Sometimes Hell Does Freeze Over

The recent decision in Reliastar Life Insurance Co. of New York v. Home Depot U.S.A., Inc., 570 F.3d 513 (2nd Cir. 2009), illustrates once again the limits of a purchaser's or lender's ability to rely on an estoppel certificate, especially when a tenant is entitled to claim constructive eviction. Moreover, the court determined that constructive eviction would trump a “hell or high water” commitment to pay rent.

The Case

In this case, Home Depot, as tenant, entered into a ground lease (the “Lease”) with G&S Investors/Willow Park L.P. (“G&S”), as landlord, for premises in Farmingdale, NY. Under the terms of the lease, G&S was obligated to provide a “building pad,” while Home Depot was responsible for building a home improvement center on the site. An earthen building pad was provided by G&S, on which Home Depot constructed a store.

Subsequent to the construction of the store, G&S mortgaged the Farmingdale property to ReliaStar, as successor-in-interest to North Atlantic Life Insurance Company of America. The mortgage was guaranteed by an assignment of lease agreement (“Assignment Agreement”), by which G&S assigned “[a]ll rents, income, contract rights, leases and profits now due or which may hereafter become due under or by virtue of any lease” to ReliaStar, including the Lease. The Lease required Home Depot to recognize assignments made by G&S, so in connection with the Assignment Agreement, Home Depot executed a Recognition Agreement dated as of Oct. 19, 1993. In it, Home Depot acknowledged that G&S's rights under the Lease had been assigned to ReliaStar.

'Hell or High Water'

The Recognition Agreement contained a “hell or high water” clause, which provided that G&S assigned all of its rights to the rents and all other payments due under the Lease to ReliaStar, and that Home Depot would be unconditionally and absolutely obligated to pay to ReliaStar all rents, purchases payments and other payments of whatever kind described in the Lease without any reduction, set off, abatement, or diminution whatever. The Recognition Agreement also included an estoppel certificate, in which Home Depot certified to ReliaStar that Home Depot had fully inspected the Premises, that the Premises was in good order and repair, and that all conditions to be performed by G&S had been satisfied.

However, several years after signing the Recognition Agreement, Home Depot claimed that it detected cracks in its store walls. The building began to settle unevenly, allegedly as a result of a defective building pad. G&S refused to make necessary structural repairs, so Home Depot made its own temporary repairs at a cost of $750,000. Despite the temporary repairs, the uneven settling continued and, in August 1999, Home Depot vacated the premises on the advice of its structural engineers. Home Depot stopped paying rent in August 1999 and notified G&S that the building pad failure resulted in its constructive eviction from the premises. Constructive eviction is commonly defined as “a landlord's act of making premises unfit for occupancy, often with the result that the tenant is compelled to leave.”

ReliaStar sued Home Depot in federal district court, demanding payments that ReliaStar claimed were owed pursuant to the Lease and the Recognition Agreement. In its defense, Home Depot argued that the constructive eviction relieved it of its obligation to pay rents. The district court found in favor of ReliaStar, reasoning that the “hell or high water” clause was enforceable and prevented Home Depot from claiming that the constructive eviction was a defense to its obligations under the Lease. Home Depot appealed, claiming that neither the “hell or high water” clause nor the estoppel certificate barred it from asserting constructive eviction as grounds for voiding its obligation to pay rent to ReliaStar under the Recognition Agreement. The Second U.S. Circuit Court of Appeals agreed with Home Depot.

The Appeal

The appellate court decided that the estoppel certificate did not bar Home Depot from asserting the constructive eviction claim. It pointed out that the estoppel certificate speaks in the present tense, and makes no warranties about present or future conditions that were not known when it was executed. In this case, Home Depot alleged that it did not discover the defective building pad until at least two years after the Recognition Agreement, with the included estoppel certificate, was executed. While the appellate court did not make a determination of facts in this case (as to whether Home Depot did inspect the building pad prior to construction, or whether Home Depot was reasonable in its lack of awareness of the faulty condition of the building pad when it executed the Recognition Agreement), the court found that the estoppel certificate did not bar Home Depot's constructive eviction defense and left it up to the lower court to determine whether the facts supported the defense.

In its evaluation of the “hell or high water” clause, the Second Circuit reasoned that the rights of G&S (and by assignment, ReliaStar) to payments under the Lease would terminate in the event of a constructive eviction. However, the Recognition Agreement contained the “hell or high water” clause which expanded the rights of G&S and obligated Home Depot to continue making payments to ReliaStar “unconditionally and absolutely.” Between sophisticated parties, such clauses are generally enforceable under New York law (although more commonly dealt with in the context of finance leases or equipment leases rather than a real property lease). The appellate court discussed whether or not the clause created an unconditional guarantee by Home Depot to continue to make all described payments to ReliaStar irrespective of any defenses that Home Depot might have. Ultimately, it determined that any guarantee made by the Recognition Agreement only applied to rents due, and since a constructive eviction terminates a lease and relieves the tenant of its obligation to pay rent, no rents would be due to ReliaStar (assuming Home Depot successfully proved that it was constructively evicted). Therefore, the appellate court found that if the district court determines that Home Depot was constructively evicted, that the “hell or high water” clause would be ineffective.

Conclusion

It should be noted that the appellate court specifically considered the issue of the “hell or high water” clause and estoppel from the Recognition Agreement, but did not mention nor analyze a similar clause in the Lease itself. However, based on this decision it seems a strong argument could be made that landlords will fare no better with such clauses in their leases than the lender did in the case with such clauses in its Recognition Agreement.

Gary A. Goodman, a member of this newsletter's Board of Editors, is a real estate partner in the New York office of Sonnenschein Nath & Rosenthal LLP. Rachel D. Ittner is a real estate associate in the firm's Chicago office.

The recent decision in Reliastar Life Insurance Co. of New York v. Home Depot U.S.A., Inc. , 570 F.3d 513 (2nd Cir. 2009), illustrates once again the limits of a purchaser's or lender's ability to rely on an estoppel certificate, especially when a tenant is entitled to claim constructive eviction. Moreover, the court determined that constructive eviction would trump a “hell or high water” commitment to pay rent.

The Case

In this case, Home Depot, as tenant, entered into a ground lease (the “Lease”) with G&S Investors/Willow Park L.P. (“G&S”), as landlord, for premises in Farmingdale, NY. Under the terms of the lease, G&S was obligated to provide a “building pad,” while Home Depot was responsible for building a home improvement center on the site. An earthen building pad was provided by G&S, on which Home Depot constructed a store.

Subsequent to the construction of the store, G&S mortgaged the Farmingdale property to ReliaStar, as successor-in-interest to North Atlantic Life Insurance Company of America. The mortgage was guaranteed by an assignment of lease agreement (“Assignment Agreement”), by which G&S assigned “[a]ll rents, income, contract rights, leases and profits now due or which may hereafter become due under or by virtue of any lease” to ReliaStar, including the Lease. The Lease required Home Depot to recognize assignments made by G&S, so in connection with the Assignment Agreement, Home Depot executed a Recognition Agreement dated as of Oct. 19, 1993. In it, Home Depot acknowledged that G&S's rights under the Lease had been assigned to ReliaStar.

'Hell or High Water'

The Recognition Agreement contained a “hell or high water” clause, which provided that G&S assigned all of its rights to the rents and all other payments due under the Lease to ReliaStar, and that Home Depot would be unconditionally and absolutely obligated to pay to ReliaStar all rents, purchases payments and other payments of whatever kind described in the Lease without any reduction, set off, abatement, or diminution whatever. The Recognition Agreement also included an estoppel certificate, in which Home Depot certified to ReliaStar that Home Depot had fully inspected the Premises, that the Premises was in good order and repair, and that all conditions to be performed by G&S had been satisfied.

However, several years after signing the Recognition Agreement, Home Depot claimed that it detected cracks in its store walls. The building began to settle unevenly, allegedly as a result of a defective building pad. G&S refused to make necessary structural repairs, so Home Depot made its own temporary repairs at a cost of $750,000. Despite the temporary repairs, the uneven settling continued and, in August 1999, Home Depot vacated the premises on the advice of its structural engineers. Home Depot stopped paying rent in August 1999 and notified G&S that the building pad failure resulted in its constructive eviction from the premises. Constructive eviction is commonly defined as “a landlord's act of making premises unfit for occupancy, often with the result that the tenant is compelled to leave.”

ReliaStar sued Home Depot in federal district court, demanding payments that ReliaStar claimed were owed pursuant to the Lease and the Recognition Agreement. In its defense, Home Depot argued that the constructive eviction relieved it of its obligation to pay rents. The district court found in favor of ReliaStar, reasoning that the “hell or high water” clause was enforceable and prevented Home Depot from claiming that the constructive eviction was a defense to its obligations under the Lease. Home Depot appealed, claiming that neither the “hell or high water” clause nor the estoppel certificate barred it from asserting constructive eviction as grounds for voiding its obligation to pay rent to ReliaStar under the Recognition Agreement. The Second U.S. Circuit Court of Appeals agreed with Home Depot.

The Appeal

The appellate court decided that the estoppel certificate did not bar Home Depot from asserting the constructive eviction claim. It pointed out that the estoppel certificate speaks in the present tense, and makes no warranties about present or future conditions that were not known when it was executed. In this case, Home Depot alleged that it did not discover the defective building pad until at least two years after the Recognition Agreement, with the included estoppel certificate, was executed. While the appellate court did not make a determination of facts in this case (as to whether Home Depot did inspect the building pad prior to construction, or whether Home Depot was reasonable in its lack of awareness of the faulty condition of the building pad when it executed the Recognition Agreement), the court found that the estoppel certificate did not bar Home Depot's constructive eviction defense and left it up to the lower court to determine whether the facts supported the defense.

In its evaluation of the “hell or high water” clause, the Second Circuit reasoned that the rights of G&S (and by assignment, ReliaStar) to payments under the Lease would terminate in the event of a constructive eviction. However, the Recognition Agreement contained the “hell or high water” clause which expanded the rights of G&S and obligated Home Depot to continue making payments to ReliaStar “unconditionally and absolutely.” Between sophisticated parties, such clauses are generally enforceable under New York law (although more commonly dealt with in the context of finance leases or equipment leases rather than a real property lease). The appellate court discussed whether or not the clause created an unconditional guarantee by Home Depot to continue to make all described payments to ReliaStar irrespective of any defenses that Home Depot might have. Ultimately, it determined that any guarantee made by the Recognition Agreement only applied to rents due, and since a constructive eviction terminates a lease and relieves the tenant of its obligation to pay rent, no rents would be due to ReliaStar (assuming Home Depot successfully proved that it was constructively evicted). Therefore, the appellate court found that if the district court determines that Home Depot was constructively evicted, that the “hell or high water” clause would be ineffective.

Conclusion

It should be noted that the appellate court specifically considered the issue of the “hell or high water” clause and estoppel from the Recognition Agreement, but did not mention nor analyze a similar clause in the Lease itself. However, based on this decision it seems a strong argument could be made that landlords will fare no better with such clauses in their leases than the lender did in the case with such clauses in its Recognition Agreement.

Gary A. Goodman, a member of this newsletter's Board of Editors, is a real estate partner in the New York office of Sonnenschein Nath & Rosenthal LLP. Rachel D. Ittner is a real estate associate in the firm's Chicago office.