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.