Liability Awaits The Unwary: Lenders And Leasing Decisions

Wednesday, December 1, 2004 - 01:00

Introduction

The dramatic increase in recent years in the number of lawsuits seeking
damages for lender liability has significantly influenced the way lenders
conduct business. Although leasing issues have not been a major focus of lender
liability litigation, the legal theories behind lender liability claims do
extend to leasing issues. Lenders should be aware of this in the context of the
various leasing decisions that they make.

Leasing Issues And Lender Liability

In general, lender liability litigation tends to be based on claims that
the lender made misrepresentations about the ultimate nature of the loan, that
the lender added new conditions to a loan after the borrower accepted the
original terms, or that the lender exercised control over or interfered with the
borrower's business.

The majority of claims against lenders are based on legal theories
governing other areas of law applied to the lender-borrower context. Three
general areas include claims based on contract theory (for example, that the
lender orally promised to extend a loan but later reneged or added new
conditions to the loan), claims based on tort theory (for example, that the
lender interfered with the landlord/tenant business relationship by attempting
to convince the tenant to modify its existing lease) and claims based on
principal/agent theory (for example, that the lender constructively "became" the
landlord by exercising excessive control over leasing
decisions).1 In addition, specific statutes applicable to
financial institutions and bankruptcy cases, as well as governmental claims for
environmental and other regulatory matters, are a growing area of lender
liability litigation.

Within the leasing context, the small but growing number of lender
liability claims typically concern allegations that the lender improperly
exercised or abused its discretion during the loan negotiation process, or tried
to control the borrower's business after the closing of the loan.

Case In Point

In a situation involving this firm's representation of a pension fund
lender against lender liability claims, the borrower had permitted a retail
tenant to commence business operations before a lease had been executed and
before the lender had been asked for its approval. Exercising its express right
to approve or disapprove tenants and leases contained in the mortgage
documentation, the lender disapproved of the proposed tenant. When the borrower
moved to evict the tenant, the tenant claimed that (a) it had an actual or a
constructive lease based on its occupancy, the borrower's financing of its
leasehold improvements, and the exchange of detailed drafts of a lease between
the borrower and the tenant; and (b) the lender had tortiously interfered with
the lease contract by disapproving the tenant.

In an unreported decision, summary judgment was granted to the lender
(and borrower) on all claims. Significantly, the judgment included a finding
that the tenant could have no valid lease without lender consent because the
tenant was on notice of the recorded (that is, public) mortgage documentation
giving the lender the right to approve all leases and tenants. Notwithstanding
the favorable outcome for the lender, this case is an example of the expanding
nature of lender liability claims in the leasing area. It is also instructive of
the ways in which lenders can, to a degree, protect themselves from successful
liability claims on a proactive, rather than merely reactive, basis.

Existing Leases

In a typical non-recourse mortgage loan context, the importance of the
rental income stream to the lender's underwriting of the loan is paramount. As
an adjunct to this, the lender will require confirmation of the existing leases.
Prior to closing a loan, the lender generally would require that it have the
right to review and approve all existing leases, that tenants provide estoppel
certificates confirming the terms and status of their leases, and that select
tenants enter into subordination and attornment agreements ("subordination
agreements").2 After reviewing the existing leases, the lender
may conclude that some lease provisions (for example, offset rights, rights of
first refusal or early termination rights) require modification or are outright
unacceptable. Modifications to existing leases between the lender and a tenant
would most often be reflected in an estoppel certificate or subordination
agreement.

Areas that are ripe for disagreement between a tenant and the lender
include expansion of the tenant's environmental liabilities and limitation of a
tenant's right to direct the use of insurance proceeds or require the landlord
to complete building renovations. Most often the lease does not proscribe a
basic form of an estoppel certificate or subordination agreement and, therefore,
lengthy negotiations can ensue.

There are two important ways in which lenders can minimize the likelihood
of successful lender liability claims in this context. One is to avoid direct
contact or negotiations with the tenant. At times it might be expedient or even
valuable for the lender's representatives to be in direct discussions with the
tenant's representatives. However, this can lead to later contract claims to the
effect that the lender made oral promises to the tenant that are not being kept,
or tort claims to the effect that the lender interfered with the borrower/tenant
business relationship. The lender should arrange for the borrower to contact the
tenant to negotiate any required changes to existing leases.

Another way is to avoid any communication, including internal
communications among the lender's personnel, that is emotional or derogatory
about the borrower or tenants. To the contrary, there should be ample internal
communications that are businesslike and thorough in articulating the
substantive reasons why a particular lease provision is unacceptable or falls
outside the underwriting guidelines. Likewise, any letter of intent or
commitment letter issued by the lender should be very clear and specific about
the lender's right to review and approve existing leases and to require estoppel
certificates and subordinations as a condition of making the loan. Many lenders
already include in their letters of intent and commitment letters extensive
boilerplate provisions designed to make clear that the lender is not bound until
all of the leasing conditions have been satisfied and definitive loan
documentation has been executed and delivered.

New Leases

Once the loan closing has taken place, the potential for lender liability
claims on leasing issues arises most commonly in the context of the lender's
approval rights over new leases. The unreported pension fund lender case
mentioned above illustrates claims made when a lender exercises its right to
disapprove a tenant. Similar claims could result from the lender's disapproving
the particular economic and other terms of a proposed lease. A lender would also
be vulnerable to waiver or estoppel claims in situations where the lender
approved (or failed to exercise its right to approve) prior tenants or leases of
similar quality but wishes to disapprove the current proposal.

The two ways for lenders to minimize the likelihood of successful lender
liability claims mentioned above with respect to existing leases have similar
application to new leases. Lenders should avoid direct negotiations with the
proposed tenant, and the lender's communications, including internal
communications, about the reasons for disapproval should be dispassionate,
businesslike and thorough.

In addition, the lender's approval rights should be clearly delineated in
the recorded mortgage documentation. This is plainly borne out by the holding of
the case mentioned above. To the extent possible, specific parameters for
acceptable leasing criteria should also be spelled out. This might include
statements about specific rental amounts, or references to fair market rentals,
acceptable duration of the lease term, definitions of creditworthiness with
respect to tenants and other material matters.3 In situations
where significant yearly leasing turnover and activity is expected,
consideration should be given to requiring the borrower to submit an annual
leasing plan for the lender's approval. The leasing plan would conform to a
general format for specificity and coverage provided by the lender prior to
closing, and once approved for the current year it would serve to undermine many
of the claims arising out of approval rights otherwise available to the
borrower.

Conclusion

Lender liability claims generally and in the leasing context are here to
stay. However, the prudent and proactive lender has mechanisms available to
minimize its exposure to these claims.

1 This is to be distinguished from a claim of
"equitable subordination," often faced by lenders in this situation, from
third-party creditors who claim that the lender's "controlling" conduct
effectively subordinated the priority of the lender's loan to the loans of the
other creditors.
2
Complicating
matters, these lender rights may exist in a negotiating environment in which the
borrower believes it has an unqualified commitment from the lender.

3
It should be noted that such specific provisions may
be viewed as undesirable from a commercial standpoint, because they would tend
to limit the lender's ultimate discretion over leasing
decisions.

Miroslav M. Fajt (mfajt@torys.com) is head of the Commercial Real
Estate Group at the New York office of Torys LLP, and Gary S. Litke
(
glitke@torys.com) is a partner
in the Group. They represent domestic and foreign lenders and corporations in
financings, acquisitions, mergers, sales and development activities. Their
extensive experience in all aspects of commercial real estate transactions
includes cross-border and international transactions. Torys LLP is a business
law firm with more than 330 lawyers in its offices in New York and Toronto. This
article first appeared in slightly modified form in Real Estate Finance Journal.
It is reprinted here with permission. Copyright 2002 West, a Thomson
business.