Daily Development for Tuesday, April 29, 2003
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC
School of Law
Of Counsel: Blackwell Sanders
Peper Martin
Kansas City, Missouri
dirt@umkc.edu
BANKRUPTCY; "FREE AND CLEAR SALE;" LEASES:
Devastating Seventh Circuit case permits free and clear
sale to wipe out all
lease rights under
365(h). Precision Industries, Inc. v. Qualitech, 2003
U.S. App. LEXIS 7612 (7th Cir. April 23, 2003)
This case, in the editor's view, is a particularly
troublesome one. It is a
bombshell on the
order of magnitude of Durrett and Fleet Factors, and
interested parties should seek to muster support for a petition for en
banc
rehearing and, if necessary, a Supreme
Court appeal. It puts virtually all
long
term leases and leasehold mortgages in mortal danger when the
landlord files for bankruptcy.
In a case of first impression, the U.S. Seventh
Circuit Court of Appeals has
held that
under 363(f) of the Bankruptcy Code, the sale of the
lessor-debtor's real property "free and clear" of any
"interest" trumps
365(h) of the Bankruptcy
Code, which protects the rights of the lessee when
the lessor-debtor rejects a lease. As a consequence, all property
interests of
the lessee will be destroyed,
leaving the lessee with a claim for damages
that may or may not have priority against the sale proceeds, and
certainly
won't satisfy the property
expectations of the lessee, or its leasehold
mortgagee.
Section 363(f) provides that the trustee may sell property
of the estate "free
and clear of any interest
in such property of an entity other than the estate"
if [note the following are in the disjunctive]: applicable
nonbankruptcy law
permits such a sale; such
entity consents; the interest is a lien and the sale
price is greater than the aggregate value of all liens against the
property; the
interest is in bona fide dispute;
or such entity could be compelled to accept
a
money satisfaction of the interest. The parties in this case conceded
that
a 363 authorized a sale in this case.
[More on this in the comments.]
The debtors (collectively, "Qualitech") owned and operated a
steel mill in
Indiana. The lessees
(collectively, "Precision") constructed a supply
warehouse at the property, for the sole purpose of providing supply
services
for Qualitech. In 1998, Precision
entered into a ten-year supply agreement
with
Qualitech. If an early termination or default occurred under either
agreement, Precision had the right to remove all
improvements and fixtures.
Otherwise, Qualitech
could buy the improvements and fixtures for $1 at end
of term. [Although, arguably, the special facts here tend to
differentiate this
case from typical landlord
bankruptcy cases, the court makes nothing of the
distinction and its interpretations of Bankruptcy law apply
universally.)
Qualitech filed its Chapter 11 bankruptcy petition on March
22, 1999, and
on June 30, 1999, sold
substantially all of its assets at auction pursuant to
a sale order "free and clear of all liens, claims, encumbrances, and
interest"
under 363(f) of the Bankruptcy
Code. The sale order approved the sale to
a
group of pre-petition secured lenders for $180 million. Precision,
which
had proper notice of the sale, did not
object. The purchasers subsequently
transferred
their interests in the property to a new entity, ("New Qualitech"),
which assumed the rights of the purchaser under the sale
order and took title
to the property. The sale
order also provided that the purchaser retained the
debtor's right to assume and assign executory contracts pursuant to
365 of
the Bankruptcy Code. Negotiations
subsequently ensued with respect to
assumption
of the lease, but were unsuccessful. The result, according to the
Seventh Circuit, was that "Precision's lease and supply
agreement were de
facto rejected." By December
3, 1999, Precision had vacated and padlocked
the warehouse on the property. Shortly thereafter, New Qualitech,
without
Precision's knowledge or approval,
changed the locks on the building.
Precision then filed suit, claiming that its possessory
interest in the leased
property, pursuant
to 365(h), survived the bankruptcy sale. The
bankruptcy court held that, based on 363(f) and the fact that
Precision's
lease was an "interest" under the
sale order, New Qualitech had obtained
title to
the property free and clear of Precision's leasehold interest. The
District Court reversed, ruling that the terms
of 365(h) prevailed over
those
of 363(f). The District Court reasoned that there was no
statutory
basis for allowing the debtor-lessor
to sell its property and terminate an
underlying lease, which would limit the lessee's post-rejection rights
solely
to cases where the debtor-lessor
retained title and possession of the
property.
The Seventh Circuit reversed the holding of the District
Court, noting as a
threshold issue that
Precision never objected to the sale order and that
"[s]ale orders are final, appealable orders," i.e., once the appeal
period has
expired, res judicata precludes a
subsequent lawsuit contesting the order.
The
court then examined the meaning of the word "interest" in
363(f)
(which term is not defined in the
Bankruptcy Code), and found that based
on
applicable case law a leasehold estate was clearly an "interest"
subject
to the provisions of
363(f). The court also noted that the parties never
disputed the fact that the conditions of 363(f) (which, standing
alone,
authorized the sale of the bankruptcy
estate's property, including any
"interest"
therein, free and clear of the lessee's possessory interest), had
been complied with.
The court then turned its analysis to 365(h), and
concluded that the terms
of this section
did not supersede those of 363(f). The court reasoned
that
because 363(f) does not contain any
cross-reference subordinating its
provisions to
the lessee protections of 365(h), Congress did not
intend
for 365(h) to limit
363(f). (According to the court, "Congress
authorized the sale of the estate property free and clear of 'any
interest,' not
'any interest except a lessee's
possessory interest.'" The court then held that
365(h) applies only where the trustee (or debtor in possession)
actually
rejects the lease, whereas in the
present case a statutory sale of the property
(which was leased) had occurred. According to the court, "[t]he
two
statutory provisions thus apply to distinct
sets of circumstances.".
Finally, the court ruled that 363(e) provides a
mechanism for lessees to
protect their
interests, i.e., it directs the bankruptcy court upon the request
of any party with an interest in the property to be sold or
transferred, to
"prohibit or condition such . .
. sale . . . as is necessary to provide adequate
protection of such interest." The court reasoned that the lessee
therefore
was not without an adequate remedy to
protect its interests, and that while
it was
not guaranteed continued possession of the property, it was entitled
to adequate protection and could seek to "be compensated
for the value of
its leasehold interest
-- typically from the proceeds of the sale." [but see
comments below about the inefficacy of this protection.
Ed.]
The court also found, conversely, where the property is not
sold and the
lessor-debtor remains in title and
possession and rejects the lease, the lessee
is
entitled to invoke its rights under 363(f) and remain in
possession.
Thus, according to the court, both
statutory provisions are given effect and
are
not in conflict. The court also reasoned that its interpretation "is . .
.
consistent with the process of marshalling
the estate's assets for the twin
purposes of
maximizing creditor recovery and rehabilitating the debtor."
Comment 1: There is obviously a major philosophical
disagreement
between the District Court and
Appeals Court panel as to the proper
application of the relevant statutory provisions, with both camps
claiming
that applicable case law (which, as
the District Court noted, is divided on
the
issue) and legislative history support their respective positions.
It is interesting that the Seventh Circuit's statement (in
connection with its
ruling that that
363(f) trumps 365(h)) that, "Where the property is not
sold, and the debtor remains in possession thereof but
chooses to reject the
lease, section 365(h)
comes into play and the lessee retains the right to
possess the property," is exactly the reason that the District Court held
that
363(f) should not trump 365(h)
("There is no statutory basis for
allowing the
debtor-lessor to terminate the lessee's possession by selling the
property out from under the lessee, and thus limiting a
lessee's
post-rejection rights solely to cases
where the debtor-lessor remains in
possession
of the property."
Comment 2: The court's holding that 365(h)
applies only where the
trustee (or debtor in
possession) actually rejects the lease, as opposed to the
situation where a statutory sale under 363(f) occurs
with respect to leased
property, and its
statement that "the two statutory provisions apply to
distinct sets of circumstances," appears to be a distinction without
a
difference because the result is exactly the
same in either scenario if, as the
Seventh
Circuit ruled in this case, 363(f) trumps 365(h). This
appears
to be a somewhat disingenuous attempt
by the Seventh Circuit to shoehorn
the facts
into the statutory interpretation the court desires in this case.
Comment 3: Read again the language of 363(f) set forth in
the text above.
Which of those disjunctive
conditions typically would apply to a lease? The
editor proposes that none of them would. Here, the tenant didn't
object to
the sale, which gave the purchaser
the right to avoid executory contracts
(which
the court ultimately interprets to include avoidance of any 365(h)
rights of the tenant). But it would appear to be
possible to object in the next
case that 363(f)
does not permit a sale free and clear of a lease because the
lease does not fit within any of the conditions supporting
a free and clear
sale. Note that, because
of the problems discussed in the next comment, if
the judge disagrees, an appeal will be quite expensive. It is vital
that the
real estate community find a way to
accomplish and win appeals of this
interpretation of 363(f) at an early stage.
Comment 4: It is important to note that there is
not really much good news
in the court's
suggestion that the lessee has the ability to avoid the terrible
consequences of the destruction of its lease by asking the
bankruptcy court
to condition its sale so as to
preserve the lease.
It is true that the lessee normally can get notice of the
proposed sale.
Although outside of a bankruptcy
case, the seller and purchaser generally
are
free to keep a potential sale confidential, . In bankruptcy, the sale
must
be made public by the filing of a motion
in the bankruptcy court requesting
the court's
approval of the sale. Notice of the sale must be provided to all
creditors, unless the court limits notice to appointed
committees, such as the
unsecured creditors'
committee and others who have formally requested
notice of all matters arising in the case.
It is further true that there is language in the Code that
suggests that a lessee
can qualify for
protection from a wipeout at the "free and clear sale."
Section 363(e) provides that upon request of any
entity that has an interest
in such property,
the court shall prohibit or condition such sale "as is
necessary to provide adequate protection of such interest." But if
the court
refuses to do this, and the sale
proceeds, the sale is final. When the
bankruptcy court has approves the sale of property of the estate by a
trustee,
363(f) provides that the buyer
acquires title free and clear of all claims in
bankruptcy and the property may not be brought back into the estate in
the
absence of fraud or collusion in the sale.
Section 363(m) provides that the
reversal or
modification on appeal of a sale authorized by the court does not
affect the validity of the sale to an entity that purchased
the property in good
faith unless such
authorization and sale were stayed pending appeal. Thus,
unless the party appealing a sale order obtains a stay
pending appeal, a
good-faith purchaser of
assets is protected from reversal on appeal. The sale
order often will contain an express finding of good faith as well as
language
similar to the following:
Pursuant to 11 U.S.C. 363(m),
absent a stay of this Order pending
appeal, the reversal or modification on appeal
of this Order, or any
provision thereof, shall not affect the validity of any sale
transaction
approved
hereby which is consummated prior to such stay, reversal
of modification on
appeal.
Under Rule 6004(g) of the Bankruptcy Rules, an order
authorizing the use,
sale, or lease of property
is automatically stayed until the expiration of 10
days after entry of the order, unless the court orders otherwise. The
trustee
(and the purchaser) likely will seek to
have the sale order contain specific
language
that, notwithstanding Rule 6004(g), the order is effective
immediately (the same is true, under Rule 6006(d), for an
order authorizing
the trustee to assign an
executory contract or unexpired lease).
In order to stay the sale on appeal of the judge's order, a
lessee have to post
an appeal bond. The
same judge who has already determined that it is in the
best interest of the estate to wipe out the lease is the
one who decides the
amount of the bond.
In many "big ticket" bankruptcies these days, the
debtor's properties are packaged and sold in a single bundle, and
many
lessees cannot afford to post a bond to
block a $200 million sale in order to
protect
their lease on a $10 million part of the package.
Reporter's Comment 5: The liens and claims that are
cut off in a 363(f) sale
attach to the proceeds
of sale. Thus, there is some chance for the sold out
lessee to recoup some damages with a priority claim other
than as an
unsecured creditor. But will
there be any money to reach? Secured
creditors will be feeding at the same trough, and remember that in a
multi-
parcel sale it will be quite difficult
for the sold out lessee to segregate
individual
value from the parcel it occupied. Further, how will the
lessee
be able to prove damages?
Establishing the value of a prematurely
terminated long term lease has always been a major problem for
state
courts. Why will it be any
different in bankruptcy? The same goes for lost
business expectations. And then there are the
leasehold mortgagees, who
undoubtedly will be
elbowing the tenant aside to get satisfaction of their
own mortgage debt (if they can). They will be seeking big
prepayment
premiums for the forced sale, based
upon yield maintenance clauses that
will also
drain any possible value from the tenant.
Reporter's Comment 6: If we get to apply
Section 365(h), there is indeed
protection for
the lessee. Although a lessor who files for reorganization
may seek approval to reject a lease, the lessee then
has the option to remain
in possession for the
balance of the lease term and any renewal or extension.
Section 365(h)(1)(A)(ii) provides that the lessee may
retain those rights in
the lease that are in or
appurtenant to the real property, "including rights
such as those relating to the amount and timing of the payment of rent
and
any right of use, possession, quiet
enjoyment, subletting, assignment or
hypothecation," to the extent that such rights are enforceable
under
applicable nonbankruptcy law.
BANKRUPTCY; LEASES; ASSUMPTION AND REJECTION;
ASSIGNMENT; RESTRICTIONS ON ASSIGNMENT;
SHOPPING
CENTERS: Shopping Center landlord may
not enforce use clause
restricting use to
identified retail outlet and must demonstrate scheme of
integration of tenant uses into a viable "tenant mix"
through its leasing
policies in order to argue
that a change of use upon assignment is protected
by "tenant mix" considerations under Bankruptcy Code Section
365(b)(3).
LaSalle National Trust v. Trak Auto
Corp., 288 B.R. 114, 2003 U.S. Dist.
LEXIS 6029
(1/10/03)
Bankrupt tenant was withdrawing from all its auto parts
stores in a four
state region. This
included the store at tenant's retail center, which
consisted of twenty five "commercial locations," nearly all of which
were
retail stores. Tenant proposed to
affirm the lease and assign it to a new
tenant
who would operate a discount clothing operation.
Landlord objected on the grounds that the new tenant's use
was inconsistent
with the use clause, which
required that the store be operated as a "Trak
Auto Store," and in addition interfered with the tenant mix.
Landlord's
expert testified that the percentage
of clothing stores in Landlord's center
already
exceeded an optimal mix, and that committing the large floor space
of this store to clothing would be very harmful to the
viability of the center.
Landlord's expert
testified that the national average for clothing stores in
retail centers was 10%, while the percentage following the
assignment in
this case in Landlord's center
would increase to 20.8%.
Landlord's center was more like a "downtown shopping
district" in that
there were nine other stores
located in building contiguous to Landlords
stores that were virtually indistinguishable to customers from the
stores
operated by Landlord. Further,
there were 28 more stores directly across the
street from Landlord's properties. Landlord had no control, of
course over
operations in any of these
properties. The Bankruptcy court had found that
the interests of "tenant mix" raised by Landlord were
relevant only if
landlord operated a "shopping
center" entitled to special protection against
assignment as set forth in 365(b)(3) of the Bankruptcy Code,
and
Landlord's properties did not satisfy the
test for a "shopping center."
The court here affirms the ruling of the Bankruptcy Court on
the following
points:
1. The use clause was an effective restraint on
alienation of the lease and
could be avoided in
bankruptcy.
2. The special provisions of Section 365(b)(3) dealing
with preservation of
landlord's interest in
synergy in a shopping center may have been
applicable here even though landlord's space was not a true center.
The
trial court should have taken more evidence
on the point.
3. Nevertheless, even if this was a true center,
landlord's arguments
concerning the negative
impact of the increase in retail clothing space were
unfounded.
In determining that the use restriction operated as a de
facto restriction on
assignment, the court
relied heavily on In re Rickels Home Centers, Incl,
240 B.R. 826 (Bkrtcy. D. Del. 1998). (The DIRT DD for 8/11/98)
In
Rickels, the Delaware court held that
restrictions on the purpose and size of
the
store operations in a shopping center were de facto restrictions on
assignment and invalid under the Bankruptcy
Code.
With respect to the specific provisions of the use clause,
the court had little
problem with interpreting
the clause, in context as a de facto restraint on
leasing. Although the Bankruptcy court had noted that the
area was
saturated with auto stores and no
prospective assignee would even bid on
the
store as limited to that purpose, the court on appeal elected not to
rely
upon that analysis. Instead, it
noted that the use limitation was not only to
auto parts stores, but to an auto store denominated "Trak Auto, " and
that
this restrictions in effect prohibited
leasing to anyone but the original
bankrupt
tenant. Clearly in the view of the court, this was a de facto
prohibition on leasing inconsistent with the policies of
the Bankruptcy
Code.
Landlord relied upon a more recent Delaware Bankruptcy case,
Sun TV &
Appliances, Inc., 234 B.R. 370
(Bkrtcy. D. Del. 1999), for the proposition
that a restriction on use would be upheld even when there was an impact
on
assignability. The court here cited to
the Sun TV case a number of times,
but barely
discussed it at all. Indeed, it is a strong case for recognition
of
the need for preservation of tenant
mix. It makes the point explicitly that
the value to the estate of assignment to a non-conforming assignee
ought
not to matter at all if there is danger
to the viability of the center.
Indeed, the specific language of 365(b)(3) seems to require
rigid adherence
both to the requirements of a
use clause and to recognition of tenant mix:
(3) For the purposes of paragraph
(1) of this subsection and
paragraph (2)(B) of subsection (f), adequate
assurance of future
performance of a lease of real property in a shopping center
includes
adequate
assurance--
(A) of the
source of rent and other consideration due under such
lease, and in the case of an assignment, that
the financial condition
and operating performance of the proposed
assignee and its
guarantors, if any, shall be similar to the financial condition and
operating performance of the
debtor and its guarantors, if any, as of
the time the debtor became the lessee under the
lease; (B) that any
percentage rent due under such lease will not decline substantially;
(C) that assumption or assignment
of such lease is subject to all the
provisions thereof, including (but not limited
to) provisions such as
a radius, location, use, or exclusivity provision, and will not
breach
any such
provision contained in any other lease, financing
agreement, or master agreement relating to such
shopping center;
and that assumption or assignment of such lease will not
disrupt
any tenant mix
or balance in such shopping center.
The court here noted that other courts have construed this
statute to require
that there actually be a
designed tenant mix that deserves protection. The
simple presence of a shopping center is not enough if there
is no evidence
of an operating scheme to
achieve tenant mix. It is true that the Sun TV case
did emphasize the special integrated nature of the stores
in that complex
(which also was not a classic
"mall-type" center. Although the lease in
question was not a percentage lease, many other stores in the center
were,
and stores were expected to draw
customers not only to their own location
but to
others.
In the instant case, however, the court noted, first, that
landlord had very
little control over tenant
mix because there were so many other stores
nearby and that, second, most of the arguable objectives that could
be
achieved by restricting the instant store to
an auto parts outlet were not
proven.
Other stores in the center already sold auto parts, and there were
other tenants that drew male shoppers that were the primary
anticipated
customers of an auto part
store. The court also noted that many of the other
leases in the center did not restrict the amount of space
that could be
devoted to the sale of clothing,
thus belying the landlord's claim that there
was a scheme that relied upon a limitation on the amount of space
devoted
to such a purpose. In short, the
landlord did not demonstrate that "the
alleged
tenant mix was part of the bargained-for-exchange of its leases and
the leases of the other tenants."
Comment 1: The editor, and many commentators, viewed the
Rickels case
as a disastrous mistake. Its
interpretation of space restrictions as
inconsistent with assignments basically gutted the essence of 365's
special
protections for shopping centers.
On appeal, the holding in Rickels was not
exactly affirmed and not exactly reversed. Instead, the appeals
court got
caught up in procedural detail that
operates to the disadvantage of the
landlord's
making a case, but did not expressly find that 365(b)(3) could
be so summarily ignored. Indeed, the subsequent
holding in Sun TV,
coming from the same
judicial district, was a distinct ray of hope on the
Rickels issue.
This case does not go nearly as far as Rickels, although it
is disconcerting
that it cites it with such
approval. Certainly a use restriction that says, in
effect, there can be no assignment to anyone who does not
use the original
tenant's name is very, very
restrictive. Although the statute says expressly
that use provisions are to be protected, regardless, if there's a
shopping
center, one can imagine a court
concluding that the overall purpose of
permitting tenants to assign leases except when shopping center's
business
synergy is endangered would be best
served by bypassing such a provision.
The bottom line, then, is that landlords ought not to view
tenant-specific use
clauses as likely to do
them much good in a tenant bankruptcy.
Comment 2: Again, the court's conclusion that there really
was no "tenant
mix" consideration to be taken
into account here, since the landlord had not
made an adequate showing that it had developed a tenant mix concept,
also
provides a good practice lesson. To
the extent possible, tenant mix
considerations
should be made explicit.
Of course, competitive factors and available tenants will
compel some
variation on tenant mix from time
to time, but there could still be a kind of
"master business plan" that contemplates alterations and variations, and
a
history could be kept of when and how these
alterations and variations came
about. As
the court focusses upon whether tenant mix is a part of the
overall leasing bargain for the landlord and each tenant,
this master plan
backdrop could be a very
useful document. Is it practical? Who knows.
The editor is in the suggestion business, not the retail
business!
Also see: In re Paul Harris, 1992 Bankr. LEXIS
2418(U.S. Bktcy Ct., S.D.
Ind.) (assignment of
a women's apparel store to a maternity store, despite
lease requiring that tenant operate under same name and for same
purpose;
ct. held that such provision was
"antiassignment"clause and invalid).
BANKRUPTCY; PROPERTY OF THE ESTATE; SINGLE
MEMBER
LLC'S: Efficacy of a single-member
LLC as an asset-protection vehicle
thrown into
doubt. In re Ashley Albright, 2003 Bankr. LEXIS 291
(Bankr. D. Colo. April 4, 2003),
Debtor, who filed a Chapter 13 bankruptcy petition that was
later converted
to a Chapter 7 liquidation, was
the sole member and manager of a Colorado
LLC
at the time of the filing. The LLC was not a debtor in bankruptcy.
The
Chapter 7 trustee contended that because
Debtor was the sole member and
manager at the
time Debtor filed bankruptcy, the trustee now controlled the
LLC and could therefore sell the real property owned by the
LLC and
distribute the net sales proceeds to
the bankruptcy estate.
Debtor argued that the trustee acted only for Debtor's
creditors and at most
was entitled to a
statutory charging order (against distributions made on
account of Debtor's LLC membership interest) and could not
assume
management of the LLC or sell its
property.
The court, however, disagreed. It referred to
the Colorado LLC statute,
under which Debtor's
membership interest constituted the personal property
of the member. According to the court, "[b]ecause there are no
other
members in the LLC, the entire membership
interest passed to the
bankruptcy estate, and
the trustee became a 'substituted member.'" The court
also stated that, "upon the Debtor's bankruptcy filing, the Trustee
now
controls, directly or indirectly, all
governance of that entity, including
decisions
regarding liquidation of the entity's assets." The court reasoned
that because there were no other members in the LLC, no
written
unanimous approval of the transfer was
necessary, as would be the case
under Colorado
law if there were other members - no matter how small such
other membership interests may be.
Colorado's LLC statute, similar to those in other states,
provides that if the
unanimous consent of all
members in a multi-member LLC is not obtained,
the bankruptcy estate is only entitled to receive the bankrupt member's
share
of the profits or other compensation that
the bankrupt member was
otherwise entitled to,
and would not be entitled to any role in the voting or
governance of the LLC. However, in a footnote the court stated that
this
statutory limitation "does not create an
asset shelter for clever debtors. To
the
extent a debtor intends to hinder, delay or defraud creditors through
a
multi-member LLC with 'peppercorn'
co-members, bankruptcy avoidance
provisions and
fraudulent transfer law would provide creditors or a
bankruptcy trustee with recourse.".
The court rejected Debtor's assertion that the trustee
should be entitled only
to a charging order,
finding that a charging order existed only to protect
other members of an LLC, and in a single-member LLC there were
no
non-debtor members to protect. The court
ruled that the trustee, as the sole
member of
the LLC, therefore controlled the LLC and could cause the LLC
to sell its property and distribute the net proceeds to the
bankruptcy estate,
or alternatively the trustee
could elect to distribute the LLC's property to the
bankruptcy estate and then liquidate the property himself. However,
the
court did permit Debtor to make a claim for
her post-petition mortgage
payments to preserve
the real property of the LLC, which was now an asset
of the bankruptcy estate.
Reporter's Comment 1: Under most state LLC
statutes if a member files
a bankruptcy case
the LLC automatically dissolves (unless otherwise
specified in the operating agreement). Is this provision of a state
LLC
statute overridden by the Bankruptcy Code
because it constitutes an *ipso
facto* clause
(i.e., a clause that modifies or eliminates a party's contractual
rights solely because of a bankruptcy filing) which is
unenforceable under
sections 541(c)(1), 363(l)
and 365(e) of the Bankruptcy Code?
The answer may depend on whether the articles of
organization and
operating agreement are
regarded as executory contracts (i.e., contracts on
which performance remains due to some extent on both sides). The
question
then becomes whether these documents
are "organic" governing documents
(as opposed
to executory contracts) and whether a bankruptcy court, even
if it held the documents to be executory, would enforce the
documents with
the sole exception of the
bankruptcy-remote provisions if the agreements
were rejected, or permit such rejection to cause a dissolution of the
LLC
without providing at least a "winding
down"
period.
Reporter's Comment 2: Because LLCs are still
relatively new state-law
creations, the
treatment of these entities in bankruptcy is uncertain, i.e., will
they be treated as partnerships or corporations for
bankruptcy purposes?
See In re ICLNDS Notes
Acquisition, LLC, 259 B.R. 289, 292 (Bankr. N.D.
Ohio 2001) ("an LLC is neither a corporation or a partnership, as
those
terms are commonly understood. Instead,
an LLC is a hybrid"). This
uncertainty is
especially troublesome with respect to single-member LLCs.
This is because if an LLC is treated as a partnership, it
could dissolve upon
the bankruptcy of its sole
member and its assets distributed to creditors and
the bankrupt member (or, as in the Albright case, to the trustee of
the
bankruptcy estate). If, on the other hand,
the LLC were treated as a
corporation, it would
not dissolve upon the bankruptcy of the last remaining
member, although the member's ownership interest could be
transferred.
Some commentators believe that, at least under the Delaware
Limited
Liability Company Act ("DLLC Act"), an
LLC should be treated as a
corporation because
the LLC operating agreement is similar to a certificate
of incorporation and a member's interest is analogous to a
share of stock in
a corporation. See Larry E.
Ribstein and Robert R. Keatings, Limited
Liability Companies, 14.04, at 14-18 (2000) ("[F]rom a policy
standpoint,
LLCs probably should be considered
corporations for bankruptcy purposes
because
the special bankruptcy provisions that apply to partnerships
primarily relate to the general partner's duty to
contribute to payment of the
firm's debts");
Carter G. Bishop and Daniel S. Kleinberger, Limited
Liability Companies Tax and Business Law, 1.04 (2)(a) (1999).
Reporter's Comment 3: Since 1998, single-member
LLCs have become
very popular in securitized
and structured-financing transactions because of
their tax advantages, flexibility and low transaction costs. However,
there
is a question as to whether a
single-member LLC will continue to exist upon
the sole member's bankruptcy, death, or dissolution. There is very
little
legal precedent or case law on this
issue. The governing law must be
consulted to see if it allows for the continued existence of the LLC
after the
sole member's bankruptcy or
dissolution. For example, the DLLC Act
(under which many LLCs are formed because of the favorable
statutory
framework) specifically provides for
the LLC's continued existence under
such
circumstances, unless otherwise provided in the operating agreement.
See Del. Code Ann. tit. 6,
18-801 (a)(4). The DLLC Act also provides that by default an
LLC's
existence is perpetual. Del. Code Ann.
tit. 6, 18-801 (a) (1). A
single-member
LLC, whose only member is the entity or individual in
question, requires the creation of only one entity, the LLC itself.
See Larry
E. Ribstein and Robert R. Keating,
Ribstein and Keating on Limited
Liability
Companies, Ch.
4, p.3 (1996) (Fall 2001
Update).
Reporter's Comment 4: Bankruptcy courts
generally look to state law to
determine
whether dissolution occurs upon the bankruptcy of the sole
member of a single-member LLC. Under the DLLC Act,
for example, an
LLC whose member is in
bankruptcy would be treated as if it were a
corporation with a bankrupt shareholder and the bankruptcy would
not
cause a dissolution. If a Delaware
LLC agreement is properly drafted, under
Delaware law even the bankruptcy of the last remaining member will
not,
by itself, cause the dissolution of the
LLC.
Furthermore, under the DLLC Act, it is permissible to admit
"springing
members," i.e., a person may be
admitted as a member (including as the
sole
member) without acquiring an interest in the LLC or being required
to
make a capital contribution. See Del. Code
Ann. tit. 6, 18-801(a)(4) and
(b); James
G. Leyden Jr., A Key State's Approach to LLCs: Delaware Can
Be Different, 9-MAY Bus. L. Today 51, 63
(2000).
Reporter's Comment 5: The single-member
LLC operating agreement
should specifically
provide for the continued existence of the LLC upon the
sole member's dissolution or the termination of its
membership in the LLC.
The operating agreement
also should condition the sole member's right to
withdraw on the existence of a succeeding member (or "springing"
member)
who would be capable of continuing the
operations and existence of the
LLC.. Typical "bankruptcy remote" provisions, which are
promulgated by
rating agencies and appear in
almost all LLC formative documents
involving
securitized loan transactions, also would be applicable with
respect to single-member LLCs. Legal opinions as to the
bankruptcy
remoteness of the borrowing entity
(and perhaps its principals) are also
usually
also required by the rating agencies, such as Moody's, Fitch, and
Standard & Poor's, in connection with securitized
financing transactions to
provide support for a
high rating. This is especially so in connection with
a single-member LLC, where the bankruptcy treatment of such a vehicle
is
less clear. The enforceability of
choice-of-law provisions in LLC documents
is
also extremely important, because the ability of a single-member LLC
to
continue in existence after the departure of
the sole member is often
dependent on state law
that enables the single-member LLC to continue in
existence.
Reporter's Comment 6: The DLLC Act also
specifically provides for the
exercise of a
deceased or terminated member's rights by a personal
representative. Del. Code Ann. tit. 6, 18-705. The DLLC Act
also
provides for termination of an LLC without
members, but contains a
mechanism to prevent
the winding up the LLC.
The DLLC Act permits the admission of a personal
representative of the
departed member within 90
days after such departure, if the representative
agrees in writing to be admitted or such representative is admitted
pursuant
to a provision in the LLC agreement
providing for such admission on the
departure
of a member. See Del. Code Ann. tit. 6, 18-801(a)(4).
Reporter's Comment 7: It has been suggested that
the single-member LLC
operating agreement
provide (where permitted) that a board of managers,
containing at least two "independent" members, would govern
certain
management and operating decisions. The
operating agreement would
provide that no
bankruptcy filing or related action could occur without the
unanimous consent of all the board members. See Alexander
Dill, Yaron
Ernst, Michael Kanef, and Adam
Toft, Handle With Care: Single Member
LLCs in
Structured Transactions, Special Report, Moody's Investor
Services, March 19, 1999. However, if the outside managers
are not truly
independent and do not perform
their fiduciary duty to the entity (and to all
creditors, including unsecured creditors), as opposed to specific
third-party
creditors, the goal of
bankruptcy-remoteness may not be achieved.
The inclusion, however, of such a "bankruptcy remote
provision" in an LLC
operating agreement,
especially one that requires approval of certain entity
actions by an independent director who is in actuality
under the influence
of a major secured lender,
may later be determined by a bankruptcy court
to run afoul of the Code's prohibition of provisions preventing an
entity
from commencing a bankruptcy
reorganization.
Also, several courts have held that as an entity approaches
insolvency, i.e.,
becomes unable to pay its
debts as they become due in the ordinary course
of business, the directors owe a fiduciary duty to all the creditors of
the
company. See, e.g., In In re Kingston
Square Associates, 214 B.R.
713, 735 (Bankr.
S.D.N.Y. 1997). In this case, the debtor was unable to
obtain its board of directors' permission to file a voluntary
bankruptcy
proceeding because of the refusal of
the "independent director" to authorize
such a
filing. The debtor then orchestrated an involuntary filing by
certain
unsecured creditors (with the help of
the debtor's limited partners). The
bankruptcy
court found that such actions were not taken in bad faith and
that the debtor reasonably believed that the best course of
action for the
entity was to file bankruptcy.
The court further held that such actions were
necessary because the "independent director" had abdicated his
fiduciary
duty to the debtors, creditors and
limited partners in favor of the interests
of
the mortgage lender. The court therefore refused to grant the
secured
creditor's motion to dismiss the
involuntary filing. The court also appointed
a
Chapter 11 trustee, and held that the debtor's board of directors
had
violated their fiduciary duties owed to the
debtor, its limited partners and
its unsecured
creditors and interest holders, in favor of the interests of the
mortgage lender. The court declined, however, to
specifically nullify the
debtor corporation's
bylaw provision containing the bankruptcy-proof
provisions as against public policy.
Reporter's Comment 8: Another proposed method of
enhancing the
bankruptcy-remoteness of a
single-member LLC is to structure the entity so
that the sole member is itself a single-purpose bankruptcy-remote
entity.
Unlike an individual, who can (and
eventually will) die, the sole member
of a
single-member LLC that is itself structured as a single-asset
bankruptcy-remote entity will have a perpetual existence.
However,
borrowers may resist the imposition of
such a requirement because they lose
some of
the flexibility and cost-saving advantages, including direct
personal
ownership, of single-member
LLCs.
The Reporter for this item is Jack Murray of First American
Title Insurance
Company.
BROKERS; LISTING AGREEMENTS; COMMISSION:
Although
a series of letters and other
documents, taken together, may satisfy the
Statute of Frauds applicable to brokerage agreements, the requirement
that
the writing set forth either a dollar
amount or the rate of commission cannot
be
satisfied by specifying or implying a "reasonable" commission.
C&J
Colonial Realty, Inc. v. Poughkeepsie
Savings Bank,355 N.J. Super. 444,
810 A.2d 1086
(App. Div. 2002).
This lengthy case reads like a bad screenplay - "The Broker
Who Wouldn't
Go Away." I understand that
there's an HBO special. . .
A bank, through its subsidiary, became the half-owner (with
RTC) of an
abandoned and partially completed
condominium development as a result
of
foreclosure proceedings. A real estate broker became aware of
the
property and called the bank's contact
person. The bank told the broker that
the
bank did not yet own the property free and clear and thus could not
convey title. The broker also was advised that the
bank was not going to list
the property with a
broker "because the property had already elicited
substantial unsolicited interest from developers and the Bank had
been
successful in selling properties
directly."
The broker told the bank's officer "that he wanted to
introduce the property
to some people he worked
with on an ongoing basis ... [and the bank's
officer] said that would be fine but that the bank would 'not take a dime
less
than three million dollars.'" The broker
also understood that there would be
other
financial requirements for any offer. The bank's officer invited
the
broker "to send him a letter with his
business card requesting a sales
information
package for the property," and when asked if the broker could
visit the site, he said, "sure, be my guest."
The bank never sent a package about the property.
Nonetheless, the broker
wrote to the bank
saying, "I may be a principal in a group to buy the project
but failing that I will offer it out at 3 million plus my
commission to
preserve the bank's net figures
desired." There was no response to this
letter.
The broker visited the site with
his builders, but they were not interested or
able to meet the bank's cash requirements. The broker then
contacted
various developers and showed the
property only to those people who
signed a
"notice of showing" which stated that the broker "had the seller's
authorization to offer the property and that the seller
would pay the
commission." None of those
notices were ever sent to the bank.
Eventually,
after unsuccessful attempts to reach the bank's officer, the
broker wrote to the bank's president listing a number of
people who had
been shown the property by the
broker. In each case, the broker had quoted
a purchase price, which after a ten percent commission would still net
the
bank more than the minimum amount the bank
had been seeking.
The bank's president responded by pointing out that the
original bank
officer was "responsible for
managing and marketing" the asset and pointing
out that the broker had never been given authorization "either verbally
or in
writing to show this property to a
prospective purchaser." Even before the
broker received that letter, he arranged to show the property to
two
individuals who had responded to the
broker's newspaper advertisements
and signed a
"notice of showing" indicating that they had visited the bank's
property. The notice included an acknowledgment by
the two individuals
that the broker had
informed them that the broker would claim a ten percent
commission on the sale of the property and that the broker
would be
specified as the procuring
broker. One of these two individuals then met
with the bank's original officer.
Another real estate developer became aware of the
availability of the
property through a chain of
contacts in the form of social contacts and the
like that began with one of the two individuals that the broker
had
introduced to the property.
Eventually, it appeared that this developer
would be purchasing the property. At that time, the bank's attorney
wrote
to the real estate broker alleging that
the broker, "without authority [had]
represented to certain potential purchasers that [it had] authority to
show
this property." It went on to say,
"[y]ou have no listing agreement. Without
such a listing, the owners are not obligated to pay you commission,
no
matter how many telephone calls or letters
your [sic] may sent [sic] to my
client alleging
that such a listing exists."
The broker responded that it wanted either an exclusive
listing or some
other form of authorization to
offer the property for sale on an open-listing
basis. The broker's letter reiterated that based upon its earliest
discussions
with the bank's original officer,
the broker believed that it had authorization
to offer the property to several potential buyers. The bank
instructed its
attorney to send the broker a
"get-out-of-our-hair letter" saying, among
other things, that the broker had no authority to represent the
bank.
Eventually, the property was sold and the
buying entity did not include any
of the
individuals that the broker had introduced to the property. It
did
include people that learned of the property
through those individuals. The
sales
contract included a provision whereby the buyer agreed to indemnify
the bank for any commission claimed by the broker. A
separate agreement
between the buyer and one of
the two individuals that the broker had
introduced to the property was executed, whereby the buyer paid
that
individual on a monthly basis. That
agreement included a provision
whereby the
individual agreed to indemnify the buyer against brokerage
commissions from the original broker.
The broker sued for its commission, and after a lengthy
bench trial, the
lower court found in favor of
the broker (yes, the broker!!) and awarded a
commission based on a five percent rate. The bank and the buyer
were held
to be jointly liable. Each
appealed and the broker appealed the application
of only a five percent commission.
As to the rate of commission, the bank had testified that
the typical
commission paid by the bank was two
percent or two and one-half percent
and the
largest was four percent, which was warranted where there was a
low purchase price. The bank also testified that it
had used a broker on only
two or three of the
ten or twelve sales it had accomplished in the prior two
years. One of the buyers explained that he was
accustomed to paying on a
sliding scale
beginning with a five percent commission and running down
to about a two percent commission. The broker argued
that he first told the
bank that his commission
"could be five or ten" percent and that the bank
responded "I don't care what you charge." The broker asserted that
the
commission on "raw land" was typically ten
percent. The Appellate
Division found the
legal basis for the lower court's commission decision to
be less than clear. It also found the factual basis
for the lower court's
conclusions to be
"somewhat contradictory."
The bank argued that the broker did not have an enforceable
commission
agreement because it failed to
satisfy any element of the Statute of Frauds.
The lower court had found that the Statute of Frauds was "fully satisfied
by
the series of correspondence" because "[w]e
don't need a single writing" and
even if there
was a statutory failure, there was "no question" that the broker
was the efficient procuring cause of the
purchase.
The Appellate Division carefully reviewed all of the
correspondence and
found that there was never a
clear and "uncontroverted" agreement
regarding
the amount of the commission. Further, despite the lower
court's
finding that the authorization was
based on the "series of correspondence,"
the
lower court never discussed the ten percent commission figure,
"finding
only that the Bank had agreed to pay a
'reasonable' commission."
The Statute of Frauds in force at the time in question
required that the
writing state "either the
amount or rate of commission." In fact, "[t]o hold
that the specific statutory direction is
satisfied by an implied agreement to
pay a 'reasonable' commission renders that portion of the
statute
meaningless and would be a violation of
the basis statutory construction."
Further,
"[a]n implied agreement to pay a 'reasonable' commission is fraught
with the risk of misunderstanding, misinterpretation and
possible litigation,
the avoidance of which is
the statute's purpose."
Consequently, the Court concluded that there was "no factual
or legal basis
in support of the [lower
court's] conclusion that [the critical broker's] letter
satisfied the written authorization requirement of the
statute of frauds
entitling [the broker] to a
'reasonable' commission." The Court then
analyzed all of the other correspondence and concluded that the
lower
court's finding that the "parties'
writing created an enforceable agreement
under
the Statute of Frauds [was] unsupported by the record and the law,
and [that the lower court's] decision that [the broker] was
entitled to a five
percent commission must be
reversed."
Comment 1: Of course, we don't necessarily know "the truth
and nothing
but the truth" about this
deal. The court's recitation of the facts, however,
is the basis for the opinion, and what we should assume to
be the
controlling narrative.
The best case for the broker is that it notified the seller
that it would show
the property and would
expect a commission based upon a net listing. The
seller never responded positively in writing to this
proposal, but later
acknowledged some
responsibility with regard to several individuals to
whom the broker had introduced the property.
In the editor's view, there is a difference between an open
listing, to which
the client apparently never
agreed, and an acknowledgment that in one
instance the bank would be willing to negotiate a commission respecting
a
certain prospect. In the end, that
prospect did not become a principal of the
ownership group. Because that prospect had local connections, and
there
was some bad blood, the ownership group
elected to make some payments
to the prospect
to "keep him happy." (In return, he agreed to indemnify the
group for any exposure on commission to the
broker.)
As a consequence of the above in the editor's mind there is
no reason to talk
about the vagueness as to the
commission amount. There simply was no
listing.
Comment 2: The case is a good object lesson to those who
lack experience
dealing with commercial
brokers. Although most are reputable and
straightforward professionals, some are in the business of ensnaring
clients
in a web of half promises and uncertain
representations, leading to a
colorable claim
that can be used to extort a payoff. Since we may not have
all the facts, the editor is not saying that the broker
here actually fit that
description, but the
court's narrative describes a set of events that illustrates
the problem. The bottom line - authorize no behavior
except what is set
forth in a clear and
unambiguous listing agreement.
COMMUNITY ASSOCIATIONS; DEVELOPER TRANSITION:
If
transition from a developer to a community
or property owners' association
does not take
formally take place because of the developer's bankruptcy, it
will be deemed to have taken place at the time of the
bankruptcy if it was
clearly intended that the
affected common elements were to be conveyed to
the association. Poblette v. Towne of Historic Smithville
Community
Association, Inc., 355 N.J. Super.
55, 809 A.2d 178 (App. Div. 2002).
The developer of a planned unit development created a
nonprofit
corporation (Association) to maintain
the development in accordance with
the
provisions of a "Declaration." The Declaration described "[a]n
easement for the present and future installation and
maintenance of electric
service, master and/or
cable TV service, telephone service, water (storm
water and a sanitary sewer), gas and drainage facilities and the
necessary
appurtenances to the same" drawn in
favor of the developer, the
Association, and
others. Each Association member's right to enjoyment and
use of the community facilities was subject to that
easement. The
Association had
responsibility for the maintenance, governance, and
administration of common facilities as well as the responsibility
for
maintenance of certain facilities, not
owned by the Association, but known
as limited
common facilities.
The development experienced a significant storm and some
homeowners in
the development "suffered
substantial damage to their homes from flooding
allegedly caused by the overflow of a detention basin on the
Development
that was to form part of the storm
water drainage system. Significantly, the
developer had gone bankrupt well before the flood had occurred."
The
homeowners sued the Association and others
on the theory that the
Association and the
others were "under a duty to maintain and repair the
detention basin ... as the holder of an easement granting exclusive
control
of said detention basis to [the
Association]."
The lower court, on a motion for summary judgment, held
that: (a)
transition of the development took
place with respect to the storm water
system
between the bankrupt developer and the Association; (b) the
Association had responsibility for the basin; (c) the
Association, "as the
easement holder, was 'the
owner' and 'operator' of the storm water basis";
and (d) the Association "had a duty by way of the easement created by
the
[Declaration] to inspect, as an element of
its maintenance obligations, the
storm water
basin which [was] the subject of [the] litigation." The
failure
of the Association to inspect the storm
water basin and discover and correct
the lack
of an outflow mechanism and/or the lack of adequate depth of the
structure as the proximate cause of the flooding" was
preserved for
determination at trial. At
trial, a jury found the Association and its
management company liable for damages.
On appeal, the Association argued that: "(1) no easement in
favor of the
Association existed under the
relevant provisions of [the Declaration]
because the detention basis [was] neither a 'Community Facility' nor
a
'Limited Community Facility' as those terms
were defined, and (2) even if
the basin did
meet either definition, no easement was created because there
never was a 'transition' of the duty to maintain the
detention basis from the
developer to the
Association."
The Appellate Division rejected those arguments. To
the Court, it didn't
matter that the detention
basis, by definition, did not fall exactly into either
the category of Community Facilities or Limited Community
Facilities.
That was because the Court
concluded "that whether or not the basin falls
within these definitions is not dispositive in determining whether
the
Association held an easement to the basin
in view of the broad language
contained" in the
Declaration. It then looked to easement language
reserving, to the Association, an easement for the "water [storm water
and
sanitary sewer], ..., which easement shall
run in favor of the ...
[Association]...
." To the Court, the import of that language was that the
easement was not "circumscribed to cover only community and
limited
community facilities, but to all
property within the development."
As to the Association's argument that the easement to
maintain the storm
basin "never attached to the
Association because there had not been a
formal
'transition' of this responsibility from the developer to the
Association, the Court pointed out that although the
Declaration did not
expressly discuss the
concept of transition, this would not be the end of its
analysis. The Court also recognized that New Jersey
courts had never
"addressed the precise issue
of when a transition has occurred in which the
developer cedes to a homeowner's association, or similarly
empowered
organization, the rights and duties
under an easement to maintain common
facilities
for the benefit of the property owners in a planned development."
In light of the lack of controlling authority, the Court
looked to the intent of
the developer "as to
the existence, timing and scope" of such an easement.
In doing so, it examined the overall Declaration "and the
circumstances
surrounding its adoption."
Here, the Court found that the intent of the
developer was "intertwined with the statutory provisions governing
his
conduct in developing and offering for sale
a community development."
Under that statutory
scheme, a developer must create an association with the
obligation to manage the common elements of the
facility. The legislative
history
explains that associations are required to be formed "to safeguard
the interests of the individual owners or occupants."
Further, a New Jersey
statute provides that
"[t]he association shall exercise its powers and
discharge its functions in a manner that protects and furthers the
health,
safety, and general welfare of the
residents of the community." To aid in its
analysis, the Court pointed out that when trying to determine the
developer's
intent, it must recognize that, "at
least in part, [such an attempt must have
been]
to draft a declaration in compliance with the requirement of the Act
and the purpose underlying its provisions." Against
that "backdrop," the
Court needed to determine
what would happen if a developer went bankrupt
before a "formal transition."
With the circumstances presented in this case, the Court
found that the
transition of duties had
actually occurred. This was because "the detention
basis in question was constructed to serve the common
interests of the
individual property owners of
the development. Hence, the detention basis
was intended to be a limited community facility as defined in
the
Declaration." More importantly, the
Court found "it inconceivable that it
was the
intent of the Legislature or of the developer upon drafting the
easement provision described above, that in the event of
the developer's
bankruptcy, the easement in
favor of the Association should not be given
effect. To hold otherwise would allow the Association to disclaim
any
responsibility as to the very duties it was
almost exclusively formed to
assume simply
because there was not a formal declaration that these duties
had been transferred to it by the developer." As
such, the Court concluded
that a de facto
transfer to the Association "of those rights and obligations
under the easement provisions contained in the Declaration
occurred."
The Court also pointed out the well established general rule
that "absent a
contrary agreement, the holder
of an easement has a duty to maintain and
repair the property/facility on a servient tenement subject to the
easement."
Further, New Jersey case law has
specifically held "that a duty to inspect
property subject to an easement exists as to the easement holder."
In
furtherance of that duty to inspect, the
Court looked to County Development
Standards
which stated "that detention and retention basis 'drainage systems'
must be inspected on a routine basis to ensure that they
are functioning
properly." According to
the Court, had the Association conducted such
inspections, it would have seen that the drainage basin lacked
sufficient
outlets.
Comment 1: Someone has got to be in control of these
facilities, and it
clearly was the intent of
the developer to transfer them at some time to the
Association. But it does seem to be an unfortunate "gotcha" if
the
Association lacked the awareness of its
ownership and responsibility in this
case.
The court plays a little loose with the issue of developer's
intent. First, it
ought to be set that
the intent ought to be mutual - in other words the
homeowners and the developer ought to agree upon or at least
understand
the process by which the facilities
are transferred. Second, it is difficult to
say that either the developer or the owners, at the time the Declaration
was
filed, had any intent other than to
transfer the facilities at the appropriate
time
provided for assuming no bankruptcy. The developer didn't intend
to
go bankrupt, and the homeowners also didn't
expect the bankruptcy.
Consequently, and
discussion as to what the partied "intended" in the event
of the developer's bankruptcy is nothing but castles in the
air.
Comment 2: Let us assume, for instance, that the developer
had a
considerable amount of work to do on the
flood facilities themselves, but
went bankrupt
before completing them. Is it fair to say that the Association
really expected to be in charge of those facilities upon
such bankruptcy?
Isn't another interpretation
that the homeowners were entitled to wait and
see what would come out of the bankruptcy - whether the developer has
a
successor? Further, is it possible that
the homeowners, in the event of the
developer's
bankruptcy, might elect not to take over the responsibilities,
which, because of the bankruptcy and developer's other
derelictions, might
be hugely expensive to
complete and maintain - totally out of any rational
economic planning by the association?
In other words, does the Association have the obligation to
a few owners to
complete expensive but
uncompleted works that the developer originally
promised would be complete prior to transition? In the
editor's view, there
may be "changed
circumstances" here that would preclude the operation of
the scheme set forth in the Declaration, preventing
transition from occurring
and leaving the
affected homeowners and the Association to negotiate a
new relationship in light of new realities.
BANKRUPTCY; COMMUNITY ASSOCIATIONS: If transition from
a developer to a community or property owners' association
does not take
formally take place because of
the developer's bankruptcy, it will be deemed
to have taken place at the time of the bankruptcy if it was clearly
intended
that the affected common elements were
to be conveyed to the association.
Poblette v.
Towne of Historic Smithville Community Association, Inc.,
355 N.J. Super. 55, 809 A.2d 17 (App. Div. 2002), discussed
under the
heading: "Community Associations;
Developer Transition."
BANKRUPTCY; LEASES; ASSUMPTION OR REJECTION;
RIGHTS OF SUBTENANTS: Where master tenant files
bankruptcy and
rejects master lease,
subtenant's lease is terminated absent special language
in master lease or other agreement with master landlord
guaranteeing non-
disturbance.
Syufy Enters., LP v City of Oakland, 128 CR2d 808 (Cal.
App. 2002) , discussed under the heading: "Landlord/tenant;
Assignments
and Subleases; Subtenant's Rights;
Master Tenant's Bankruptcy."
CONSTITUTIONAL LAW; DUE PROCESS; NOTICE; TAX
FORECLOSURES: New York Court of Appeals upholds tax
foreclosure
where mailed notice was returned
and county did not check "ordinary
sources" for
alternative addresses. Mosssafa v. Kleiman, 2003 WL 443797
(N.Y. 2/25/03)
As most real estate lawyers know, constitutional due process
requires notice
and opportunity for a hearing
before government can take away property,
even
when the governmental action is a tax foreclosure. Although
there
hasn't been a lot of judicial discussion
of what constitutes a proper
opportunity for a
hearing in the tax foreclosure context, there has been some
important law on the question of notice. In the noted
U.S. Supreme Court
decision in Mennonite Board
of Missionaries, 462 U.S. 791 (1983), the
Court ruled that the Mullane standard of constitutional notice applied
-
"notice reasonably calculated, under the all
circumstances, to apprise . . . ."
Here, when the property owner acquired the property, she
registered an
address with the County.
The property owner later changed her address.
She claimed that she notified the County of the address change, but
could
not produce the letter (not surprisingly)
and in fact the County did not
change her
address on its records. The County continued to send the
bills
to the address on its records, and
indeed, in every year from 1983-1998,
property
owner paid the taxes, except in 1996. Several of the letters
by
which the property owner paid her taxes had
the correct address as the
return address, and
the checks had the correct address.
In 1996, there was no tax payment. This occasioned the
County, in its 1998
tax bill, to put on the
bill a warning that back taxes had not been paid and
that there was a risk of a foreclosure if payment was not made. The
1998
taxes were paid, but there was no payment
of the delinquent 1996 taxes.
The County initiated a tax foreclosure. The applicable
law required notice
of the foreclosure to be
sent to owners whose property interest was a matter
of public record at the time of the delinquent taxes and "whose name
and
address are reasonably ascertainable from
the public record, including the
records in the
office of the surrogate of the county." The County sent notice
to the same address it had been using all along - that
shown on its tax rolls.
This time the post
office returned the notice with the notation: "not
deliverable as addressed unable to forward."
The County made no further search and obtained a default
judgment of
foreclosure. A purchaser bid
$8000 at the auction, far in excess of the
$605.44 tax delinquency, and the County retained the surplus.
The
statutory redemption period ran, and
thereafter the purchaser at the tax
foreclosure
sale sought to quiet title, leading to this action.
Property owner (or, more accurately at this point, former
property owner)
argued that when the County
received back the returned letter indicating
that notice had not been effected, it had an obligation to take ordinary
steps
to ascertain her correct address, such as
to look in the telephone book or the
internet.
The New York Court of Appeals disagreed. Although it
acknowledged that,
by statute, the County had a
duty to look at more than the tax rolls, it stated
that the property owner had not demonstrated that it would have found
her
address in public records in the
surrogate's office. It rejected her claim that
the letters and checks by which she had paid earlier bills provided
notice to
the County, since there was no
requirement or expectation that the County
would use these for notice address verification and, indeed, the County
did
not keep them.
The Court's critical ruling, of course, was on the question
of whether the
County had a duty to go beyond
the surrogate's office. It rejected such a
proposition:
"As an initial matter, we reject
the view that the enforcing officer's
obligation is always satisfied by sending the
notice to the address
listed in the tax role, even where the notice is returned as
undeliverable. In such
cases, the enforcing officer is in no different
position than if an initial examination of the
roll had yielded no
address. Generally, when the notice is returned as undeliverable,
the
tax district
should conduct a reasonable search of the public record.
. . . A reasonable search of the
public record, however, does not
necessarily require searching the Internet,
voting records, motor
vehicle records, the telephone book or similar resource."
The court does not explain why it reach the somewhat
surprising conclusion
that there is no duty
even to look for the address in other readily available
public records not in the Surrogate's Office. It
admits that the County
cannot rely upon the
notice of default that it appears likely that property
owner did receive. This is not notice of foreclosure.
Nevertheless, the court
points to this notice,
together with the fact that other notices sent to the
address in the record, both before and after the 1996 default
notice,
apparently did reach property owner,
since she regularly paid taxes billed
to that
address. The owner's carelessness in not changing the record
address, despite the fact that she in fact received many
letters sent to the
wrong address, was a factor
the court took into consideration:
"While to an owner who has not
abandoned his or her property,
learning of its foreclosure is distressing -
particularly when the tax
due constituted a minuscule percentage of the
market value of the
property - the owner's interest must be balanced against the State's
interest in collecting delinquent
taxes, taking into account the status
and conduct of the owner in determining whether
notice was
reasonable." (emphasis added)
Later, the court expanded on this notion:
"When th conduct of a party does
not excuse the collecting officer
from providing notice to those whose contact
information is
reasonably ascertainable, it is nevertheless relevant in determining
whether the party's contact
information was reasonably
ascertainable."
Comment: The Editor admits to being a person of
tender sensibilities, but
the Editor is shocked
by this result. The editor understands that there is an
argument for "mass due process" here. Public agencies
can't be required
to be overly punctilious at
taxpayer's expense. "Reasonable" is good
enough. Therefore, it may be admitted that the County need not
have
checked outside of the public
records. There are many phone books these
days and they are changed frequently, and if we required phone
book
checking, we'd have to decide which phone
book was sufficient. Further,
the County
need not be required to have an Internet adept on its foreclosure
staff. But why is it all that great a burden to at
least check the voting
records or other records
that contained address at which public agencies
regularly had been able to reach the property owner?
The court qualifies its outcome, of course, by stressing the
special
circumstances here - that there was
evidence that other mail got through,
perhaps
putting into doubt the bona fides of property owner's claim that the
foreclosure notice didn't in fact reach her. But the
blanket statement that
there is no requirement
to go beyond the limited records available in one
public office when a potentially ruinous tax foreclosure is at
hand
establishes precedent that difficult to
distinguish away. It seems to the
Editor
that the court has overreached here. Tax foreclosures aren't
so
numerous that a little more caution isn't in
order when the potential
consequences of an
unnoticed foreclosure are so severe.
CONSTITUTIONAL LAW; FREE SPEECH; NOISE INJUNCTION:
Inunction that states that occupants of land may not
"unreasonably disturb"
of neighboring tenants
through excess noise is unconstitutional as an overly
vague restriction on free speech. Howard Opera House Assoc. v.
Urban
Outfitters, Inc., 322 F.3d 215 (2nd Cir.
2003), also discussed under the
heading:
"Landlord/Tenant; Good Faith and Fair Dealing; Noise Nuisance."
A city code section stated that it was unlawful to
make or cause to be made
a any loud or
unreasonable noise. "Noise shall be deemed to be
unreasonable when it disturbs, injures or endangers the peace or health
of
another . . .Any such noise shall be . . . a
public nuisance."
Landlord and other tenants brought suit for nuisance.
The question of
whether there was a breach of
the lease as well arose on landlord's claims
based upon breach of contract and breach of the implied warranty of
good
faith and fair dealing.
The court entered an order requiring Urban Outfitters to
refrain from
operating the sound system in the
store in a manner "that substantially and
unreasonably interferes with the other tenants' use of their
space." The
court also, inexplicably
ordered defendants affirmatively to operate the
sound system in a way that did not disturb the other tenants. (Does
the
defendant violate the second order if it
doesn't operate the sound system at
all?
If not, why the two phrasings?)
The court commented that it is one thing for a noise
ordinance to be broadly
worded so as to
comprehend a variety of circumstances. It is another for a
specific judicial order to have similar vagueness as this
may tend to inhibit
free
speech.
The court commented that it appeared that there was ample
evidence to
tailor the court's order more
specifically to give the defendant direction as
to just how much noise was too much. It stated that, in light of
the free
speech ramifications involved, it was
not too much to expect the trial court
to
provide this level of detail. It affirmed the finding of a public
nuisance
but reversed the injunction and
remanded.
EASEMENTS; SCOPE; ACCESS: An easement grant conveying "a
25
foot access and utility easement" may be
used not only to serve the water
tower on
adjacent property that was the original intent of the parties, but
also for general access to such adjacent property,
including access to a
cellular tower later
constructed there. Bishop v. City of Fayetteville, 2003
WL 292119 (Ark. App. 2/12/03)
In 1987, Coveys granted to the City an easement in
connection with a water
tower the City had
built on adjacent land. The easement stated that it
granted "the right of way and easement to construct, lay,
remove, relay,
enlarge and operate a water
and/or sewer pipeline or lines, manholes,
driveway and appurtenances thereto. The deed described the easement
as
"a permanent easement of 25 feet in width
for the purposes of laying a water
line and an
access driveway. . . " and described the specific metes and
bounds. In the habendum clause, the deed stated that
the right would last
so long as the "pipe line
or lines, manholes, driveway and or appurtenances,
thereto shall be maintained" for the purpose of "inspecting, maintaining
and
repairing said lines, manholes, driveway
and appurtenance of Grantee . . .
and the
removal, renewal and enlargement of such at will. . . ."
Subsequently, the city leased to Alltel the right to attach
a cellular
transmission facility to the water
tower, and Alltel used the easement to
access
the tower for three years. During this three years, Coveys
transferred
the servient estate to
plaintiffs.
After Plaintiffs obtained title, the city transferred to
another cell company
the right to build a new
cell tower on the city water tower parcel.
Plaintiffs sued to establish that the use of the easement to provide
access to
the cell tower was a surcharge of the
easement. They lost.
The appeals court ruled that the deed was unambiguous in
creating a
straight right of access to the City
owned property, and that the right of
access
was not limited to utility use. The fact that the deed also created
a
utility easement did not mean that this
purpose modified the uses that could
be made of
the road. The court commented that the language in the deed
suggesting that the parties could come on the land for the
"enlargement" of
the "lines drivew and
appurtenance of Grantee"
indicated that the
parties foresaw that the use of the right of way might
intensify over time.
The court had other evidence that a broad construction of
the right of way
was what the parties intended,
both in the implementing of a broader use by
Alltel and its continuation through the time of transfer to plaintiffs,
and in
the testimony of Dr. Covey, who indicate
that he intended a broad access
right.
Comment 1: Congratulations to the Arkansas court
for straightforwardly
interpreting the language
of the deed and not getting lured by the available
extrinsic evidence into declaring the deed to be ambiguous. It
wasn't
ambiguous. It said that it was
providing an "access driveway."
Certainly if
there is a general right of access to municipal property used as
a water tower, there is no surcharge when the access right
is used for other
significant activities,
including cell towers.
Comment 2:
The editor does have a cavil, however, with the court's
suggestion that the language in the habendum clause
indicating that the
easement could be used for
"enlargement" might mean that the roadway
could
be enlarged. Other parts of the deed unambiguously set forth
the
precise dimensions of the roadway, and the
"enlargement" language should
not be read as a
license to exceed those dimensions, since it can also be read
to permit enlargement of the pipelines and other utility
facilities, which
don't have precise
dimensions.
Comment 3: As the editor has commented in the past, lawyers
often are
careless in the drafting of
easements, generally not anticipating what will
happen in the future. This is true both of lawyers drafting on
behalf of the
benefitted parties and those
working for the burdened properties.
Each side
should think into the future as to what value is really being
transferred and what is being retained.
Representing the burdened party, lawyers should think
of the easement as
a right to use the property
for an identified use and only that use. The
unique location and other characteristics of the property might make
it
valuable for other uses that might come
along in the future. Since we can't
put a
price on that value today, we shouldn't be selling it for pottage due
to
an overly broad description of permitted
uses.
Representing the benefitted party, lawyers should try to get
things as broad
and loose as they can, of
course. But if there is on the other side a savvy
negotiator, who is trying to limit the uses, then the
responsibility ought to
be to identify all
potential future applications of the easement that the client
ought now to be able to foresee and conclude are worth
purchasing.
Where these other uses are not
particularly harmful to the burdened parcel,
and we're buying something today, many of these uses can be acquired
more
cheaply now than when they are truly
valuable later. Cellular
telecommunications access, of course, is exhibit A.
DEEDS; BOUNDARIES: Description stating property is
"bounded . . . by
public road" does not convey
any portion of the road and boundary was
right
of way line of the road. Lamson Petroleum v. Hallwood
Petroleum,
824 So.2d 1194 (La.App. 3 Cir.
2001).
DEEDS; CAPACITY; PRESUMPTION: Properly executed deed
has
presumption grantor was mentally competent
at time of execution and clear
and convincing
evidence is required to overcome this. In re
Conservatorship of Moran, 821 So.2d 903 (Miss.App. 2002).
DEEDS; DELIVERY: Delivery of deed to attorney/escrow agent
is
insufficient delivery to pass title where
grantor conditions ultimate delivery
upon
execution of note and mortgage by both grantees. Smith v.
Smith,
820 So.2d 64 (Ala. 2001).
DEEDS; DELIVERY: Deed was not effectively delivered
where it was
signed and handed to one grantee,
but never recorded. James v. Mabie, 819
So.2d 795 (Fla.App. 1 Dist. 2002).
This 2-1 decision tells an interesting tale, but appears to
the editor to come
to the wrong
conclusion.
Mabie, an experienced attorney, apparently had extensive
dealings with
Urquardt and his company, Work
Enterprises. In 1992, Mabie handed
Urqhardt a deed to the property in which the company was located.
The
deed named Work as a 75% owner and one
Eugene James as a 25% owner.
James also had
dealings with Work. Apparently it was Urquardt's intent to
pay for the property by retiring mortgages against the
property, and indeed
Urquardt thereafter made
some payments on the mortgages.
In 1993, Work Enterprises entered into a lease of the
property. In 1994, the
tenant discovered
that Work did not have record title and contacted Mabie.
Mabie then notified the tenant that he had taken over
ownership of the
property and that the tenant
should remit payments to him. Later, Mabie
executed a separate lease with the tenant.
Urquardt knew of all of this and
apparently
made no objection. It should be noted that Urquardt and Work
had debt obligations to Mabie at this point. Further,
the tenant was not
getting along with Urquardt
and preferred not to deal with him.
Apparently many people knew of the deed and urged Urquardt
to record it,
but he never did. Both
Mabie and Urquardt passed away. In 1997, Work,
which had extensive liabilities to Eugene James, the named
cotenant,
quitclaimed its interest in the
property to him.
A real estate broker present at the time the deed was handed
over gave some
vague testimony about the fact
that the parties did not expect title to pass
until Urquardt had paid the mortgage. There was also evidence
that
Urquardt wanted the deed in order to show
it to some unnamed person.
Held: No intent to deliver - deed void.
Comment: The case is so "fact driven" that it likely
establishes little
precedent. But the
notion that an experienced lawyer would execute a deed
to another person and leave it with that person without objection for
more
than a year, during which time that person
made mortgage payments on the
property, and
that nevertheless the grantor had no delivery intent, strikes the
editor as absurd. To pile on more data, the dissent
indicates that Mabie
declared the gain on the
sale of the property on his income tax return for
1993. Further, the "star witness" - the realtor whose
"uncontroverted"
testimony (he was the only one
present still alive) was critical to the
majority view - also was the one who advertised the place for lease and
who
delivered the potential tenant to Urquardt
(and not to Mabie.)
All deed delivery cases are sui generis, but it does seem
that when a
competent and knowledgeable party
hands over a deed with no good
explanation, and
the parties later behave in ways that suggest that ownership
has passed, then all presumptions should favor the
conclusion that delivery
has occurred.
The later ambiguous dealing between Urquardt and Mabie
may suggest an informal "transfer back," but there apparently was never
a
formal conveyance. And in any event
Urquardt's company owned only
75% of the
property.
EMINENT DOMAIN; POLLUTED PROPERTY: Where a
condemning
authority makes a price offer, but
reserves the right to adjust it based upon
possible environmental contamination, its offer constitutes a bona
fide
offer, rejection of which permits the
condemning authority to file suit, and
the
condemning authority still has the option of filing a separate
clean-up
action. The Housing Authority of
the City of New Brunswick v. Suydam
Investors,
L.L.C., 355 N.J. Super. 530, 810 A.2d 1137 (App. Div. 2002).
The primary issue presented by this appeal was "whether a
condemnor may
consider the presence of
environmental contamination in valuing the subject
property or must [it] value the property as if it were uncontaminated
and
bring a separate action for costs of
cleanup under applicable environmental
statutes." The action involved three parcels of land located in
a
municipality's downtown area. The
municipality's housing authority sought
to
acquire the properties for a redevelopment project. Before filing
an
eminent domain action, it made an offer
based upon its expert's appraisal.
The offer
was "contingent on the satisfactory environmental status of the
property, as the appraisal does not take into account any
environmental
problems that could affect
value." The property owner made a
counterdemand nearly two and one-half times the authority's offer.
A
condemnation action was filed with the Court
and the property owner did
not oppose the
taking. In fact, it withdrew the amount that the authority had
deposited with the court. Then, the authority sought
to amend its complaint
for the purpose of
"alleging the presence of environmental contamination
as a factor affecting the value of the property and reserving its right
to
recover environmental cleanup costs" from
the property owner. The
property owner
opposed the motion on the ground that the authority had
"unfairly withheld information concerning the alleged
environmental
contamination on its
property." The Court granted the authority relief to file
an amended complaint and "also granted a six-month stay of
the
commissioner's hearing to enable the
Authority to 'attempt to complete its
environmental investigations and commence any action that it
deemed
necessary and appropriate to resolve all
issues relating to environmental
liability and
for remediation costs associated with the development of the
subject property.'"
On appeal, the Court agreed that the authority could file an
amended
complaint. It also agreed that
the authority's "valuation expert [could] take
that alleged contamination into consideration when valuing the
property
even if the Authority file[d] a
separate environmental action against [the
property owner]." On the other hand, it reversed the part of the
lower
court's order that required that any
"commissioners' award in excess of the
sum the
Authority deposited into the court [] be kept on deposit pending the
conclusion of any environment[al] action the Authority may
bring against
[the property
owner]."
One argument made by the property owner was that the
authority violated
its statutory obligation to
engage in bona fide negotiations for a voluntary
acquisition of the property when it failed to disclose the
alleged
contamination in its original
complaint. It contended that the authority
waived any right it may have had to assert that the property
was
contaminated "by not making this allegation
until after entry of the
judgment appointing
condemnation commissioners." Its arguments rested
primarily on a statute "that imposes an obligation upon a
condemnor to
engage in bona fide negotiations
for voluntary acquisition of a property
before
filing a complaint." The statute provides that a condemning
authority, in its pre-suit offer, must provide "a
reasonable disclosure of the
manner in which
the amount of such offered compensation has been
calculated, and such other matters as may be required by the
rules." A
particular Court Rule requires,
among other things, that a condemning
authority
disclose "any unusual factors known to the condemnor which may
affect value." If the condemnor fails to disclose the
information required by
the relevant statute
and the Court Rule, "the condemnee is entitled to
dismissal of the complaint." Here, the property owner contended
that the
"alleged environmental contamination
on its property constituted an
'unusual
factor[] known to the condemnor which may affect value' within
the intendment of [the Court Rule] and therefore the
Authority's failure to
disclose that
contamination in either pre-complaint negotiations or the
complaint constituted a breach of the Authority's duty to
engage in good
faith negotiations... ."
The Court rejected that argument for two reasons.
First, "the presence of possible environmental contamination was not
one
of the factors the authority's appraiser
considered in determining" the fair
value of
the property. In fact, the authority's appraiser's report
explicitly
stated that it had not considered
the possible presence of toxic waste.
Further,
the report also assumed that the property was "free of negative
impact" with respect to environmental conditions.
Therefore, the authority's
obligation to make
"a reasonable disclosure of the manner in which the
amount of ... offered compensation [was] calculated, ..., did not
include
possible environmental
contamination." Second, "even if the Authority
violated its 'reasonable disclosure' obligation, [the property owner's]
only
remedy would be a dismissal of the
complaint." Here, the owner was not
seeking such relief. Instead, it was seeking to bar the authority
from
introducing evidence that the value of its
property was reduced by the
presence of
environmental contamination.
The Court refused to bar the authority from alleging that
the value of the
property was adversely
affected by environmental contamination on the
basis of a waiver or judicial estoppel. Even though the original
complaint
did not allege contamination, "the
possible presence of contamination was
disclosed during pre-complaint negotiations." The authority had
sent the
property owner excerpts from its Phase
I environmental assessment and
asked for access
to conduct a Phase II environmental assessment.
Consequently, it was clear that the authority did not withhold evidence
of
possible contamination. Moreover, the
Court believed that the property
owner was
aware of visible conditions that indicated the possible presence
of a contamination.
The Court then reviewed the property owner's argument that
any
environmental claim must be asserted in a
separate action under the
environmental statute
and "thus a condemnor may not rely upon
environmental contamination as the basis for reducing the award to
a
condemnee." In assessing this argument,
the Court looked to the definition
of "fair
market value," which the New Jersey Supreme Court has described
as "the value that would be assigned to the acquired
property by
knowledgeable parties freely
negotiating for its sale under normal market
conditions based on all surrounding circumstances at the time of
the
taking." According to the Court,
based upon its reading of prior case law,
the
possibility or actual presence of environmental contamination is one
of
the considerations that "would influence a
willing buyer and a willing seller
in coming to
terms as to price... ." According to the Court, "[e]xcluding
contamination evidence ... is likely to result in a
fictional property value
a result that is
inconsistent with the principles by which just compensation
is calculated. It blinks at reality to say that a
willing buyer would simply
ignore the fact of
contamination, and its attendant economic consequences...
." Consequently, the property's fair market value was
not dependent on
whether the authority files a
separate action against the property owner
under environmental statutes.
Lastly, the Court held that there was no authority in the
Eminent Domain
Act "for an order requiring a
condemnation award to be held on deposit in
court based on the pendency of another claim against the condemnee.
Such
an order would be a form of prejudgment
attachment, which is authorized
only under the
limited circumstances set forth in [New Jersey's] attachment
statute."
FAIR HOUSING; DISCRIMINATION BASED ON FAMILIAL
STATUS; STANDING: Residents of condominium that
restricts
ownership of upper floors to families
without children have standing to seek
injunction and damages arising from such policy although they
themselves
have no children and in fact live on
the first floor, where children are
permitted,
because they are part of the community affected by the policy..
Hamad v. Woodcrest Condominium Assoc., 2003 FED App.
0118P,
http://www.michbar.org/opinions/home.html?/opinions/us_appeals/20
03/042203/18790.html
(6th Cir. 3/11/03)
According to the dissent, the real gist of this battle was a
bad blood between
the two owners and the
Condominium Board, and the dispute here was only
part of an ongoing dispute involving a number of minor irritations
going
both ways. Unfortunately, the
Association was vulnerable, as any
Association
would be, when it had a bylaw specifically prohibiting families
with children from occupying the upper floors of the four
level complex.
Two of the plaintiffs alleged that they had been told
categorically when they
first looked at units
in the complex that if they anticipated having children,
they should buy on the lower floors, because the "anti
children" rules were
rigidly enforced.
They ultimately bought a unit on the first floor, and
ultimately had a child (legal on the first floor.) They elected to
move, and
did not seek to buy a unit on an
upper floor, but rather simply to sell their
unit. They alleged that others were deterred from purchasing their
unit
because of concerns about the "no child"
policy on the upper floors.
A second plaintiff lived on an upper floor and entered into
discussions to
obtain custody of her teen age
nephew. Although she was not in fact the
legal custodian of the nephew, and never expressly sought to have him
live
with her, she alleged that she was injured
by the policy.
Both plaintiffs also alleged that after they first filed
discrimination suits
against the Association,
the Association engaged in retaliatory acts, and they
sought injunctive relief and damages on those counts as well.
The trial court granted summary judgment to the Association,
apparently on
the grounds that the plaintiffs
lacked standing under the Federal Fair
Housing
Act. It based its ruling, according to the majority here, on
Fair
Housing Congress v. Weber, 993 F. Supp.
1286 (C.D. Cal. 1997), where the
court found no
standing in favor of a plaintiff who alleged that defendants
engaged in "steering" of families with children away from
second floor
units although plaintiffs,
who were not themselves residents of the
community in question, did not get "steered."
The Sixth Circuit here reversed the trial court's granting
of summary
judgment, but elected to remand the
case rather than take up either the
injunction
or damages issues. It noted that the Association had already
reached a settlement with HUD and was no longer enforcing
the policy in
question, that there were special
facts that ought to be evaluated outside of
the
standing question by the trial court itself regarding both injunctive
relief
and damages.
With regard to the standing question, the court cited cases
that established
that residents of the
community that is the subject of discriminatory
practices can have standing to object to those practices even though
they
themselves are not the target of the
practices, since they suffer from the
resulting
segregated atmosphere in the community.
Comment 1: It should be noted that the 2-1 majority also
appeared
somewhat dubious that a colorable
claim for damages could be made here,
but felt
that remand was the proper way to address the problem. The
dissent
emphasized that there was scant
evidence that the policy in question really
affected the ability of the plaintiffs to sell their unit or the ability
of their co-
plaintiff from bringing in her
nephew. Since the policy later terminated,
there was no continuing impact.
Comment 2: Both the Fair Housing Congress case and this case
suggest
that there may be some difficulty for
the plaintiffs in showing that there was
a
"segregated community" here from which the plaintiffs suffered since
families with children were still welcome in the community
- just not on
upper floors.
Comment 3: In case you're wondering - it appears that the
bulk of the
complex was occupied by elderly
tenants and that, in fact, there had been
some
thought to turning the complex into an "elderly only" complex, from
which children might lawfully be excluded. Remember,
though, that these
"elderly only" complexes in
fact involve much more than a simple policy
welcoming elderly tenants. The HUD Regulations are at
http://www.fairhousing.com/legal_research/regs/fhr_100-302.htm.
FEDERAL INCOME TAX; DEDUCTIONS; BUSINESS
EXPENSES;
IMPACT FEES: Impact fees
incurred by a taxpayer in association with
the
construction of a new residential rental building must be capitalized
and
allocated to the building. Rev. Rul.
2002-9, 2002-10 I.R.B. 614.
This Revenue Ruling addressed whether impact fees incurred
by a taxpayer
in connection with the
construction of a new residential rental building are
capitalized and allocated to the building under 263(a) and 263A of
the
Internal Revenue Code.
Taxpayer develops, owns, and leases residential rental
property and
purchased unimproved land to build
a new residential rental building. The
taxpayer was required by the County to pay impact fees on the
new
development. "Impact fees are
one-time charges that are imposed by a state
or
local government against new development or expansion of existing
development to finance specific offsite capital
improvements for general
public use that are
necessitated by the new or expanded development.
Section 263(a) provides that no deduction is allowed for any
amount paid
out for new buildings or for
permanent improvements made to increase the
property value. Citing Oriole Homes Corp. v. United States, 705 F.
Supp.
1531 (S.D. Fla. 1989), the IRS stated
that impact fees must be capitalized
under
263(a) of the I.R.C. Oriole addressed specifically required costs
of
providing traffic signals as well as road,
educational, regional park, and
municipal park
impact fees paid for the approval and recordation of plats.
Section 263A provides that direct costs and a portion of
indirect costs of
real or tangible personal
property produced by a taxpayer must be
capitalized to the property produced. The regulations provide
that
"produce" includes "develop" and
"improve." Citing Von-Lusk v.
Commissioner, 104 T.C. 207 (1995), the IRS stated that certain
expenses
incurred by a developer before
physical work began on undeveloped land
are
subject to 263A. Therefore, the IRS held that impact fees must
be
capitalized under 263A.
The Revenue Ruling also provided rules regarding the
application of the
ruling. First, if a
taxpayer changes its method of accounting in order to
conform to the revenue ruling, the provisions outlined in Rev. Proc.
2002-9
must be followed with minor
exceptions. Second, if a depreciation
deduction is allowed pursuant to 167(a), then the taxpayer must
depreciate
the impact fees under 168 as
residential rental property or nonresidential
real property. Finally, the IRS held that impact fees are included
in the
eligible basis of a qualified low-income
building.
Comment: Cheer up, folks. If you hire lawyers to fight
the impact fees,
presumably those expenses are
deductible. Otherwise, tax law is all a
matter of hair slicing and (dare we say it in April?) risk
taking.
Compliance with a revenue ruling like
this is certainly the safest course,
and,
really, did you think the Service would find otherwise?
FEDERAL INCOME TAX; DEDUCTIONS; BUSINESS
EXPENSES;
SELF-CHARGED MANAGEMENT FEES:
Although sympathetic to
taxpayers, the United
States Tax Court does not permit taxpayers to deduct
self-charged management fees against management fee income. Hillman
v.
Commissioner, 2002 WL 531157 (U.S. Tax
Ct.).
Petitioner is the controlling shareholder of a Subchapter S
corporation that
provides real estate
management services to various pass through entities.
Petitioner also has direct and indirect interests in these pass through
entities,
but did not participate in their
management. He did, however, materially
participate in the S corp.'s real estate management activity.
While Petitioner computed his tax return by including the
salary received
from the S corp. in gross
income, the pass through entities deducted the
corresponding management fees paid to the S corp. as trade or
business
losses. Consequently, Petitioner
treated his proportionate share of the pass
through entities' deduction as a reduction of his gross income received
from
activities characterized as
nonpassive. In other words, Petitioner claimed
gross income from the S corp., and then deducted an equal amount as
a
trade or business loss from of the pass
through entities. The IRS issued a
notice
of deficiency disallowing the characterization of the management fee
expense as nonpassive (the passive activity rules only
permit passive losses
to be offset against
passive income).
Petitioner initially argued that the method should be
permitted under the
self-charged approach
pursuant to Proposed Income Tax Regulation
1.469-7. However, the Fourth Circuit did not approve. In the
alternative,
Petitioner argues that the real
estate management fee deductions are part of
a
separate trade or business of the real estate entities, i.e. the
nonpassive
activity part. This would
allow Petitioner to deduct the losses against his
nonpassive income.
The court held that the payment of management fees by the
pass through
real estate entities did not
constitute a trade or business or separate activity
from the rental activity of those entities. The fees were incurred
in
connection with rental activity.
Accordingly, these payments did not meet
IRC 469(1)'s definition of "Trade or Business"
expenses.
The court also noted that Petitioner "[has] been snared by
the reach of
section 469 in, what appears to
be, most inequitable circumstances."
Although
the commentary contained in the legislative history of 469
suggests that self-charged items should be provided for,
the court states it
is up to Congress to
change, and not the courts.
FEDERAL INCOME TAX; LIKE-KIND EXCHANGES; BASIS:
The
taxpayers did not present evidence to
support their asserted FMV of
property they
received Bundren v. Commissioner, 2002 WL 481589 (10th
Cir.).
Taxpayers claimed two deductions in 1995 and 1996 that the
Commissioner
determined were overstated.
First, Taxpayers took a depreciation deduction
for rental property they acquired. Second, the Taxpayers took a
loss on the
sale of the property in 1996.
The property in question was acquired by
exchanging other rental property they owned for the property at
issue. The
transaction qualified as a
like-kind exchange under 1031 of the I.R.C.
The adjusted basis of property received in a like-kind
exchange is equal to
the carryover basis in the
relinquished property, minus any "boot", and
adjusted for any recognized gain or loss. The issue in this case
involves the
carryover basis of the property
given up. The property given up was
Taxpayer's residence that was converted to rental property. The
adjusted
basis in the converted property equals
the fair market value ("FMV") at the
time of
conversion. The FMV is what is in dispute in this case.
Taxpayers took depreciation deductions and calculated the
loss on the sale
of the property using a FMV
(basis) of $200,000. The IRS determined that
the FMV (basis) was $134,500, which was the price the taxpayers listed
it
for sale. Taxpayers argue that the IRS
did not incorporate taxpayers'
pressure to sell
the land in a hurry; they were strapped for cash. The Tenth
Circuit stated that Taxpayers have the burden to present
evidence
supporting a FMV of $200,000.
Taxpayers failed to do so. Accordingly,
the court affirmed the decision of the Tax Court adopting the
$134,500
amount.
FEDERAL INCOME TAX; TAX LIENS; FORECLOSURE:
Property
liens recorded by the IRS for
delinquent taxes may be discharged at the
IRS's
discretion for purposes of selling the property; the liens reattach to
the
proceeds. Cook v. Layman, 2002 WL
741563 (E.D. Cal.).
Plaintiff purchaser is moving for an order permitting the
sale of real
property. Defendant seller
is the holder of property that is subject to IRS
liens for delinquent taxes. Defendant purchased the property in
1987, but
failed to record the transfer until
1992. The IRS recorded the liens in 1990.
The plaintiff filed this action for specific performance in state
court. The
Government intervened and
removed the case to federal court seeking
foreclosure on the liens.
In a separate
suit, Defendant brought a quiet title action against the
Government. The Magistrate Judge granted summary
judgment in favor of
the Government ruling that
the lien attached to the land at issue. The Ninth
Circuit affirmed. In this action, Plaintiff seeks an
order (1) permitting the
sale of the property;
(2) holding the proceeds from the sale in the custody
of the court pending the outcome of the action between the Government
and
Defendant; and (3) permitting recovery of
attorney's fees.
Under 26 U.S.C. 6325(b)(3), the IRS is allowed to
discharge property
from a lien so that it may
be sold and the liens reattach to the sale proceeds.
However, that section provides relief only at the Government's
discretion
and pursuant to a written
agreement. The Government opposes Plaintiff's
discharge request because the proposed sale price no longer represents
the
fair market value. The Government
contends that there is no basis for the
court
to order the discharge. The U.S. District Court for the Eastern
District
of California denied Plaintiff's
motion, stating that 6325(b)(3) does not
authorize the issuance of a certificate of discharge without approval
from
the IRS.
FEDERAL INCOME TAX; INCOME; RENTAL INCOME;
PASSIVE/NON-PASSIVE INCOME: Rental income from a
taxpayer-
controlled corporate tenant is
characterized as non-passive income unless
the
controlling lease was entered into before Feb. 19, 1988 and was
binding.
Krukowski v. Commissioner, 279 F.3d
547 (7th Cir. 2002).
Appellant taxpayers ("TP") own two buildings that are leased
and earning
rental income. One of the
tenants is a law firm in which TP is its president
and sole shareholder. On March 1, 1987, TP and the law firm entered
into
a five-year lease that includes three
consecutive options to renew the lease,
each
for a term of three years. The lease provides that the rental amount
is
"to be mutually agreed to by the Lessor and
Lessee prior to the
commencement of a renewal
term ."
In their 1994 federal income tax return, TP reported rental
income from the
law firm as passive income and
applied passive losses derived from other
rental buildings against that income. The Commissioner issued a
deficiency
claiming that the law firm rental
income is non-passive income and
accordingly
cannot be offset by passive losses pursuant to I.R.C. 469
(stating that passive activity losses can only be used
against passive activity
income).
Further, the Commissioner points to I.R.C. 469(c)(1), which
defines passive activity income as one "which
involves the conduct of any
trade or business,
and [one] in which the taxpayer does not materially
participate." The Commissioner contends that the rental income is
not
passive activity income because TP is the
president and sole shareholder of
the law firm,
failing 469's requirements.
TP argued
that the rental income is passive pursuant to Treasury Regulation
1.469-11(c)(1)(ii), which allows taxpayers to
characterize lease
agreements as passive when
the agreement was a "written binding contract
entered into before February 19, 1988." The Seventh Circuit held
that the
renewal options contained in the lease
were not a binding extension of the
original
agreement (which was entered into in 1987). The fact that the
parties had to mutually agree on a new rental price made
the renewal option
a new agreement, not a
binding extension of the original agreement.
Finally, TP argued that Treas. Reg. 469-2(f)(6), which permits
rental
income to be recharacterized as
non-passive, is invalid. The Seventh
Circuit, siding with the First and Fifth Circuits, held Tres. Reg.
469-
2(f)(6) valid.
FEDERAL INCOME TAX; "TRADE OR BUSINESS;"
COTENANCY; IRS RULING REQUESTS: IRS Revenue
specifies the
conditions under which the
IRS will consider a request for a ruling that an
undivided fractional interest in rental real property is not an interest
in a
business entity. Rev. Proc. 2002-22,
2002-14 I.R.B. 733.
Taxpayers can request a ruling from the IRS regarding
whether their
undivided fractional interest in
rental real property (other than a mineral
property) is not an interest in a business entity within the meaning of
section
301.7701-3 of the regulations.
Certain information must be contained in the
request and certain conditions must exist before the IRS will consider
the
taxpayer's request. Even if the
request conforms to this Revenue
Procedure, the
IRS may nevertheless decline to issue a ruling. Further, this
Revenue Procedure applies to co-ownership of rental
property treated as a
tenancy-in-common under
local law.
Any request must contain a complete statement of all facts
relating to the
co-ownership; material facts
must be explained and may not be merely
incorporate by reference. Section 5 of the Rev. Proc. lists the
required
information that must be submitted
with the ruling request. Section 6
provides the conditions for obtaining the rulings.
FEDERAL INCOME TAX; TAX LIENS; PROCEDURE: The
United
States can seek summary judgment in an
action to obtain a judgment for
delinquent
taxes and to foreclose on tax liens. United States v. Weldon,
2002 WL 442267 (E.D.N.C.). aff'd 2002 WL 856475 (4th Cir.
2002).
This case involves three different motions: (1) a motion for
partial summary
judgment filed by Defendant,
(2) a motion for summary judgment filed by
the
Government, and (3) a motion for leave to amend the complaint filed
by
the Government.
In the underlying action, the Government is seeking to
reduce to judgment
tax assessments made against
Defendant for nine different tax years,
including 1993, 1994, and 1995, and to foreclose the resulting liens
against
Defendant's property. For years
1993, 1994, and 1995, Defendant
completed tax
returns that reported money was due. Rather than pay,
Defendant filed the returns with a letter denying
liability. After the initial
complaint
was filed, the Government realized that the letters included in
Defendant's 1993, 1994, and 1995 tax returns caused the
returns to be
invalid. Thus, the
Government must assess the taxes against the Defendant
through tax deficiency procedures. Accordingly, the Government
filed a
motion for leave to amend their
complaint. Defendant moved for partial
summary judgment, asserting that the 1993, 1994, and 1995
assessments
and liens were invalid.
The court granted the Government's motion for leave to amend
their
complaint and denied Defendant's motion
for partial summary judgment as
moot. In
so holding, the court discussed the Federal Rules of Civil
Procedure and stated that the Government's motion must be
granted absent
bad faith, with a dilatory
motive, or with the intent to cause undue delay.
The court stated that the Government's failure to realize that the tax
returns
were invalid may be negligent, but that
the failure did not rise to the level
to
warrant a denial of the motion for leave to amend.
The Government also moved for summary judgment to reduce to
judgment
assessments for income taxes for the
remaining six years, and to foreclose
federal
tax liens against Defendant's properties. The court granted
the
motion, stating there is a presumption that
a timely assessment is correct,
and it is up to
the taxpayer to produce evidence refuting the validity of the
assessment. Defendant did not produce such
evidence.
Defendant also owned three pieces of property that were
subject to liens.
However, he transferred the
property to his mother in exchange for $10.00.
The court stated that the liens are in effect at the time of the tax
assessment.
As the transfer occurred after the
tax assessment, the property was subject
to the
liens at the time of transfer. Accordingly, the motion to foreclose
on
the liens was granted.
FRAUDULENT CONVEYANCES; CREDITORS: A conveyance
made
prior to the incurring of debts to
creditors now challenging the conveyance
as
fraudulent may be treated as fraudulent if made with the intent to
defraud
these later arising creditors.
Smith v. Orman, 822 So. 2d 975 (Miss. App.
2002)
Smith was named executrix in her brother's will. In
the six weeks prior to
her formal application
for appointment as executrix, Smith appropriated
some of her deceased brother's estate to her personal use. On the
same day
that she applied for formal
appointment, she also transferred a fee interest
in a farm to her daughter, reserving a life estate in
herself.
In the following six years, Smith expropriated quite a bit
of additional
money from the estate, for her
own use and that of her son. During that
time, she filed a false accounting and otherwise mislead the heirs of
the
state about her activities.
Ultimately, the heirs filed suit, got a new
accounting, and sought reimbursement of the misappropriated funds.
In
connection with that suit, they filed to set
aside the conveyance of the farm
as a
fraudulent conveyance.
Smith admitted that the transfer of the farm rendered her
without assets to
pay her debts, but argued
that the purpose was in fact to defraud another
creditor, not in this action. She noted that the transfer of the
farm occurred
a short period before she was
appointed executrix of the estate, and that the
beneficiaries of the estate were not then her creditors.
The court concluded that the relevant question is whether
there was reason
to believe that Smith was in
fact attempting to shield her property from
these creditors, even though their claims had not yet fully
ripened. It noted
that she had already
stripped some money from the estate prior to her
appointment.
The court also noted that the ordinary three year statute of
limitations would
not apply here because Smith
fraudulently withheld information that would
have permitted the estate beneficiaries to realize that they had a
claim. The
court distinguished a prior
Mississippi case that had refused to toll the
statute based upon fraud because the creditor had not exercised
"due
diligence." In that case, although
the debtor had testified falsely in a
creditor's claim hearing, the creditor knew that it had a claim and
could
have examined the property records and
detected the conveyance. Here,
unlike in
the precedent case, the creditors were misled about the presence
of the claim itself.
The court also slugged the Smith with punitive damages and
the attornies'
fees of the beneficiaries.
It established a constructive trust on the farm. The
grantees of the farm included parties who themselves were
potential
claimants as beneficiaries of the
estate.
Comment 1: The editor found interesting the notion that the
fraudulent
purpose could operate
prospectively. Seems right in theory. Note that the
conveyance in fact stripped the debtor of
assets. But if her assertion was
true that she had another "live" creditor that she really intended to
defraud,
it does seem that the court stretches
the analysis a bit to help out these
creditors. The court clearly bases its conclusion on the "future
intent to
defraud" analysis and does not rely
upon the small diversions made prior to
the
appointment and the challenged transfer.
Comment 2: One piece of testimony is worth noting, as the
court did. In
response to a question as
to why Smith and her son could not produce
copies of bank statements relating to the decedent's personal
checking
account, from which $11,000
disappeared in a week's time, the son testified
that the statements arrived but were discarded unopened, since "you
must
have so much room to keep
things."
FRAUDULENT CONVEYANCES; INSOLVENCY: A debtor
without
liquid assets may be found insolvent
for fraudulent conveyance purposes if
it is not
paying debts when due even if it has been awarded a multimillion
dollar judgment which was on appeal at the time of the
challenged
conveyance. Levin v. Ethan
Allen, 823 So. 2d 132 (Fla. App. 2002)
Plaintiff, a furniture manufacture was in a dispute
with Georgetown, a
retailer, about late
payments for furniture that plaintiff had shipped to
Georgetown's stores. Plaintiff terminated its business at those
stores, thus
allegedly diverting business to
other stores carrying plaintiff's brand. In the
same action, Georgetown sued for tortious interference and
plaintiff
counterclaimed for the late
payments. The trial court, without a jury gave
Georgetown a verdict for tortious interference including over $7 million
for
future profits. It also awarded a
judgment of $2.5 million for plaintiff on
the
furniture payments.
While an appeal was pending, Georgetown transferred the real
estate it
owned and effectively became
insolvent. In one case, it transferred property
to a company owned by the Levins, the same parties that owned
Georgetown, who also received a $425,000 mortgage on the
property.
Later, that property was sold to
third parties and Levins were paid for the
mortgage. In another case, Georgetown gave Levins a $500,000
third
mortgage on the property allegedly for no
consideration. Later, Levins
acquired the
first mortgage on the property and foreclosed from that
position. Plaintiff in the fraudulent conveyance
action argued that the third
mortgage shielded
$500,000 in equity from the reach of creditors. (Whether
there was in fact any impact on creditors is an issue to be
resolved on
remand.)
Later, the net $5 million judgment in favor of Georgetown
was reversed,
leaving the $2.5 million judgment
in favor of plaintiff as a claim against
Georgetown, and Plaintiff sought to have the benefits from the above
real
estate transactions disgorged on the
grounds that they constituted fraudulent
conveyances.
The majority, in this 2-1
decision, first affirmed the trial court ruling that
the presumption of insolvency that arose from the fact that Georgetown
was
no paying creditors (mortgage creditors and
property taxes) was not
overcome by the
evidence of the judgment on appeal. As to Levin's
argument that the judgment on its face should have
been treated as an asset,
the court commented:
"A judgment on appeal may be presumed correct, but
it does not follow that the judgment is . . . an asset worth its face
amount."
As to the argument that the judgment nevertheless had
settlement value, the
court acknowledged that
this could be true, and that the trial court had
erroneously refused to consider evidence of proposed settlement
offers. But
the appeals court noted
that there had been no formal proffer of proof by
Levins, so the issue was not preserved on appeal. (The dissenting
judge
scoffed that in a judge-tried trial it
was very likely that the judge was fully
aware
of the evidence concerning settlement even without an offer of
proof,
and that the lack of a proffer should
not have prevented reversal on this
ground.)
Comment 1: The case certainly underscores the old maxim "it
ain't over till
its over." Parties who
find themselves in the gloomy position of appealing
a significant net judgment against them in favor of an insolvent
creditor
would wise to keep this in mind and
keep careful track of the disposition of
the
creditor/debtor's property, just in case the light at the end of the
tunnel
in fact is real.
Comment 2: If, indeed, there was concrete evidence of a
significant
settlement offer, it does seem that
injustice occurred here someplace, either
in
the trial court's rulings or the judgments made by the Levin's counsel
not
to make a formal proffer.
JOINT TENANCY; JUDGMENT LIENS: Judgment lien on
real
property interest held by tenant in common
survives both change in title to
joint tenancy
and death of debtor joint tenant.
Dieden v
Schmidt , 128 CR2d 365 In 1981 (Cal App. 2002)
Schmidt recorded an abstract of judgment against property
owned by
Conchita and Benjamin Dieden. In 1991,
First Nationwide made a loan to
the Diedens
secured by a deed of trust on the property. Schmidt renewed his
judgment in 1992, but only against Benjamin, and then
recorded a second
abstract of judgment. When
Schmidt recorded the second abstract, the
Diedens owned the property as tenants in common. In 1994, the
Diedens
conveyed their interests in the
property to themselves as joint tenants. In
1998, Benjamin sued Schmidt to quiet title to the property. In
1999,
Benjamin died leaving Conchita as the
surviving joint tenant. Schmidt
cross-complained for foreclosure of his lien. The trial court found
that
Schmidt's judgment lien terminated on
Benjamin's death.
The court of appeal reversed, holding that Schmidt's
judgment lien survived
both the change in title
to joint tenancy and Benjamin's death, and was
therefore enforceable against Benjamin's one-half interest.
Schmidt's
judgment lien attached to Benjamin's
interest as a tenant in common before
the
creation of any right of survivorship. Until the lien was satisfied
or
extinguished, it was enforceable against
Benjamin's interest in the property
regardless
of who held that interest. When Benjamin and Conchita
transferred their tenant-in-common interests to one another in 1994
and
created a joint tenancy, she took her
interest in the property subject to the
judgment lien. The conveyance or encumbrance of an interest in
real
property subject to a judgment lien does
not affect the lien (CCP 697.390),
which may be
enforced against the property in the same manner and to the
same extent as if there had been no transfer, even after
the death of the
judgment debtor. CCP
695.070.
Reporter's Comment: This decision, like Bratcher v
Buckner109 CR2d 534
(Cal. App.. 2001),
illustrates the wisdom of keeping judgment liens alive.
Here, a 1981 judgment is finally about to pay off because
it was properly
renewed along the way. (The
court's description of the case suggests that the
judgment was entered in 1981 and renewed in 1992, which would be
too
late; more likely, the action was filed in
1981, but the judgment was not
entered until
1982, or later.) Undoubtedly the judgment has grown
considerably, with statutory interest running at 10 percent. Even if
the
judgment is ultimately determined to be
subject to equitable subrogation to
the
mortgage lien, that mortgage lien today would only have priority for
the
amount of the old mortgage loan owing back
in 1991, when the refinancing
occurred, which
should leave a sizeable equity, given payments on the
mortgage and appreciation of the property for the 12 years
thereafter.
As for the joint tenancy issue, the rule has to be that a
judgment lien
imposed on the interest of one
tenant in common cannot be defeated by a
conveyance by the two tenants in common to themselves as joint
tenants,
followed by the death of the judgment
debtor. Thus, the judgment lien still
burdened
at least half of the property.
(The judgment creditor's rejected argument that his lien now
burdened the
entire property appears
correct. If A and B, tenants in common, convey
their property to C, I would think that a judgment recorded
against A alone
burdens the entire property,
not just the half that A once owned. Thus one
imagines that the judgment creditor can sell the entire property, not
just half
of it. The same would be true if A
and B had conveyed to C and D, rather
than just
to C. And why is it not also the same case when A and B convey
to themselves, as they did here?) The court's holding that
the judgment
burdens only half of the property
(now owned entirely by the judgment
debtor's
surviving spouse) is going to create difficult allocation problems
if
the mortgagee's equitable subrogation claim
is upheld only in part. Likely
this
means that, after the property is sold, the proceeds should be
distributed as follows:
First, they should be used to pay off the equitably
subrogated part of First
Nationwide's loan
(i.e., the amount paid to retire the previous first loan).
Second, half of the remaining proceeds should go to Schmidt
to the extent
of his judgment lien, on the
ground that his lien attached to half the property
and was next in priority. If that is sufficient to pay him off, any extra
should
go to First Nationwide-along with the
other half of the proceeds-to cover the
portion
of its loan that is nonequitably subrogated.
Third, if there is any surplus after Schmidt and First
Nationwide are paid
off, it should go to
Conchita. If First Nationwide did not need all of the
funds left after Schmidt was paid, that surplus should go to Conchita,
even
if Schmidt was not fully paid off; the
fact that he had a judgment lien on
only half
the property has to mean that he has absolutely no claim to the
proceeds from the sale of the other half. -Roger
Bernhardt
(The Reporter for this case was Roger Bernhardt of the
California Bar,
writing in the California Real
Property Reporter.)
JUDGMENTS; LIENS; JOINT TENANCY: Judgment lien
on real
property interest held by tenant in
common survives both change in title to
joint
tenancy and death of debtor joint tenant.
Dieden v Schmidt , 128 CR2d 365 In 1981 (Cal App. 2002) ,
discussed
under the heading: "Joint Tenancy;
Judgment Liens.")
LANDLORD/TENANT; ASSIGNMENTS AND SUBLEASES;
RIGHTS OF SUBTENANT: Where master tenant files bankruptcy
and
rejects master lease, subtenant's lease is
terminated absent special language
in master
lease or other agreement with master landlord guaranteeing non-
disturbance. Syufy Enters., LP v City of
Oakland, 128 CR2d 808 (Cal.
App.
2002)
This was a major battle in which the subtenant hired a
leading California
real estate lawyer who fired
all the cannons. Landlord was represented by
a former contributor to the ABA Quarterly Report and to DIRT.
Although
the subtenant lost, we are rewarded
with a thorough analysis of many of the
relevant arguments and authorities on this issue.
Subtenant, a movie theater operator, held possession
under a sublease in
which it had expressly
assumed the master tenant/sublandlord's obligations
under the master lease. The master tenant filed bankruptcy and the
period
for assuming or rejecting the master
lease expired without the master tenant
taking
any action, leading to the consequence that the master lease was
deemed rejected ain bankruptcy. The master landlord
landlord then evicted
Subtenant.
Subtenant sued the landlord for, among other things, breach
of contract
based on its claim that it was a
third party beneficiary of the master lease.
The trial court found that Subtenant lost its right to possession of
the
property when the master tenant rejected
the lease in its bankruptcy
proceedings, and
granted the landlord a judgment of nonsuit. The Court of
Appeal affirmed, agreeing that rejection of the master
lease terminated the
subtenant's right of
possession.
The court first considered whether the issue was resolved by
federal
bankruptcy law. It noted
that federal courts have reached different
conclusions on this issue. It stated that some courts have
concluded that
rejection in bankruptcy
results in a complete termination of the lease. This
has been held also to terminate subleases. The
California court, however,
concluded that more
recent courts have viewed the rejection as, in effect, a
breach of the lease, suggesting that such
construction does not adjudicate
rights
of third parties who may retain the right to assert their
subservient
interests. The rights of such
parties, then, would be disposed of according
to state law.
The court ascertained that the current trend in Ninth
Circuit bankruptcy
cases was to treat a
debtor's rejection of a lease as a breach, rather than a
termination, and that therefore the continuing viability of
the sublease was
a question of California
law.
The court, goaded apparently by thoroughly briefed arguments
from
Subtenant's counsel, exhaustively
evaluated California law and finally
concluded
that forfeiture of the master estate terminates the derivative
interest of a sublessee..
The court rejected Subtenant's argument that, because it
enjoyed direct
contractual privity with the
landlord (under the assumption), its rights were
not merely derivative. The court pointed out that the subtenant's
asserted
right to possession was based entirely
on the master lease and its derivative
sublease; there was no separate contract for the subtenant to
enforce. It
distinguished Vallely
Investments, L.P. v. BancAmcerica Commercial
Corporation, 106 Cal.Rptr.2d 689 (Cal. App. 2001) (the DIRT DD
for
6/4/01), which had held that termination of
a sublease in bankruptcy does
not relieve a
prior assuming party of liability, since liability in that case is
based upon the assumption, not the sublease itself.
By contrast, the
Sublessee here was trying to
bootstrap the assumption into a claim under the
sublease.
The court, rather relied upon a portion of the holding in
Ilkhchooyi v. Best,
45 Cal. Rptr. 2d 766 (Cal.
App. 1995) (the DIRT DD for 4/18/66), which
found that rejection of a master lease in bankruptcy terminates
subleases.
Editor's Comment: The Ilkhchooyi case is really about
the validity of a
provision in a new lease
entered into by the subtenant after the original
master lease was terminated, and the discussion of the impact of the
prior
master tenant's bankruptcy is not
critical to the result. Further, the authority
relied upon by Ilkhchooyi is the very federal bankruptcy law that the
Court
of Appeals in the instant case had
earlier rejected. The cases Ilkhchooyi
relied upon had held that rejection automatically terminates subleases,
while
the California Court of Appeals in the
instant case chose to view such
rejection as a
default, but not an automatic termination of all derivative
rights. To the extent that Ilkhchooyi was based upon
the now discredited
federal cases, it is
difficult to reach the conclusion that it also states a
conclusion of California state common law. All of
this is somewhat moot,
of course, because the
court in the instant case is making the common law
even if it didn't exist before.
Reporter's Comment: [I have substantially altered the report
that Roger
Bernhardt originally included in
this case in a California Bar publication.
But
Roger's notes to that case are worth repeating [although I've
shortened
them. I'll give a further
response to Roger's comments in a second Editor's
Comment at the end. Here are Rober's comments:}
The case is an object lesson in showing that what is often
considered as
inconsequential boilerplate can,
in the end, really make a difference. The
lack
of critical bouilerplate language in a master lease here really hurt
an
innocent subtenant. The rejection of
the lease and termination by the
landlord were
driven by defaults by the master tenant occurring prior to the
sublease and assumption. Thus, these events entitled
the landlord to evict
the subtenant even though
the sublease had never been in default and the
subtenant had not even been notified of the prime tenant's
bankruptcy.
Although termination was hard on the subtenant in this case,
in other
situations it could be equally hard on
the landlord- e.g., when the landlord
may have
been counting on the subrent to cover the rent it was to receive for
the balance of the term. Both landlord and subtenant may
want the same
kind of security that motivates
landlord and tenant (and master tenant and
subtenant) to enter into their own binding long-term arrangements in
the
first place.
That security may be obtained, but it does not arise
automatically. A binding
long-term lease
between landlord and tenant, combined with a binding
long-term sublease between tenant and subtenant, do not together
amount
to a binding long-term arrangement
between landlord and subtenant that
will
survive the disappearance of the intermediate tenant. That
arrangement
has to be accomplished separately,
in one of two ways.
First, appropriate provisions can be included in the master
lease when it is
initially executed that will
make a later-executed sublease effectively
binding on landlord and subtenant. Or, second, comparable provisions
can
be included in the sublease or in a
separate document accompanying the
sublease
when it is later executed. There are virtues in both approaches, and
the best arrangement would be to use both.
A major virtue of the first arrangement is that it was used
and upheld in
Chumash Hill Props. Inc. v Peram
1226, 46 CR2d 366 (Cal. App. 1995) .
This
outcome is in striking contrast to Syufy. The sublease in Chumash
Hill
survived the prime tenant's bankruptcy and
deemed lease rejection because
of good language
in the original master lease. That lease provided that, in
the event of an incurable default by the prime tenant
(e.g., filing
bankruptcy), then the
"sublessee's possession and use shall not be disturbed
by lessor or by mortgagee as long as . . . sublessee performs his
sublease's
provisions . . . [and] attorns to
lessor and mortgagee." The court of appeal
held
that this provision-a kind of nondisturbance and attornment (NDA)
clause-was not defeated when the master lease (which
included it) was
deemed rejected in bankruptcy,
was enforceable by the subtenant as a third
party beneficiary, and did not violate public policy. That's about as
good as
it gets.
While it is possible the Chumash Hill landlord may not have
been very
happy to put such a clause in the
lease, it is equally likely that that was
exactly what it originally wanted-the security of knowing that it would
have
a back-up tenant even if its main tenant
later failed.
That means that if you represent a subtenant negotiating a
sublease, you
should check the master lease for
the kind of protection it offers your client,
and the kind of requirements your client has to meet to get that
protection.
You not only want to get the
landlord's assent to your sublease (if that is
required), but you also want some kind of estoppel letter from the
landlord,
acknowledging that the NDA provisions
are still in force and that you
qualify under
them.
If you don't find that kind of provision in the master
lease, it is not too late
to create one.
Indeed, a new arrangement between landlord and subtenant
may be more effective than the old one between landlord and
tenant, and
could be created even though there
were appropriate provisions in the
master
lease. Under an agreement directly between landlord and subtenant
specifying contingent future arrangements between them in
case of a prime
tenant default, the subtenant
acquires the status of an express beneficiary
rather than an implied third party beneficiary of the old master lease
(who
may not have even been in existence at the
time it was signed). Privity of
contract is
always helpful. As a two-party agreement, it would not require
the prime tenant's assent, and it surely would survive his
bankruptcy, if that
ever happened. It would be
wise for the subtenant to propose this new
agreement even though the original lease already provided for it,
especially
if there are other details to be
worked out-e.g., the time gap between the
different remaining terms of the lease and the sublease, other property
that
is included in the lease but not the
sublease, and curing the tenant's existing
defaults.
Of course, these provisions are only the beginning. After
this basic
arrangement between landlord,
tenant, and subtenant has been worked out,
the
parties next have to deal with the rights, duties, and priorities of the
fee
mortgagee, the leasehold mortgagee, the
tenant's assignees, and the
landlord's
purchasers. Who is subordinating what interest to which lien in
return for what additional NDA provisions? But if that
seems too
complicated to work out in advance,
just imagine what the litigation would
be like
if those arrangements haven't been made-think about poor Syufy
Enterprises.
Editor's Comment: The editor appends a further comment
here only to note
that he would not regard a
clause in the master lease agreeing to attorn to
any non-default subtenant as nothing more than "boiler plate."
Whether to
attorn to a subtenant following the
master tenant's bankruptcy is an
important
separate decision on the part of the master landlord, which the
master landlord may not want to make until all the
consequences of the
master tenant's bankruptcy
on the overall economic picture of the landlord
are clear. Perhaps there were lessons learned as to the original
lease that the
landlord now would like to
change, based upon bitter experience. Perhaps
the economic picture that drove the original lease is quite different,
and,
given a blank slate, the landlord would
like the opportunity to go in a
different
direction entirely.
In short, lawyers representing master tenants and subtenants
should not
assume that even an assuming
subtenant will easily win an advance
commitment
from the master landlord to attorn following the master
tenant's bankruptcy.
LANDLORD/TENANT; ASSIGNMENTS AND SUBLETS;
BANKRUPTCY: Shopping Center landlord may not enforce
use clause
restricting use to identified retail
outlet and must demonstrate scheme of
integration of tenant uses into a viable "tenant mix" through its
leasing
policies in order to argue that a
change of use upon assignment is protected
by
"tenant mix" considerations under Bankruptcy Code Section 365(b)(3).
LaSalle National Trust v. Trak Auto Corp., 288 B.R. 114,
2003 U.S. Dist.
LEXIS 6029 (1/10/03), discussed
under the heading: "Bankruptcy; Leases;
Assumption and Rejection; Assignment; Restrictions on
Assignment;
Shopping Centers."
LANDLORD/TENANT; ASSIGNMENTS AND SUBLEASES;
LIABILITY OF ASSIGNEE: Where lender has prior assignment of
lease
for security, but later, after bankruptcy
of tenant, acquires the tenant's
leasehold
estate in a bankruptcy auction, the controlling relationship is that
established by the assignment in bankruptcy, and the terms
of the prior
assignment for security have no
impact on the question of lender/assignee's
obligation to pay rent. Cherry v. First State Bank, 2003 WL
288467 No.
E2002-0081-COA-R#-CV (Tenn App.
12/12/02)
Tenant earlier had executed a leasehold mortgage and an
assignment for
security of the lease in favor
of Lender. The assignment for security
provided that Lender would not be liable for the rent or any other
obligation
of Borrower under the Lease "so long
as the Bank shall not have exercised
its option
[of taking over the leased premises pursuant to written notice.]"
Later, Tenant declared bankruptcy. At a "sale free and
clear of liens" in the
bankruptcy proceeding,
the auctioneer offered the tenant's leasehold estate
for sale at auction, and also offered at auction adjacent property that
the
tenant owned in fee. The bid for the
two items offered together exceeded
the sum of
the bids for each of the items offered separately and the lease and
fee together were hammered off to the successful bidder,
which was, lo and
behold, Lender!
Lender paid rent under the lease for a while, and then
stopped, running up
a bill that eventually
totaled over $100,000 (plus attorney's fees.) When
Landlord came looking for the rent, Lender pointed to the
language of the
original assignment for
security and argued that it had never given the
Borrower written notice of exercising its option to take over the
leased
premises, and hence was not liable for
any of the obligations under the
lease.
Lender attempted to explain this apparently absurd position
by claiming
that, at the time of the bankruptcy
auction, it had bid for the fee and
leasehold
estate together "to protect its position" and that it had not
intended to take a new and different assignment of lease,
and refused to
execute an assignment when
tendered by the debtor, who was acting as
Debtor in Possession in the bankruptcy. The court notes that an
assignment
later was entered into between the
parties.
Lender made payments under the lease for the period it did,
Lender claimed,
"for the purposes of preserving
its rights under the lease" - apparently this
refers to the earlier assignment for security. Lender never took
possession,
never announced that it was
asserting rights under the earlier lease, and
therefore did not deem itself bound by the lease obligations. They
note that
Landlords knew of and consented to
the original assignment of lease for
security.
The trial court, not surprisingly, granted summary judgment
for Landlord.
It is surprising, of course, that
Lender still hadn't figured things out, and
appealed. But the Tennessee Court of Appeals properly slammed
Lender
again. By bidding at the
bankruptcy auction, Lender had taken a new
assignment unrelated to the first assignment, and was bound by its
privity
of estate to pay the rents.
Comment 1: In fairness to Lender, there is a
suggestion in the opinion of
a subtext
involving shadowing evidence of various special agreements and
discussions among the parties that they agreed, for one
reason or another,
would not be part of the
evidence in this case. So Lender may have felt that
it had right and justice on its side, even though it
clearly didn't have the
law, at least based
upon what was presented to the court. Otherwise, the
case is such a "slam dunk" that it is hard to understand
why Lender would
pay for an appeal, which cost
Lender not only its own attorney's fees, but
those of the landlord as well.
Comment 2: The editor, in fact, has selected this case not
for the distinct
legal point discussed above,
but to raise the question: What's up with these
assignments of tenant's interest for security? The editor has seen
them
before, and, from talking to an
experienced landlord/tenant lawyer,
understands
that in fact they are used quite commonly as security devices
when tenants borrow.
There is absolutely no question in the editor's mind that
these assignments
for security are invalid as
assignments. They are clogs on the equity of
redemption, analogous to an absolute deed intended as a mortgage, and
any
decent lawyer ought to be able to
demonstrate to a court that they should be
converted into an equitable mortgage, with right of redemption,
either
before or after they are "activated" by
the lender.
Note that we're talking about an assignment of the tenant's
possessor
interest under the lease - which is a
real estate interest almost everywhere.
We're
not talking about an assignment of the landlord's interest.
The
landlord's interest in a lease may be a
"chose" which can be assigned for
security. Even in the rare jurisdiction (if one exists) where the
tenant's
interest is a personal property
interest, one would assume that Article Nine
would operate to control some of the lender's rights in any event.
The
assignment would not always be
absolute.
It is true that the consequence to the lender of taking such
an assignment is
not so dramatic if the worst
thing that can happen is that the assignment gets
"flipped into an equitable mortgage." But it's still not a good
idea if the
lender is in a state like Missouri
where a legal deed of trust covering the
leasehold could be foreclosed in 21 days, but an equitable mortgage
would
require a court action stretching out six
months or more in an urban area.
There's also the problem of lawyers writing opinions
approving the
enforceability of the lender's
remedy under these things and title insurers
insuring their validity. The editor doesn't know that these things
happen,
but is led to believe that they must,
in light of the frequency that these
instruments apparently appear.
Comment 3: Even Milton Friedman in the revered Friedman on
Leasing
doesn't really make the point that
assignments for security are invalid. He
simply reports, in footnote 2 on page 464, a number of cases in which
courts
have construed issues concerning
assignments for security. A quick look
at
these cases indicates that the lawyers did not apparently raise the
equitable mortgage argument, and the courts didn't pick it
up. Be warned.
It's there.
LANDLORD/TENANT; ASSIGNMENTS AND SUBLEASES;
SUBTENANT'S RIGHTS; MASTER TENANT'S BANKRUPTCY:
Where master tenant files bankruptcy and rejects master
lease, subtenant's
lease is terminated absent
special language in master lease or other
agreement with master landlord guaranteeing non-disturbance.
Syufy
Enters., LP v City of Oakland, 128 CR2d
808 (Cal. App. 2002)
This was a major battle in which the subtenant hired a
leading California
real estate lawyer who fired
all the cannons. Landlord was represented by
a former contributor to the ABA Quarterly Report and to DIRT.
Although
the subtenant lost, we are rewarded
with a thorough analysis of many of the
relevant arguments and authorities on this issue.
Subtenant, a movie theater operator, held possession
under a sublease in
which it had expressly
assumed the master tenant/sublandlord's obligations
under the master lease. The master tenant filed bankruptcy and the
period
for assuming or rejecting the master
lease expired without the master tenant
taking
any action, leading to the consequence that the master lease was
deemed rejected ain bankruptcy. The master landlord
landlord then evicted
Subtenant.
Subtenant sued the landlord for, among other things, breach
of contract
based on its claim that it was a
third party beneficiary of the master lease.
The trial court found that Subtenant lost its right to possession of
the
property when the master tenant rejected
the lease in its bankruptcy
proceedings, and
granted the landlord a judgment of nonsuit. The Court of
Appeal affirmed, agreeing that rejection of the master
lease terminated the
subtenant's right of
possession.
The court first considered whether the issue was resolved by
federal
bankruptcy law. It noted
that federal courts have reached different
conclusions on this issue. It stated that some courts have
concluded that
rejection in bankruptcy
results in a complete termination of the lease. This
has been held also to terminate subleases. The
California court, however,
concluded that more
recent courts have viewed the rejection as, in effect, a
breach of the lease, suggesting that such
construction does not adjudicate
rights
of third parties who may retain the right to assert their
subservient
interests. The rights of such
parties, then, would be disposed of according
to state law.
The court ascertained that the current trend in Ninth
Circuit bankruptcy
cases was to treat a
debtor's rejection of a lease as a breach, rather than a
termination, and that therefore the continuing viability of
the sublease was
a question of California
law.
The court, goaded apparently by thoroughly briefed arguments
from
Subtenant's counsel, exhaustively
evaluated California law and finally
concluded
that forfeiture of the master estate terminates the derivative
interest of a sublessee..
The court rejected Subtenant's argument that, because it
enjoyed direct
contractual privity with the
landlord (under the assumption), its rights were
not merely derivative. The court pointed out that the subtenant's
asserted
right to possession was based entirely
on the master lease and its derivative
sublease; there was no separate contract for the subtenant to
enforce. It
distinguished Vallely
Investments, L.P. v. BancAmcerica Commercial
Corporation, 106 Cal.Rptr.2d 689 (Cal. App. 2001) (the DIRT DD
for
6/4/01), which had held that termination of
a sublease in bankruptcy does
not relieve a
prior assuming party of liability, since liability in that case is
based upon the assumption, not the sublease itself.
By contrast, the
Sublessee here was trying to
bootstrap the assumption into a claim under the
sublease.
The court, rather relied upon a portion of the holding in
Ilkhchooyi v. Best,
45 Cal. Rptr. 2d 766 (Cal.
App. 1995) (the DIRT DD for 4/18/66), which
found that rejection of a master lease in bankruptcy terminates
subleases.
Editor's Comment: The Ilkhchooyi case is really about
the validity of a
provision in a new lease
entered into by the subtenant after the original
master lease was terminated, and the discussion of the impact of the
prior
master tenant's bankruptcy is not
critical to the result. Further, the authority
relied upon by Ilkhchooyi is the very federal bankruptcy law that the
Court
of Appeals in the instant case had
earlier rejected. The cases Ilkhchooyi
relied upon had held that rejection automatically terminates subleases,
while
the California Court of Appeals in the
instant case chose to view such
rejection as a
default, but not an automatic termination of all derivative
rights. To the extent that Ilkhchooyi was based upon
the now discredited
federal cases, it is
difficult to reach the conclusion that it also states a
conclusion of California state common law. All of
this is somewhat moot,
of course, because the
court in the instant case is making the common law
even if it didn't exist before.
Reporter's Comment: [I have substantially altered the report that
Roger
Bernhardt originally included in this
case in a California Bar publication.
But
Roger's notes to that case are worth repeating [although I've
shortened
them. I'll give a further
response to Roger's comments in a second Editor's
Comment at the end. Here are Roger's comments:}
The case is an object lesson in showing that what is often
considered as
inconsequential boilerplate can,
in the end, really make a difference. The
lack
of critical bouilerplate language in a master lease here really hurt
an
innocent subtenant. The rejection of
the lease and termination by the
landlord were
driven by defaults by the master tenant occurring prior to the
sublease and assumption. Thus, these events entitled
the landlord to evict
the subtenant even though
the sublease had never been in default and the
subtenant had not even been notified of the prime tenant's
bankruptcy.
Although termination was hard on the subtenant in this case,
in other
situations it could be equally hard on
the landlord- e.g., when the landlord
may have
been counting on the subrent to cover the rent it was to receive for
the balance of the term. Both landlord and subtenant may
want the same
kind of security that motivates
landlord and tenant (and master tenant and
subtenant) to enter into their own binding long-term arrangements in
the
first place.
That security may be obtained, but it does not arise
automatically. A binding
long-term lease
between landlord and tenant, combined with a binding
long-term sublease between tenant and subtenant, do not together
amount
to a binding long-term arrangement
between landlord and subtenant that
will
survive the disappearance of the intermediate tenant. That
arrangement
has to be accomplished separately,
in one of two ways.
First, appropriate provisions can be included in the master
lease when it is
initially executed that will
make a later-executed sublease effectively
binding on landlord and subtenant. Or, second, comparable provisions
can
be included in the sublease or in a
separate document accompanying the
sublease
when it is later executed. There are virtues in both approaches, and
the best arrangement would be to use both.
A major virtue of the first arrangement is that it was used
and upheld in
Chumash Hill Props. Inc. v Peram
1226, 46 CR2d 366 (Cal. App. 1995) .
This
outcome is in striking contrast to Syufy. The sublease in Chumash
Hill
survived the prime tenant's bankruptcy and
deemed lease rejection because
of good language
in the original master lease. That lease provided that, in
the event of an incurable default by the prime tenant
(e.g., filing
bankruptcy), then the
"sublessee's possession and use shall not be disturbed
by lessor or by mortgagee as long as . . . sublessee performs his
sublease's
provisions . . . [and] attorns to
lessor and mortgagee." The court of appeal
held
that this provision-a kind of nondisturbance and attornment (NDA)
clause-was not defeated when the master lease (which
included it) was
deemed rejected in bankruptcy,
was enforceable by the subtenant as a third
party beneficiary, and did not violate public policy. That's about as
good as
it gets.
While it is possible the Chumash Hill landlord may not have
been very
happy to put such a clause in the
lease, it is equally likely that that was
exactly what it originally wanted-the security of knowing that it would
have
a back-up tenant even if its main tenant
later failed.
That means that if you represent a subtenant negotiating a
sublease, you
should check the master lease for
the kind of protection it offers your client,
and the kind of requirements your client has to meet to get that
protection.
You not only want to get the
landlord's assent to your sublease (if that is
required), but you also want some kind of estoppel letter from the
landlord,
acknowledging that the NDA provisions
are still in force and that you
qualify under
them.
If you don't find that kind of provision in the master
lease, it is not too late
to create one.
Indeed, a new arrangement between landlord and subtenant
may be more effective than the old one between landlord and
tenant, and
could be created even though there
were appropriate provisions in the
master
lease. Under an agreement directly between landlord and subtenant
specifying contingent future arrangements between them in
case of a prime
tenant default, the subtenant
acquires the status of an express beneficiary
rather than an implied third party beneficiary of the old master lease
(who
may not have even been in existence at the
time it was signed). Privity of
contract is
always helpful. As a two-party agreement, it would not require
the prime tenant's assent, and it surely would survive his
bankruptcy, if that
ever happened. It would be
wise for the subtenant to propose this new
agreement even though the original lease already provided for it,
especially
if there are other details to be
worked out-e.g., the time gap between the
different remaining terms of the lease and the sublease, other property
that
is included in the lease but not the
sublease, and curing the tenant's existing
defaults.
Of course, these provisions are only the beginning. After
this basic
arrangement between landlord,
tenant, and subtenant has been worked out,
the
parties next have to deal with the rights, duties, and priorities of the
fee
mortgagee, the leasehold mortgagee, the
tenant's assignees, and the
landlord's
purchasers. Who is subordinating what interest to which lien in
return for what additional NDA provisions? But if that
seems too
complicated to work out in advance,
just imagine what the litigation would
be like
if those arrangements haven't been made-think about poor Syufy
Enterprises.
Editor's Comment: The editor appends a further comment
here only to note
that he would not regard a
clause in the master lease agreeing to attorn to
any non-default subtenant as nothing more than "boiler plate."
Whether to
attorn to a subtenant following the
master tenant's bankruptcy is an
important
separate decision on the part of the master landlord, which the
master landlord may not want to make until all the
consequences of the
master tenant's bankruptcy
on the overall economic picture of the landlord
are clear. Perhaps there were lessons learned as to the original
lease that the
landlord now would like to
change, based upon bitter experience. Perhaps
the economic picture that drove the original lease is quite different,
and,
given a blank slate, the landlord would
like the opportunity to go in a
different
direction entirely.
In short, lawyers representing master tenants and subtenants
should not
assume that even an assuming
subtenant will easily win an advance
commitment
from the master landlord to attorn following the master
tenant's bankruptcy.
LANDLORD/TENANT; GOOD FAITH AND FAIR DEALING;
NOISE NUISANCE: Tenant that deliberately plays loud music
that
"unreasonably disturbs the peace" of other
tenants is liable for breach of
implied
covenant of good faith and fair dealing when such activity violates
public noise ordinance and compliance with local law is
required by the
lease. Howard Opera House
Assoc. v. Urban Outfitters, Inc., 322 F.3d
215
(2nd Cir. 2003)
Tenant Urban Outfitters apparently has a business model that
involves
playing pop music at a certain volume
in its store premises. Landlord
rented to
an Urban Outfitters store operator in a building also occupied by
office tenants, including a law office. Friction soon
developed.
The other tenants prevailed upon the landlord to deal with
the noisy
neighbor. The lease did not
expressly restrict noise, but stated that the
tenant had an obligation to comply with "all applicable laws." A
city code
section stated that it was unlawful
to make or cause to be made a any loud
or
unreasonable noise. "Noise shall be deemed to be unreasonable when
it
disturbs, injures or endangers the peace or
health of another . . .Any such
noise shall be
. . . a public nuisance."
Landlord brought suit for breach of the implied covenant of
good faith and
fair dealing, breach of the
lease itself, and nuisance. The other tenants
joined in the suit for nuisance. Although the plaintiffs withdrew
complaints
for anything but injunction, the
trial court elected to "try the case as an
action for damages before an advisory jury " and found for
plaintiffs.
Presumably the landlord was seeking to establish liability
under the breach
of the duty of good faith and
fair dealing so that it could obtain damages
based upon a tort theory - perhaps punitive damages. By the time
the case
was finally resolved, there was no
specific damages claim, but the court still
made a finding as to damages liability.
The other tenants were suing for nuisance, and one would
think that the
landlord also could recover in
nuisance for injury to the landlord's
relationship with its other tenants, so it is not clear what the good
faith and
fair dealing claim really adds other
than a more dramatic voicing of the
same
complaint.
LANDLORD/TENANT; LANDLORD'S REMEDIES; DAMAGES;
PENALTIES: Lease provision that doubles the amount of rent
in the event
of any breach is void as a
penalty. Harbor Island Holdings v. Kim,
(Cal.
App. 4/2/03)
The introduction by the appeals court is admirably succinct,
and can be
quoted verbatim:
"A landlord, displeased with its
tenant, reluctantly agreed to a lease
extension requiring greatly increased rental
payments. The landlord
demanded one price if the tenant complied with
the lease agreement
in
every regard and double that amount in the event of any breach.
After the conclusion of the
extended lease term, the landlord sued
the tenant, seeking both damages occasioned by
the tenant's failure
to properly maintain the premises, plus nearly a quarter of a
million
dollars for
the doubled rent. The trial court awarded damages for
the failure to maintain the
property, but held the lease provision for
the doubled rent was unenforceable as a
penalty. The landlord
appeals. We agree with the trial court's
reasoning and affirm."
In fact, as the court later explains, the lease phrased
things in a slightly more
subtle way. The
rent, which had been around $31,000 per month during an
earlier three year term, was raised to $96,000 per month
during the three
month extension (while tenant
completed construction on a new facility),
but
half the rent was "deferred" and ultimately would be forgiven if the
tenant performed all the covenants of the lease. In fact,
tenant posted a
security deposit in the amount
of the one month of the deferred rent - or
$48,000. The landlord refused to return the deposit and sued for
the
doubled rent for the entire term - around
$24,000. The trial court found
that the tenant's failure to maintain the premises caused damages of
around
$14,000 and ordered the balance of the
$48,000 security deposit refunded.
Apparently the landlord argued that the arrangement
concerning the $48,000
"deferred rent" was a
"rental inducement." The court here concluded, with
the trial court, that it could only be analyzed under the
California statute
dealing with liquidated
damages clauses. Under that statute, the liquidated
amount must be "reasonable." California courts have
concluded that the
such a clause is
"unreasonable" if "it bears no reasonable relationship to the
range of actual damages that the parties could have
anticipated would flow
from the
breach."
Landlord argued that the $96,000 per month was actually the
rent that the
landlord was willing to accept
for the property, and that tenant was willing
to pay, if the tenant insisted on being able to breach the conditions of
the
lease. The court responded that such
reasoning would permit parties always
to avoid
construction of lease terms as creating penalties simply through
rephrasing them as alternative forms of
performance.
The court acknowledged that both players in this little
drama were
sophisticated commercial parties who
knew and intended what they were
doing, but
concluded that the state's policy against permitting contract
clauses creating penalties applies even in that
context. It acknowledged that
the
landlord claimed that the method used here to "incentivize" the
tenant's
performance was a commonly used
device, but said that the fact that it was
in
common use also would not change the application of the court's
ruling
here.
Comment 1: Compare this case to Benderson-Wainberg, L.P. v.
Atlantic
Toys, 228 F. Supp. 2d 584 (E.D. Penn.
9/17/02) Shopping center landlord
may enforce
contract provision giving it an amount equal to the base rent
for everymonth a defaulting tenant's premises remains
vacant and in
addition can charge a 2% per
month late fee on the amounts of actual rent
owed for
that period.) (New Jersey law),
the DIRT DD for 2/18/03.
Comment 2: The case likely is more consistent with
prevailing law than the
Benderson-Wainberg
ruling. Even sophisticated parties cannot bargain to
create penalties.
The Reporter for DD is Harris Ominsky, writing in the Blank
Rome
newsletter (the editor has edited the text
and added comments)
LANDLORD/TENANT; TENANT'S REMEDIES; RESCISSION:
A
breach of landlord's title warranty in
a lease that doesn't actually, as
opposed to
hypothetically, increase the liability of the tenant or its
guarantor
will not invalidate the lease or the
guaranty, and if there has been substantial
performance under the lease, recision may be denied because is an
equitable
and discretionary remedy.
Center 48 Limited Partnership v. The May
Department Stores Company, 355 N.J. Super. 390, 810 A.2d 610
(App.
Div. 2002).
A department store entered into a lease at a shopping
center. In the lease,
the landlord
warranted and represented that it was the owner in fee simple
of the leased premises. The lease further stated that
the tenant was relying
on that warranty and
representation in executing and delivering the lease.
Contemporaneously with the execution of the lease, the tenant's
parent
company executed a guaranty agreement,
unconditionally guarantying the
lease.
The guaranty expressly stated that no modification of the lease
would
"in any way release [the parent company]
from liability [thereunder], or
terminate,
affect, or diminish the validity of [the] Guaranty, except to the
same extent, but only to such extent, that the liability or
obligation of
Tenant [was] so released,
terminated, affected or diminished." Notice to the
guarantor of lease modifications was waived.
In fact, at the time that the department store signed
its lease, the land was
actually owned by a
third party and not the landlord. The landlord was
negotiating to acquire the property to build the
center. At some point, the
landlord's
transaction with the owner of the property changed from a sale to
a land lease due to capital gain
considerations.
The tenant later asserted that
it did not know that its landlord did not own
the land even though a memorandum of ground lease had been
recorded.
The guarantor claimed that it and its
subsidiaries "tried to avoid subleasing
property on which it operated a store because subleasing created a risk
that
the subtenant might lose its right to
occupy the premises through no fault of
its
own, such as if the ground lease was terminated or if the tenant under
the
ground lease defaulted." In cases
where it did enter into a sublease, "it
insisted on assurances, typically in the form of a non-disturbance
agreement
with the landowner, whereby the owner
agreed that the subtenant may
continue to
occupy the premises even if the lessee under the ground lease
lost its lease with the owner." But, as things
developed, the tenant, without
registering any
objection to the landlord's lack of ownership, and in fact,
likely in ignorance of the fact, took possession and
commenced operation.
Tenant's possession
of the property was never in fact disturbed by the
ground lessor or anyone else. The store continuously operated until
Tenant
filed for bankruptcy and even
thereafter, for a time. Eventually, pursuant
to a bankruptcy court order, the tenant rejected the lease on the
property.
The parent company guarantor no longer owned the department
store tenant.
Nevertheless, subject to a
reservation of rights, it honored its guaranty and
voluntarily paid all of the obligations. When the
landlord finally found a
replacement tenant,
the new annual rent fell short of what would have been
payable under the old lease, and the landlord sought to recover
the
difference from the guarantor.
Eventually, the matter of exactly how much
money the guarantor owed was presented to a court. The guarantor
argued
that it was not liable at all, arguing
"the guaranty agreement was not
enforceable
because there had been no meeting of the minds and that,
alternatively, [the guarantor] was entitled to rescind the
agreement because
of a unilateral
mistake."
Specifically, the guarantor argued that "ownership of the
underlying
property had been an essential
material fact of the guaranty agreement and
because the lease agreement had warranted that the [landlord's]
predecessor
was the owner, this was a risk
fundamentally different than what the
guarantor
had agreed to assume." It further claimed that, as guarantor,
it
had been prejudiced because its subsidiary
"never received a non-
disturbance agreement
from the property owner." The lower court did not
believe the guarantor's claims were sufficient to set aside the
guarantee.
On appeal, the Appellate Division was "called upon to decide
whether a
modification of the underlying
lease whereby the lessor became a long
term leasehold rather than fee owner operate[d] to discharge
the
guarantor." It concluded "that in
order to effect a discharge of the
guarantor,
an alteration or modification of the underlying lease must either
injure the guarantor or actually increase the guarantor's
risk or liability." It
determined that
the modification "neither injured the guarantor nor
increased its risk or liability under the contract of
guaranty."
"It is fundamental that the guarantor is not bound beyond
the strict terms of
its promise and its
obligation cannot be extended by implication." The
guaranty agreement "provided that it was made solely in
consideration of
[the landlord] having entered
into the lease at [the guarantor's] request."
Consequently, the Court rejected the argument that the guarantor "gave
its
guaranty in reliance on the representation
contained in the lease that [the
landlord]
owned the land." This left only the question as to whether the
change in the landlord's interest "from a property owner to
a ground lessee
should have operated to
discharge [the guarantor] from liability under the
guaranty." Essentially, since the guarantor "expressly agreed that
any
modification of the lease would not release
it from liability or 'terminate,
affect or
diminish the validity of' the guaranty except if [its subsidiary's]
liability was 'released, terminated, affected or
diminished,' and while the
change may have
theoretically increased [the guarantor's] risks under the
guaranty, it never resulted in any actual injury or
prejudice to it." In
addition, the
court recognized that had the ground lease been terminated, the
subsidiary would have been released from any further
obligation to pay rent
and this would have
operated to discharge the guarantor from liability under
the guaranty agreement. Consequently, "any increased
risk ... was more
illusory than
real."
The guarantor also argued that "there was never was a
meeting of the minds,
or alternatively, that a
contract may be rescinded where there had been a
unilateral mistake." Here, the alleged "mistake" was that it
thought the
landlord owned the land.
Although, "[c]ontracts may be rescinded where
there is original invalidity, fraud, failure of consideration, or
material breach
of default, ... [t]he remedy is
discretionary with the court and should not be
granted where there has been substantial performance of the
contract."
Comment 1: Where was the "modification" of the lease?
There was always
a warranty of title. We
simply had a breach of that warranty. But the court,
in light of all the circumstances, adopts a "no harm, no
foul" approach.
Note that the court says that the guarantor didn't rely
specifically on the
warranty, but on the
tenant's entering into the lease. Problem is that the
tenant's lease said that the *tenant* was relying on the
warranty. So it is
quite possible there
would have been no lease had the tenant known that the
warranty wasn't good. It's not all that clear whether the tenant
knew at the
time of the lease that the landlord
didn't own the land, but intended to
acquire
it. But apparently the court concluded that the breach of the
warranty in any event was "innocent" on the part of the
landlord. And
there were no
damages.
Comment 2: One suspects that there was
already momentum toward
agreement here, and it
is unlikely that the switch to the ground lease would
have effected a change. But a substantial tenant would likely
demand, and
get, at least a notice right and
quite possibly a non-disturbance right in any
event. It would be relevant to the editor to know whether other
tenants
similar to this one got such agreement
from the ground lessor. If not, and
if the tenant had no knowledge that the landlord was not the owner and
did
not become the owner, then we have more
than a breach of warranty. We
have a
material misrepresentation, and the guaranty, in the editor's view,
should not be effective. Rescission could be granted
with the tenant liable
for restitution of
benefits conferred in the form of rents paid.
Comment 3: Certainly one object lesson here is that if
tenants are serious
about these warranties,
they ought to be checking title and timely raising
objections.
LANDOWNER LIABILITY; CHURCHES; SIDEWALKS: A
church
that does not operate its property for
commercial purposes is not a
"commercial owner"
for the purpose of allocating liability for injuries
occurring on the church's sidewalk. Dupree v. City of Clifton, 351
N.J.
Super. 237, 798 A.2d 105 (App. Div.
2002).
A pedestrian tripped while walking on the sidewalk abutting
a church's
property, and sued the church for
negligence. In order to prevail, the
pedestrian needed to show that the church had a duty to maintain
the
sidewalk and that it breached that
duty. The church claimed that, as a non-
commercial property owner, it owed no duty to the public to maintain
the
sidewalk. It moved for summary
judgment, which was granted by the lower
court.
The Appellate Division affirmed because non-commercial
property owner
does not have a duty to maintain
the sidewalks abutting its property. Here,
the pedestrian claimed that any property that is not used for
residential
purposes constitutes a
commercial property. The Court disagreed, noting
that a property used exclusively for religious purposes is not a
commercial
property even though, where a
religious or charitable organization uses its
property for both religious/charitable and commercial purposes, it has a
duty
to maintain its entire property, and not
just the portions used for commercial
purposes
and is liable for injuries caused by unrepaired defects.
The pedestrian also claimed that even if the church did not
owe a duty to
maintain the sidewalk, it was
still responsible for her injuries because it
constructed or repaired the sidewalk. A property owner is
liable if it
negligently constructs or repairs
a sidewalk, or if use of the property renders
the sidewalk unsafe or if it actually creates a dangerous condition in
the
sidewalk by building on it. The Court
rejected the claim because the
sidewalk's
uneven condition was caused by tree roots that had lifted the
sidewalk over time and the church's conduct did not cause
the sidewalk to
lift.
Comment: For a particularly interesting contrast, see the
recent New Jersey
decision in Abdallah v.
Occupational Center of Hudson County, Inc., 351
N.J. Super. 280, 798 A.2d 131 (App. Div. 2002). (for an
organization
organized for charitable purposes
to enjoy charitable tort immunity, it must
receive most of its funding from private, not government,
sources.)
LIMITED LIABILITY COMPANIES; BANKRUPTCY:
Efficacy of
a single-member LLC as an
asset-protection vehicle thrown into doubt. In
re Ashley Albright, 2003 Bankr. LEXIS 291 (Bankr. D. Colo. April
4,
2003), discussed under the heading:
"Bankruptcy; Property of the Estate;
Single
Member LLC'S."
MORTGAGES; DISCLOSURE; CONSTRUCTION LENDERS:
Construction lender must provide information to the
permanent (takeout)
lender about the financial
condition of the borrower. Wells Fargo Bank v.
Arizona Labors, Teamsters and Cement Masons Local No. 395
Pension
Trust Fund, 38 P. 3d 12 (Ariz..
2002)
The case has a bit more interest because an important
principle of the
fraudulent borrower here was
Fife Symington, later Governor of Arizona,
who
was indicted and convicted in connection with allegedly fraudulent
real
estate dealings, but who's conviction was
later set aside. Symington
thereafter was
pardoned by President Clinton. The story goes that
Symington, as a young man, rescued the young Clinton from
possible
drowning during a New England
summer. Symington, reports have it, has
gone to cooking school and now is a successful pastry chef in
Arizona.
What got served to the lenders here,
however, was not such a tasty dish.
A permanent lender ("the Fund") alleged that the
construction lender,
("Wells Fargo"), had
deliberately delayed foreclosing against the borrower
on an unrelated loan to buy time until the the Fund paid off the
construction
loan. The Fund further
alleged that Wells Fargo did not disclose to the
Fund that the borrower had submitted false financial statements to the
Fund,
and that Wells Fargo knew that the
statements were false.
The court held that even though the construction lender had
no
common-law duty to disclose the borrower's
worsening condition, the
construction lender
could still be liable for an intentional tort or for breach
of contract when it structured its own activities relative
to the borrower in
ways that might divert the
take out lender's attention from the borrower's
problems and which might lead the Funds to complete the take out and
thus
alleviate Wells Fargo of the
burden.
The Supreme Court of Arizona reversed a summary judgment
granted to
Wells Fargo and held that the
alleged conduct of Wells Fargo was enough
to
make it vulnerable to tort claims for aiding and abetting fraud,
fraudulent
concealment and tortious
interference with contract, as well as a contract
claim for breach of its duty of good faith and fair dealing. It
upheld the
lower court's refusal to find that
Wells Fargo engaged in a fraudulent
conspiracy.
The case revolves around a tri-party agreement entered into
among the
borrower, the Fund and the
predecessor to Wells Fargo on the construction
loan. Based on the permanent lender's commitment to take out
the
construction loan upon completion of
construction of a project called
"Mercado,"
Wells Fargo agreed to advance an interim construction loan of
$10,000,000. While tri-party agreements are not frequently
used any more,
the form used in the Wells Fargo
Bank case was fairly typical at one time.
The Fund had conditioned its takeout obligation on a
personal guaranty of
the borrower's general
partner, and production by the borrower and the
guarantor of various financial statements of the borrower, its principals
and
its guarantors. Even though the borrowers
and guarantors were required to
deliver
financial statements to the Funds, Wells Fargo had no obligation to
furnish information to the Fund during construction of the
project, such as
existence of the liens,
unless the Funds made a "reasonable request" for
such information. Wells Fargo also agreed to inform the Funds of
any
default under the construction loan, or any
intention by the bank to foreclose
on that
loan. The tri-party agreement stated that the bank had no other
obligations in connection with the Fund's loan.
During the construction period the borrower ran into
trouble, not only with
the Mercado project but
also an unrelated project, Alta Masa Village, that
had also been financed by the bank for $2.3 million. When the Alta
Masa
loan matured, the bank extended the loan,
and when the borrower was still
unable to pay,
the bank entered into a short-term forbearance agreement
with the borrower agreeing to delay any collection efforts
on the Alta Masa
project until after the
"takeout" date when the Fund was to pay off the
bank's interim construction loan on the Mercado project.
The court in a long, detailed analysis of the facts,
concluded that there was
enough evidence that
the bank had acted deliberately to cloak the borrower
with a false appearance of financial vigor and to deprive the Fund of
any
reason to refuse to Fund the permanent
commitment. In short, the court
found that the
Fund had raised enough material factual issues to require trial
on the various theories put forward by the
Fund.
In arriving at its conclusion the court rejected various
defenses that the
lower court had
allowed.
First, Wells Fargo had argued that it had no fiduciary duty
of disclosure to
the Fund because the duties of
disclosure were patent on the face of the
tri-party agreement. That agreement only required information
upon the
Fund's "reasonable request;" and there
had been no such request; The bank
was not
aware of any fraudulent activity by the borrower; The bank acted
lawfully to protect its own interest when it postponed
collection efforts on
the Alta Mesa project.
Despite the inaccurate financial statements, no event
had occurred to the borrower's financial status that would have given
the
Fund the legal right to refuse to honor the
tri-party agreement; and Wells
Fargo had a duty
not to disclose confidential customer information.
The court acknowledged that there may have been no direct
duty of
disclosure, but felt that was beside
the point. The court stated:
". . . If simple nondisclosure were
the essence of this case, the Bank
would not be liable . . .. But, as discussed,
simple nondisclosure is
not the claim the Fund makes. The real questions
are the propriety
of
the Bank's affirmative decision not to institute foreclosure
proceedings against Alta Mesa, the
forbearance, the failure to report
Symington's false statements to federal
authorities, and whether
these intentional actions or omissions
interfered with the Funds'
right to receive from Symington information
material to their
decision to fund the Mercado loan."
Second, the tri-party agreement had given the Fund the right
to terminate if,
among other things, the
borrower was "generally not paying its debts as
such debts become due," or "became insolvent," as that term is defined
in
. . . the "Bankruptcy Code". Wells
Fargo maintained that no event had
occurred to
the borrower which would qualify under the relevant bankruptcy
statutes as failing to pay its debts "as such debts become
due."
Consequently, any non disclosure to the
Fund was not material. The Fund
retained
its responsibility to take out the loan.
The court disagreed with this and held that despite the loan
extensions and
the forbearance agreement, the
Alta Mesa loan was absolutely in default and
amounted to a clear failure to pay a debt when due.
Reporter's Comment 1: The decision for the Fund was
made easier because
of the conduct of the bank
in connection with the Alta Mesa loan and
because Arizona law implies a covenant of good faith and fair dealing
in
every contract. However, many other disputes
under tri-party agreements
arise under
circumstances where the construction lender does not have
another loan with the same borrower, and many arise in
states that do not
apply that somewhat
mysterious and vague standard of "good faith" to all
contracts.
Reporter's Comment 2: One of the lessons the case can
provide to
construction lenders is to negotiate
carefully the conditions in a tri-party
agreement that relate to the change of a borrower's financial condition.
A
construction lender expects to rely on the
permanent commitment to pay it
off once the
project is completed. It would like to know that all of the
conditions of the takeout commitment are under its control.
Therefore, if the
construction lender has
properly budgeted construction funds and
supervised the job, it can have reasonable confidence that the project
is
completed to specifications within the
designated deadline of the tri-party
agreement.
From the construction lender's perspective, completion of the
project in accordance with plans and specifications within
a specified period
of time is an appropriate
condition to the takeout.
One of the issues frequently negotiated in these agreements
is whether the
risk of a borrower's change of
financial circumstances should fall on the
construction or the permanent lender. That is a factor that is out of
the
control of the construction lender; and a
cautious approach by the
construction lender
would be to resist any condition that relates to changed
financial circumstances of the borrower. Despite that, the
construction
lender may have to concede that
the takeout lender can walk away when the
borrower goes bankrupt before the takeout closing. However, the
bank
should resist any other conditions that
would permit the takeout lender to
wriggle off
the hook if the borrower falls into default on other loans or if the
borrower's financial condition deteriorates.
In this world of volatile stock markets, it is not unlikely
that during a
prolonged construction period, a
borrower's net worth could rise, or fall by
substantial percentages. A construction lender would not want that
change
of fortune to trigger a loss of its
takeout loan. That is particularly true where
permanent lenders are making the loan commitment and the credit
decision
based largely on the appraised value
of the completed project, or on the
credit of
specified tenants who have accepted the completed construction
project.
Although these details are not discussed in the Wells Fargo
Bank case, it
appears that the decision would
have gone the other way if the bank had not
permitted the takeout loan to be conditioned on contract provisions
related
to the borrower's changed financial
condition.
Editor's Comment 1: Arizona is that same wonderful place
that gave us
Lombardo v. Albu, 14 P.3d 288
(Ariz. 2000) (the DIRT DD for 12/14/2000)
(Buyer's broker has duty to disclose adverse financial
information
concerning buyer because buyer also
has such a duty under concept of good
faith and
fair dealing. This is not what you'd call a caveat emptor
state.
The editor has the same problem with
this result that he did with Lombardo
- it's
hard enough to understand your own economic position when dealing
with a difficult borrower. It's virtually impossible
to make determinations
as to what information
might be material to third parties who are making
evaluations of their own risk. Absent evidence of a deliberate
intent to
deceive, can we be sure that the
Wells Fargo personnel in the field were
completely certain that they had all the facts both about the buyer and
about
the take out lender's knowledge and
objectives?
Note that here, perhaps in response to Lombardo, Wells Fargo
put language
in the agreement delimiting its
disclosure obligations. Didn't help.
Editor's Comment 2: It is difficult to know just how much of
the decision
was based solely on the fact that
there was fraud on the part of the borrower.
The bulk of the opinion does seem directed at the notion that Wells
Fargo
had direct information that fraud was
occurring and did not warn the Funds
of this
fraud in order to further its own interest in implementing the
Mercado take out. That strikes the editor as a
reasonably solid holding.
But when the court starts discussing good faith and fair
dealing, the
contours and limits of the
lender's duties in such cases fuzz up.
Where a party has some awareness that certain activities
*may* be
fraudulent and acts in its own
financial interest without any intent to
mislead others, the editor is less comfortable with the party becoming
liable
for what is, at bottom, the failure of
the third party to look after its own
affairs. For instance, absent the fraud, the simple
extension of the due date
on another loan so
that the borrower could meet its financial goals regarding
the take out strikes the editor as quite consistent with
the contract provision
stating that Wells Fargo
had no duty to discuss the financial condition of the
borrower with the Funds unless asked.
MORTGAGES; FORECLOSURE; FINALITY; PAYOFF:
Purchaser
at foreclosure sale acquired title to
property, regardless of defaulting
borrower's
sale of property on same day as foreclosure sale, when lender did
not receive mortgage payoff until three days after
foreclosure sale.
Nguyen v Calhoun 105 CA4th 428, 129 CR2d 436
(2003)
In 1994, Chavez obtained a loan on
a residence secured by a deed of trust.
When
Chavez stopped making payments on the loan in March 1998,
Chavez's lender recorded a notice of default and election
to sell. Attempting
to sell the property before
foreclosure, in late April, Chavez contracted to
sell the property to Nguyen, who was aware of the pending foreclosure.
In
late June, the lender recorded a notice of
trustee sale scheduled for July 9.
The escrow
company (Financial Title) was aware of the scheduled sale, and
also knew that the sale had been postponed one day and was
set for July 10,
at noon. The funds for
Nguyen's new loan were received in escrow by wire
on July 9 at 1:30 p.m. On July 10, Financial Title closed escrow on the
sale,
recorded the grant deed transferring
title to the property to Nguyen, and sent
the
lender (1) a check by Federal Express and (2) a fax of the final
escrow
settlement statement. The check and fax
were not received until July 13.
Not having received notice of the funding of Nguyen's loan,
the lender
proceeded with the foreclosure as
scheduled, on July 10 at noon. The
foreclosure
trustee complied with all statutory requirements and the crier
accepted Calhoun's bid, giving him a sworn declaration of
trustee sale. As
is customary, the trustee deed
was to be delivered later. On Monday, July
13,
the lender received the faxed escrow statement and check from
Financial Title, and three days later issued a refund check
to Financial Title
and Chavez. On July 31, the
trustee sent its trustee deed to Calhoun, who
recorded it on August 3. Nguyen sued to quiet title; the trial court
found that
the conditions for a timely escrow
were met and that title had passed to
Nguyen.
The court of appeal reversed. As grantee, Nguyen took title
to the property
subject to the lender's
preexisting deed of trust. To protect his interest in the
property from the pending foreclosure, Nguyen had to ensure
that the
underlying obligation to the lender
was satisfied. That did not occur,
because the
debt was not paid before the foreclosure sale. Depositing a
check in the mail (or with a courier) does not constitute
payment. Although
there is an exception to that
general rule when the lender has directed the
borrower to mail the payment, that was not the case here. Because
the
payment sent by the escrow holder via
Federal Express was not received
until three
days after the foreclosure sale, the debt remained unsatisfied at
the time of the foreclosure sale.
The court also concluded that the foreclosure sale could not
be set aside
based on the lender's alleged
breach of an oral agreement to postpone the
trustee sale, and there was no other basis for invalidating the trustee
sale.
Reporter's Comment: I felt very sorry for this
plaintiff, who lost the house
he had just
purchased to a trustee sale bid that was a mere five cents higher
than what he believed had been paid to extinguish that loan
the day before.
On the other hand, I felt
equally exasperated at the inept and nonchalant
way he went about trying to protect himself. Couldn't he have called
back
the next morning to make sure his message
had been received? Couldn't he
have at least
double checked the fax number and recipient's name?
To the above list of blunders, I was tempted to add:
Couldn't he have sued
the lender for damages
rather than suing the uninvolved purchasers to set
aside the sale. But, based on the court's recitation of facts, it doesn't
look
like that theory would have gotten
anywhere either. While the opinion does
hold
that the defendants were BFPs protected by the trustee's recitals,
that
does not really matter in light of the
substantive holding that it was proper
for the
lender to go to sale anyway.
But while neither the buyers nor the lender seem in jeopardy
here, these
facts make further litigation among
other parties likely. The loser here was
the
innocent buyer of the property, not the defaulting trustor-seller. Did
their
sales contract really permit title to be
transferred subject to an unpaid (and
very
delinquent) mortgage? Was cash actually paid to the seller? If so,
can
it be recovered under either a breach of
contract theory or breach of the
statutory
covenant against encumbrances? Did the escrow instructions really
permit payment to the seller before the mortgage was either
extinguished or
released of record? If so, who
drafted them? And, if not, why did the escrow
agent let that happen? Finally, what about the broker who had put the
deal
together? Did his duty to protect the
parties end once the contract was
signed, even
though the escrow had to close in a timely fashion for the
contract to be meaningful?
The Reporter for this item is Roger Bernhardt, writing in
the California
CEB Real Property
Reporter.
PARTNERSHIP; TERMINATION; "GOOD FAITH BELIEF:"
Right
of termination of partnership agreement,
which required good faith belief
in
irreconcilable differences between partners, is measured by
subjective
standard, not objective
standard. Crow Irvine #2 v Winthrop Cal.
Investors L.P., 104 CA4th 996, 128 CR2d 644 (Cal. App. 2002)
In 1985, Winthrop and Crow entered a real estate
development limited
partnership that provided
for termination "if either partner believes in good
faith that irreconcilable differences between the Partners prevent
the
Partnership from achieving its purposes. .
. ." Over the years, the partners
sued each
other seven times over matters such as access to partnership
records and breach of fiduciary duty.
In 2000, Winthrop attempted to invoke the termination
provision of the
partnership agreement which
used the "tendered buy out" approach. The
party seeking termination would offer a buy out price; the other party
could
elect to buy out or be bought out for
that price. Crow contended that
Winthrop
had no right to terminate, and Winthrop sued for declaratory
relief.
The trial court determined that Winthrop's "good faith
belief" that
irreconcilable differences were
preventing the partnership from achieving
its
purposes must be measured by an objective standard. On that basis,
the
court concluded that there were
insufficient grounds to conclude that the
partnership was not realizing its purposes and refused to grant
relief.
The court of appeal reversed, holding that the "good faith
belief" standard
requires evaluation of a
party's subjective state of mind, without regard to
whether the belief is objectively reasonable. The court remanded
for
determination of whether the surrounding
circumstances (e.g., Winthrop's
own conduct and
the reasonableness of the purported belief) indicated that
Winthrop honestly believed what it professed. The court
also found that the
trial court had erred in
holding that the partnership's "purposes" had been
achieved; the issue was whether Winthrop believed, in good faith, that
they
had not been achieved. The court,
therefore, also remanded for
determination of
that issue.
Most of the opinion dealt with California cases in which the
term "good
faith belief" had been interpreted
in a wide variety of contexts, statutory and
contractual, civil and criminal. It concluded that, although
there was some
disagreement and ambiguity in
the precedent, the best overall interpretation
of the term was that it required only subjective belief. In
response to
Crow's argument that this
interpretation did not give meaning to both terms
- "good faith" and "belief" and that the term "good faith" was thus
rendered
superfluous, the court responded that
repetitive language was common and
accepted in
legal documents, referring to "every lawyer's favorite"
California Civil Code provision - CC Sec. 3537, which
provides, in its
entirety: "Superfluity does
not vitiate." To require in every case that every
word have independent meaning, the court suggested, would
mean that a
court would be required to read the
phrase "the striped zebra" to mean that
"striped" really meant "spotted," since it had to mean something other
than
the markings appearing typically on
zebras.
Just before oral argument, the parties introduced the court
to Storek &
Storek, Inc. v Citicorp Real
Estate, Inc.100 CA4th 44, 122 CR2d 267 ((Cal.
App. 2002), which held that where an acceleration clause set forth a
clear
right to acceleration upon the occurrence
of certain conditions there was no
test
governing exercise of the right other than the existence of those
conditions. The court in Storek further commented
that in general the
regular maxim of "good
faith and fair dealing" requires that a party's
decisions under a contract be "objectively reasonable," and that a
subjective
test was appropriate only where
discretion involved a clear exercise of taste
or judgment.
The court here concluded that Storek, although it
established an objective
test for apply the
concept of "good faith and fair dealing" in fact was not
inconsistent with its conclusion here that the term "good
faith belief"
required only a subjective
standard. The court concluded that the Storek
court differentiated between "reasonableness" and "good faith"
and
indicated that where the parties in an
agreement had set no other standard,
then
"reasonableness" was the ordinary test. Here, of course, the parties
did
set a standard, and the court's function is
to give it credence as the
statement of a
subjective test.
Reporter's Comment: In commenting on Storek, last year
(25 CEB RPLR
186 (Sept. 2002)), the Reporter
opined that, for a lender thinking about
cutting off a borrower in default, objective reasonableness might be a
safer
standard than subjective good faith,
because the mere existence of the
default
almost automatically satisfies a reasonableness standard, whereas
good faith might be breached by the fact that the lender
was looking out
only for its own interests
rather than the borrower's. (Storeck, with the
editor's comments, is reported as the DIRT DD for 8/22/02 - on the
DIRT
website).
This case shows that, as far as partnerships, rather than
loans, are
concerned, a subjective standard may
be more appropriate. Dissolving a
floundering
partnership is not the same thing as calling a delinquent loan.
Under a reasonableness standard, a trial judge could
conceivably second
guess and reject Winthrop's
decision to terminate the partnership on the
ground that, in a similar position, he (the judge) would have stayed on
as a
partner; but, under a good faith test, the
question would be whether he
believed the
partner's testimony about its motives for terminating, rather
than reevaluating the wisdom of that decision.
Is good faith such a low standard that it could make the
agreement illusory?
There is no suggestion of
that in the opinion. Good faith may seem
self-proving in dissolution cases - no one is going to say in bad faith
that he
dislikes somebody that he really does
like - but one can nevertheless think
of
situations where a judge can disbelieve the terminating partner's
testimony about its motive, e.g., where the enterprise has
done well and
there has been no past bickering,
but the partner has suddenly received an
invitation to go into a more attractive venture elsewhere.
Of course, to decide whether you prefer a good faith or a
reasonableness
standard requires you to be able
to predict whether you will be the one
trying
to withdraw later on rather than the one trying to stop the
withdrawal
of the other. Depending on your
enthusiasm for the venture, that may be
foreseeable. But then, that may only push the issue back a step to
whether
you acted in bad faith in bargaining
for a clause that allowed you to act
unreasonably, so long as you did so in good faith.
The Reporter for this case was Roger Bernhardt - reporting
in the California
CEB Real Property Law
Reporter - reprinted with permission. The editor
has edited both the report and the comments.
Editor's Comment: This is an important case because it does
supply a
concrete meaning for what ought to be
a reliable term - "good faith belief."
Once we
have a clear case defining the meaning of the term, subsequent
cases, God willing, will follow this interpretation, and we
won't be faced
with further contextual
complexity. The parties have to use some language
to express their understanding, and shouldn't be required
to retain
philosophers to perfectly express
their views. The editor isn't saying that
there wasn't room for argument prior to this case, but let's hope that
the
issue is now resolved for the
future.
Note also the important qualification that this case makes -
it is not a case
of "good faith and fair
dealing." Here the parties set the standard and the
court simply is applying it.
TRUSTS; DEEDS: A deed to a trustee effects a change in
ownership of
property, even if the grantor, the
trustee and the beneficiary of the trust are
the same person. Austin, Trustee v. City of Alexandria, 265 Va. 89
(2003)
James W. Duncan, III owned commercial property in
Alexandria, Virginia.
In 1993, Duncan deeded
the property to himself as trustee under a revocable
living trust in which he was the only beneficiary. In 1999, Duncan,
signing
as an individual, conveyed the same
property to himself as trustee under a
new
charitable trust. After Duncan died, the successor trustee under
the
1993 living trust sued the successor
trustee under the 1999 charitable trust
to
determine who owned the property.
The Court held that the 1999 deed to the charitable trust
did not revoke the
1993 deed to the living
trust, even though the 1993 living trust was
revocable and Duncan was its only trustee and beneficiary. The
Court
reasoned that the 1993 deed caused a
change in the ownership of the
property.
After the 1993 deed, Duncan owned the property as a trustee, not
in his individual capacity. Because he signed the
1999 deed to the
charitable trust in his
individual capacity rather than as trustee, the 1999
deed was ineffective to transfer title to the property.
Comment 1: Although there might be some
jurisdictions in which
antiquated
technicalities would bar this result, it strikes the editor as
absolutely correct. In light of the various probate
and tax benefits of
holding property as one's
own trustee, there is every reason to permit this
practice. Certainly no harm is done. But if a person chooses
to use the trust
device as a method for holding
property, there is no injustice in expecting
that person to treat the trust as a real thing. This would include
making
transfers in the trustee
capacity.
Comment 2: Although it might be argued that parties could
assume that
when there are no conflicting
interests, a transfer by one serving as one's
own trustee would convey all the interests in the property, even if
made
individually. But the only time the
problem is likely to arise will be, as
here,
when there are conflicting interests.
As Duncan is not now available to cure the problem, if the
facts show that
he did not behave in a regular
manner in conveying to the charitable trust,
there is no reason to believe that he indeed intended the result that a
regular
transfer would have accomplished.
Perhaps he was confused about what
property he
was conveying, and in fact intended an entirely different parcel
to go to the charitable trust. That's why we require
regularity. It promotes
certainty - a
useful characteristic in real estate transactions.
VENDOR/PURCHASER; FRAUD: Grantee's reliance upon
fraudulent
representation that escrow has
closed and grantee is owner of property was
not
reasonable where grantee should understand that a co-grantee was
required to execute note and mortgage before title would
pass. Smith v.
Smith, 820 So.2d 64
(Ala. 2001).
This is another one of those tales of the old South.
It would have taken one
brief paragraph in the
New York Supplement, but in Alabama they still
know how to spin a yarn. Since it's rare that a court overturns a
jury
judgment for trial on the grounds that the
victim's reliance was not
reasonable, it's
worth reporting.
The grantees here were obviously simple people who had
little
sophistication in business
matters. They verbally agreed to acquire a lot on
which they would locate their mobile home. A
closing was scheduled at
an attorney's
office. Only one grantee appeared, as her husband was a truck
driver and was on the road. She testified that she
indicated at the closing
that she alone was
buying the property and that she wished her husband to
appear on the deed only so that he could take in the event of her
death.
Apparently the papers were not written up this way.
There was an executed
deed made out to the
husband and wife with mutual life estates with the
remainder to the survivor, but the note and mortgage had spaces for
the
signatures of both husband and wife.
Although wife testified throughout
that it was
her intent to buy the property herself, she did agree to ask her
husband to come in and sign the papers. He saw the
papers, but never got
in to sign them, perhaps
because of other financial problems the couple was
suffering. At some point in the drama, the couple's mobile home
was
removed from the lot and returned to the
seller of that home.
As the husband never executed the note and mortgage, the
attorney, holding
the deed from seller in
escrow, never recorded it, and, the court accurately
concludes, never delivered it.
The wife continued to make payments on the mortgage note,
despite the fact
that her husband had never
executed it. Further, an employee of the
attorney serving as escrow in the closing transferred to the sellers the
case
down payment that the purchaser wife had
delivered into escrow.
About six months after the original "closing meeting," the
sellers (using the
letterhead of a related
company) sent a letter to Buyers that commenced
with "Dear Landowner," and instructed them to redirect their payments
on
the note to another company. Buyers
did so, for the next three months.
It was during that three month period that the mobile home
was removed
from Buyers' lot. Sellers,
discovering it was gone, claimed that they had
concluded that buyers had elected not to go ahead with the purchase
and
resold the property to others, who promptly
put their mobile home on the
property.
This so distraught the original Buyer wife when she saw strangers
on her land that she had a doctor prescribe "nerve
pills."
A jury found that there had been a breach of contract and
fraud on the part
of the sellers - the fraud
being the misrepresentation that buyers were
owners of the property in order to induce them to continue the payments
on
the mortgage even when sellers were of the
view that there had been no
closing. The
jury awarded significant punitive damages against both
companies related to the sellers.
On appeals: held: affirmed in part and reversed
in part. The Alabama
Supreme Court
affirmed the finding that there had been no delivery of the
deed, and that there had been a contract of sale that had
been breached when
the sellers took it upon
themselves to conclude that Buyers had abandoned
the property and sold the land to others. But the court held that
the trial
court should have given a directed
verdict on the fraud claim.
The Supreme Court acknowledged that there was sufficient
evidence to
support the conclusion that the
"Dear Homeowner" letter was given with
fraudulent intent, but concluded that Buyers were unreasonable in
relying
upon that fraud, since they should have
known that they couldn't possibly
be owners of
the land because the condition that husband execute the note
had never been met.
The case was decided per curiam, with one of the nine
judges specially
concurring in the result and
two dissenting on the fraud ruling.
Comment 1: There was a verbal contract, and there was part
performance,
whether or not everyone signed
sufficient documents at the closing office.
Thus, the breach of contract claim was made. But the editor thinks
that the
reversal of the fraud verdict also
went beyond the function of the reviewing
court. Had the editor been on the jury, he might not have found
intent to
defraud based upon the facts as
reported, but believes that there was
sufficient evidence to so find. The conclusion that the reliance by
the
Buyers on the representation that they were
the owners of the property,
however, seems
absurd.
Comment 2: The Buyers clearly were simple people.
Their position that the
wife alone was buying
the property was not an unreasonable or impossible
position, and would have obviated any requirement that the
husband
execute the note. It is true that
he should have executed the mortgage, but
it
seems improper under the circumstances to conclude that they were
unreasonable in their understanding that this was a
mere formality and that
they really owned the
land regardless of this detail. In fact, under the terms
of the contract, they did have a right to own the land and
in fact the sellers
were regularly accepting
their tendered performance. At least they had
equitable title.
Courts shouldn't achieve their view of justice be distorting
the law. This
precedent isn't
likely to affect many other cases, but courts should still state
conclusions that make good sense.
WORDS AND PHRASES; "GOOD FAITH BELIEF:" Right of
termination of partnership agreement, which required good
faith belief in
irreconcilable differences
between partners, is measured by subjective
standard, not objective standard. Crow Irvine #2 v Winthrop
Cal.
Investors L.P., 104 CA4th 996, 128 CR2d
644 (Cal. App. 2002), discussed
under the
heading: Partnership; Termination; "Good Faith Belief:"
ZONING AND LAND USE; PROCEDURE; DELAY; AUTOMATIC
APPROVAL: A court will not order automatic approval of a
variance
application under the 120 day rule
where there is no bad faith on the part of
a
land use board and an applicant can arguably be charged with
contributing
to the delay or unreasonably
refusing to consent to a time extension,
because such approvals must be applied with caution. Sprint
Spectrum,
L.P. v. Zoning Board of Adjustment of
Township of Green Brook, 2002
WL 31875519 (N.J.
Super. Law Div. 2002).
A telecommunications company applied for a use variance to
install an
antenna within a zone that did not
permit transmission towers. At that same
time, its attorneys filed a similar application for a competitor.
The
competitor's application was heard first
and protracted proceedings ensued.
Rather
coincidently, or as a consequence, the zoning board did not schedule
this particular application for review until shortly before
the end of the 120
day period within which a
land use board must act on a complete
application. According to statute, if a board does not act on a
completed
application within 120 days, then the
application must be approved
automatically.
When the application reached the board about two weeks
before the
deadline, the applicant was told
that there would not be enough time to
complete
the hearing process and the applicant was asked to consent to an
extension of the 120 day rule. The applicant
refused. In later proceedings,
the
applicant claimed that its refusal was based upon its knowledge that
this
particular board was conducting protracted
hearings over the very similar
parallel
application filed by its competitor. In response to the
applicant
refusing to consent to an extension,
the board denied the application.
The applicant then sued in the Superior Court contending,
"that the denial
of its application
without a hearing was arbitrary, capricious and
unreasonable." It also contended that "even though the time
remaining prior
to the expiration of the
statutory time frame was limited, the [zoning board]
could have scheduled a special meeting... ." What the applicant
was
seeking from the Court was an order
reversing the action of the zoning
board and
granting all of the approvals sought. It contended that if the
Court refused to grant relief on this set of facts, "the
120 day time frame
mandated by the statute
[would] become a nullity."
The zoning board vigorously opposed the relief sought.
It pointed out that
when the telecommunications
company filed its application, there were
four possible regular meetings of the board before the 120 day
deadline. It
also pointed out that the
applicant's counsel, in his representation of the
competitor as well, had utilized all of the available meeting time on
three
of the four dates. In
essence, the zoning board contended that it was the
attorney for the applicant, "in reality, who created a timing crisis,
and
contend[ed] that the suggestion by counsel
for [the applicant] that an
application of this
complexity could have been heard in a single meeting or,
by extension that the companion [competitor's] application
could have been
decided more quickly than it
was [was] unrealistic and, in the end,
irrelevant." Moreover, the zoning board argued that the automatic
approval
statute was "intended to apply only to
extreme situations where an applicant
has
suffered from unfair treatment."
The Court was reluctant to order automatic approval.
It looked to the only
reported decision it
could find and that decision said that the "statutory
provisions which call for an automatic approval must be 'applied
with
caution.'" Failing to do so,
would deprive a municipality of the exercise of
its legitimate regulatory role, "for essentially procedural
failings." It also
looked to a Supreme
Court case which confronted with the automatic land
use approval rule, stated that "the appropriate dispossession of [the]
appeal
is to require that the public hearing on
plaintiff's application for preliminary
subdivision approval be held forthwith."
The purpose of the automatic approval provision "is
protection of the
applicant from 'municipal
inaction and inattention.'" Here, there was "no
suggestion in the record that the Board was inattentive or that it failed
to act
for no reason." The Court was
unwilling to speculate as to whether the
problem was caused by the board's inability to hear the application at
an
early time or by the applicant's refusal to
consent to an extension. On the
other
hand, the Court found that there was nothing arbitrary or
unreasonable
in the board's decision.
Nonetheless, it was "mindful of the admonition of
our Supreme Court that the appropriate course is to require that
public
hearings be held forthwith." As a
result, in an attempt to balance the
interests,
it ordered that the decision of the zoning board be vacated and that
the matter be remanded "for a hearing and decision on the
merits to be
completed within 120 days of the
date of the order to be entered."
Readers are encouraged to respond to or criticize this posting.
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real estate oriented literature and state legislation by contacting Antonette
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asmith4@staff.abanet.org