation is true can be viewed as irrelevant. What is important is that if the representation is false, the risk of the falsehood will lie with one party or the other, depending upon the ultimate agreement of the parties. When viewed this way, representations and warranties become as much a portion of the price of the property as its square footage or its location. The Buyer is paying a certain price for a group of rights, one of which is the right to bring an action against the Seller if the property is not in the state in which the Buyer believed the property existed when the Buyer paid for the property. There have been negotiations wherein, as an alternative to representations, a price adjustment was suggested.

As stated above, some Buyers, when pressed for an explanation of the requirement for representations and warranties, indicate that they "just want to know what the Seller knows and that the Seller is not holding anything back." Representations have been crafted to endeavor to pacify the Buyer's stated concerns and not expose the Seller to a significant post-closing potential liability. The Seller represents "to Seller's present actual knowledge, without independent investigation or review of its files and without application of the doctrine of implied knowledge" the agreed-upon representations and warranties. Ultimately, if suit is brought, the Seller may well prevail if it had no actual knowledge of any property defects. Many times the duration of representations is limited to a certain period of time. For example, some Buyers believe that a single full accounting period is a sufficient duration for survival representations and warranties. A Seller can then ‘breathe easy’ after that first period is completed.

The lesson to be learned from this discussion is that representations should be discussed early on in the formative stages of the transaction and that they play as much a part of the purchase transaction as the price and terms of the sale. Sellers should list properties at a certain price, "AS-IS, WHERE-IS," and Buyer's offers should be made subject to receipt of acceptable representations and warranties from the Seller.

"Repair" vs. "Replace"- Choose Lease Language Carefully
(Winter 1996 issue)

Owners and agents need to recognize the difference between the terms "repair" and "replace" in a lease. Those who choose to ignore this distinction may do so at their peril. The Supreme Court of Virginia recently decided (Seoane v. Drug Emporium, Inc., 457 S.E.2d 93 (Va. 1995)) that a tenant who believed that a landlord's replacement obligation extended to allegedly outmoded and inoperative heating and air-conditioning units which were in "serious disrepair" lost its right to continue as a tenant under a long-term lease.

In May 1991, Drug Emporium notified the landlord that it (Drug Emporium) planned to spend approximately $350,000.00 in leasehold improvements to enable it to occupy the major part of a previously -leased parcel as a retail drug store. According to Drug Emporium, the roof and exterior heating and air-conditioning units for the premises were allegedly in serious disrepair. Drug Emporium also advised the landlord that these "repair/replacements" were landlord obligations under the lease and that if the landlord did not fulfill them, Drug Emporium would fulfill them and make a charge-back against the rent. The landlord advised Drug Emporium that it disagreed with those conclusions, but Drug Emporium made the changes and endeavored to offset rent. In court, the landlord contended not only that the tenant owed the offset monies but that the improper rent offset terminated the lease.

The relevant portions of the lease provided that the landlord would maintain and promptly "repair" any damage to the "exterior" or to the structure of the premises. The lease did not specifically list HVAC as a portion of the landlord's repair obligations and the lease required the tenant to carry a maintenance contract on the air conditioning unit. The lease also required the landlord to "make any necessary replacements [my emphasis] of and to the interior heating plant and air-conditioning equipment" and also to make "all other repairs" to the premises.

The trial court noted that whereas the landlord had the obligation to replace HVAC units, it did not have the obligation to repair any units, but held for the tenant on the grounds that the units required replacement because of their dilapidated condition. The Supreme Court conceded the trial court's finding that it was commercially reasonable for the landlord to replace the air-conditioning units. However, the Supreme Court continued, the language of the lease did not require replacement and held for the landlord, terminating Drug Emporium's lease because of the wrongful offset. Even though the roof and heating units could no longer be repaired and required replacement, the landlord's duty did not extend to replacement of those outmoded units. An unspoken premise of the Supreme Court opinion, I believe, was that the
replacement obligation should have been construed to extend only to replacements required by casualty and the like and not by ordinary wear and tear or obsolescence.

The lesson to be learned from the Drug Emporium case is that the parties, at the outset, should be careful in dividing and delineating the repair and replacement obligations under a commercial lease. An obligation to "repair" may, in fact, extend to full replacements of completely inoperative equipment if the poor condition of the equipment was caused by ordinary, as opposed to extraordinary, causes.

Creating & Preserving Lease Guarantees
(Spring 1995 issue)

There is a substantial body of law surrounding the rights and obligations of guarantors. First, if natural persons are guarantors of a lease, in Arizona both the husband and the wife must execute a lease guarantee to bind their marital community. If the signature of one spouse is missing from a guarantee and the landlord must enforce that guarantee, suit may be had against only the spouse who signed the guarantee, and then only to the extent of his or her sole and separate property. Community property will not be liable for those guarantee obligations.

Secondly, guarantors occupy a favored status under the law. In general, courts will endeavor to grant guarantors rights which are not available to primary debtors. Even though form guarantees generally contain broad language which purports to waive many guarantors' rights, the effectiveness of these waivers is subject to debate. Consequently, whenever any actions are undertaken with respect to a guaranteed lease, all guarantors of the lease should consent to those actions. Guarantors should also receive all notices which are given under the lease. For example, if a lease defaults and rental concessions are given to the tenant, the guarantors should consent to the concessions. If the term of the lease is extended or if payment terms are changed, the guarantors should likewise consent. If guarantors refuse to consent, the landlord's best advice is to enforce the lease as then-written against both the tenant and the guarantors. It would be difficult for the guarantors to complain that their rights were violated if the landlord endeavored to enforce the provisions of the lease to which the guarantors had already agreed. However, if those provisions are changed, if the security deposit (or other lease security) is changed, if the landlord's or the tenant's obligations under the lease are modified, if extensions or waivers are granted or if any other agreement by the landlord affects the tenant, the guarantors should be called upon to consent. Failure to obtain the guarantors' consents could adversely affect Landlords' rights under lease guarantees.

Enforcing Future Exclusive Use Clauses- Landlords Beware Now
(Fall 1995 issue)

Landlords are sometimes asked to grant exclusive use clauses for a limited (or sometimes not so limited) universe of delivered products and/or services to tenants which believe that they have sufficient bargaining power to extract such a clause. If a landlord is willing to grant such a clause, however, scrutiny must be given to preexisting leases in the shopping center to see if the landlord has the power, under existing leases, to restrict the use to which existing tenants may put their premises. In a landlord-form lease, the tenant's use of the premises is generally restricted to the tenant's primary use. However, many astute tenants also require that premises may be put to "any lawful use" or "any use which may be made of the premises by proposed subleases." In these latter occasions, the landlord must be cautious to circumscribe the rights of existing tenants to use their premises to exclude uses which could violate any future exclusion use clauses which the landlord might wish to grant. Otherwise, if an existing lease allows a tenant to use its premises for "any lawful use", the landlord cannot control the use of those premises and enforce future exclusive use clauses against that existing tenant. The inability to grant an encompassing exclusive use clause to a prospective tenant having "clout" (even where existing tenants do not presently utilize their premises for any use which is even remotely violative of the proposed exclusive) may be a significant impediment to leasing.

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