In the Spotlight: Lease Agreements

When negotiating a lease for a commercial real property, a tenant may request that the landlord make numerous representations. Accordingly, it seems worthwhile to provide an overview of some of the issues that should be taken into account by landlords, tenants and their counsel in the preparation and negotiation of those provisions. While these concerns may seem self evident to experienced and active real estate professionals and principals who participate in real estate transactions on a regular basis, it has been our experience that many attorneys, who do not practice commercial real estate full time, and their clients are not aware of these issues.

The provision regarding the landlord's representations will typically contain several components all of which, when taken together, can create a balanced and fair provision that provides the tenant with certain protections, while at the same time not opening up the landlord to undue liability. [Note: A discussion of fraudulent representations is outside the scope of this article.]

Which Representations Are Appropriate

While each transaction is different, and there may be different customs in different jurisdictions, as a rule of thumb, it is appropriate for a tenant to request representations from the landlord for items that cannot be determined by the tenant through its own due diligence or through some other independent means prior to becoming irrevocably bound by the contract. A logical outgrowth of this rule is that in a transaction that contains a due diligence period or inspection period during which the tenant has the opportunity to investigate the real property under consideration and terminate the deal if not satisfied, it may be appropriate for the landlord to provide fewer representations. For example, in general, landlords of commercial real property are loathe to make representations about:

• The physical condition of property that can be determined by an engineering inspection and a survey;
• The environmental condition of the property that may be determined by an inspection by a licensed environmental company; or
• The contents of documents of record that can be determined by a thorough reading of the documents pulled from land records by a title insurance company or from an online database (such as ACRIS in New York City).

On the other hand, information that is difficult or impossible to be ascertained through alternate means by a tenant, but which is readily available to the landlord, may appropriately be represented by the landlord. For example, it is almost always appropriate for a tenant to request representations concerning the authority of the landlord to enter into the transaction and execute the lease, unrecorded tenancies, and threatened legal actions.

Gray Areas

It is between the two extremes set forth above (information that is fully available to the tenant through alternate means, versus information that is not available to the tenant but which is readily available to landlord) that presents the greatest source of negotiation of representations. For example, an environmental Phase I report or engineering study will only cover the period through the date of the inspection made by the investigating company. In addition, these reports may contain carve-outs for areas of the property that could not be physically accessed or information that could not be determined. Consequently, a tenant will typically request representations to buttress those reports by covering the holes they contain. Finally, since there is often no real downside to making the request, tenants will often utilize the strategy of initially “asking for the world” and then seeing where the chips fall.

On the other hand, a landlord will typically be concerned that it may not have full knowledge of the facts in question and may therefore be very hesitant to provide certain representations. Two common reasons for this lack of knowledge are: 1) the existence of large corporate landlords with many employees and turnover of employees, such that the particular person negotiating the transaction may simply be unsure of the facts in question; and 2) facts that may have occurred before the acquisition of the property by the landlord.

Landlords may also be concerned that a representation, which is true when made, may become untrue due to circumstances outside of the landlord's control. Finally, certain landlords may simply be unwilling to make certain types of representations, whether due to corporate policy or unwillingness on the part of the individual making the deal on behalf of landlord to go out on a limb and to take on certain personal risk.

The resulting representations contained in a particular agreement will tie in to the relative negotiating leverage of the two parties in the specific deal in question as well as their respective levels of aversion to risk.

Finding a Middle Ground

It is a postulate of real estate transactions that the parties want to “get the deal done.” No one wants to have to walk away from an otherwise desirable deal because s/he cannot work out the representations. There are ways to find a middle ground and cover the tenant while at the same time limiting the landlord's contingent liability.

Representations to the Landlord's Knowledge

Seemingly, one of the simplest compromises that a tenant and landlord can make is to agree that the landlord will give a particular representation “to the landlord's knowledge.” A landlord who makes a representation with this proviso should understand that, due to the concept of “imputed knowledge,” his knowledge alone does not necessarily mean that he will be off the hook if he did not know that the representation was false. Accordingly, even though he personally might not have known, a court might find that the fact that he, or another employee of his company, had received a notice to the contrary ' which sits in a file somewhere, or is part of the public record ' is enough to say that the landlord did have knowledge and the representation is false. Similarly, a court might find that the landlord had a “duty to investigate” whether the representation was true prior to making the representation.

It is for these reasons that a more sophisticated landlord will use the following phrase or similar wording in a contract when possible: “to Landlord's actual knowledge without duty of investigation.” In addition, the landlord may designate a “knowledge party,” a particular person at his company whose knowledge will be the only relevant knowledge in determining whether the landlord knew the fact at issue. For obvious reasons, this concept is particularly important if the landlord is a large organization. It should be noted that if a landlord designates a knowledge party, the tenant must get comfortable that the designee is in a position to have knowledge of the property. One solution is to state in the contract that the knowledge party is the individual responsible for the day-to-day operation of the property.

Another concern of the parties in making representations to knowledge is that if and when the tenant makes a claim based on that representation, there will need to be a factual determination made as to whether the landlord (or knowledge party) had knowledge. Since it is likely that the landlord will disclaim knowledge, the possibility of a prolonged lawsuit with commensurate discovery is real. While this is a risk that both parties may have to take, sometimes the parties will agree that the landlord's representation may be qualified by the words “the Landlord has not received written notice that” a state of facts exists. Although this will not necessarily eliminate the risk of a prolonged lawsuit, it does offer a measure of objectivity in determining whether the landlord has knowledge.

Survival

It is also important for the parties to agree upon whether or not the representations of the landlord will survive past the date the lease is executed, and if so, for what period of time. Note, however, that a different analysis is used in negotiating a lease from what would be used if this were a transaction to sell the property. For example, if a purchase and sale agreement does not state that the representations survive, then they merge with the deed and do not survive the closing. This means that once the closing occurs, the seller has no further liability under the representations, and the buyer may not bring an action against seller if they are breached. If the purchase contract states that a representation survives the closing and does not provide a time limit, then that representation survives, and, subject to relevant statutes of limitation, the seller may bring an action on it at any later point.

In leasing transactions, the representations may survive for a limited period of time. Typical periods include 90 days, six months or one year, but can be any period that is mutually agreed by the parties. For example, the landlord may represent that the air conditioning system shall be in good working order during the first six months of the term and that Landlord will maintain and repair same if that is not the case. Similarly, only some representations may be designated to survive, and different representations may be agreed to survive for different periods of time.

The utility of a representation to a tenant, and the risk to a landlord, is obviously affected by whether the representation survives and for how long. The length of survival should generally depend on the ability of the tenant to determine whether the representation has been breached. For example, a representation given in the winter about the working order of the air conditioning should survive until it is warm enough to determine whether it is true. In the alternative, a representation may conditionally survive until confirmation is received.

Finally, it would be inappropriate for certain representations of the type are outside of landlord's control to survive the date they are made. A good example of this would be a representation stating that the property has not been condemned by the municipality in which it is situated. If it has not been condemned as of the date the lease is signed, then a future condemnation after tenant has executed the lease cannot be viewed as the landlord's problem. Note that this would be not be the case if the representation was that landlord has received no notice of a pending condemnation, since in the case of that representation there is the possibility that the landlord could have breached the representation.

Conclusion

While every transaction is different, depending on the levels of risk aversion and relative bargaining power, for nearly every leasing transaction it should generally be possible to negotiate a mutually acceptable deal by weighing several factors including the landlord's level of knowledge of the facts covered by the representations, whether those representations are really necessary to protect the tenant, and the tenant's ability to gain knowledge by alternative means.

Mark Morfopoulos, a member of this newsletter's Board of Editors, is an attorney in the real estate department at Wachtel Missry LLP. Reach him at [email protected]. Avram E. Posner is partner at the firm. He can be reached at [email protected].

When negotiating a lease for a commercial real property, a tenant may request that the landlord make numerous representations. Accordingly, it seems worthwhile to provide an overview of some of the issues that should be taken into account by landlords, tenants and their counsel in the preparation and negotiation of those provisions. While these concerns may seem self evident to experienced and active real estate professionals and principals who participate in real estate transactions on a regular basis, it has been our experience that many attorneys, who do not practice commercial real estate full time, and their clients are not aware of these issues.

The provision regarding the landlord's representations will typically contain several components all of which, when taken together, can create a balanced and fair provision that provides the tenant with certain protections, while at the same time not opening up the landlord to undue liability. [Note: A discussion of fraudulent representations is outside the scope of this article.]

Which Representations Are Appropriate

While each transaction is different, and there may be different customs in different jurisdictions, as a rule of thumb, it is appropriate for a tenant to request representations from the landlord for items that cannot be determined by the tenant through its own due diligence or through some other independent means prior to becoming irrevocably bound by the contract. A logical outgrowth of this rule is that in a transaction that contains a due diligence period or inspection period during which the tenant has the opportunity to investigate the real property under consideration and terminate the deal if not satisfied, it may be appropriate for the landlord to provide fewer representations. For example, in general, landlords of commercial real property are loathe to make representations about:

• The physical condition of property that can be determined by an engineering inspection and a survey;
• The environmental condition of the property that may be determined by an inspection by a licensed environmental company; or
• The contents of documents of record that can be determined by a thorough reading of the documents pulled from land records by a title insurance company or from an online database (such as ACRIS in New York City).

On the other hand, information that is difficult or impossible to be ascertained through alternate means by a tenant, but which is readily available to the landlord, may appropriately be represented by the landlord. For example, it is almost always appropriate for a tenant to request representations concerning the authority of the landlord to enter into the transaction and execute the lease, unrecorded tenancies, and threatened legal actions.

Gray Areas

It is between the two extremes set forth above (information that is fully available to the tenant through alternate means, versus information that is not available to the tenant but which is readily available to landlord) that presents the greatest source of negotiation of representations. For example, an environmental Phase I report or engineering study will only cover the period through the date of the inspection made by the investigating company. In addition, these reports may contain carve-outs for areas of the property that could not be physically accessed or information that could not be determined. Consequently, a tenant will typically request representations to buttress those reports by covering the holes they contain. Finally, since there is often no real downside to making the request, tenants will often utilize the strategy of initially “asking for the world” and then seeing where the chips fall.

On the other hand, a landlord will typically be concerned that it may not have full knowledge of the facts in question and may therefore be very hesitant to provide certain representations. Two common reasons for this lack of knowledge are: 1) the existence of large corporate landlords with many employees and turnover of employees, such that the particular person negotiating the transaction may simply be unsure of the facts in question; and 2) facts that may have occurred before the acquisition of the property by the landlord.

Landlords may also be concerned that a representation, which is true when made, may become untrue due to circumstances outside of the landlord's control. Finally, certain landlords may simply be unwilling to make certain types of representations, whether due to corporate policy or unwillingness on the part of the individual making the deal on behalf of landlord to go out on a limb and to take on certain personal risk.

The resulting representations contained in a particular agreement will tie in to the relative negotiating leverage of the two parties in the specific deal in question as well as their respective levels of aversion to risk.

Finding a Middle Ground

It is a postulate of real estate transactions that the parties want to “get the deal done.” No one wants to have to walk away from an otherwise desirable deal because s/he cannot work out the representations. There are ways to find a middle ground and cover the tenant while at the same time limiting the landlord's contingent liability.

Representations to the Landlord's Knowledge

Seemingly, one of the simplest compromises that a tenant and landlord can make is to agree that the landlord will give a particular representation “to the landlord's knowledge.” A landlord who makes a representation with this proviso should understand that, due to the concept of “imputed knowledge,” his knowledge alone does not necessarily mean that he will be off the hook if he did not know that the representation was false. Accordingly, even though he personally might not have known, a court might find that the fact that he, or another employee of his company, had received a notice to the contrary ' which sits in a file somewhere, or is part of the public record ' is enough to say that the landlord did have knowledge and the representation is false. Similarly, a court might find that the landlord had a “duty to investigate” whether the representation was true prior to making the representation.

It is for these reasons that a more sophisticated landlord will use the following phrase or similar wording in a contract when possible: “to Landlord's actual knowledge without duty of investigation.” In addition, the landlord may designate a “knowledge party,” a particular person at his company whose knowledge will be the only relevant knowledge in determining whether the landlord knew the fact at issue. For obvious reasons, this concept is particularly important if the landlord is a large organization. It should be noted that if a landlord designates a knowledge party, the tenant must get comfortable that the designee is in a position to have knowledge of the property. One solution is to state in the contract that the knowledge party is the individual responsible for the day-to-day operation of the property.

Another concern of the parties in making representations to knowledge is that if and when the tenant makes a claim based on that representation, there will need to be a factual determination made as to whether the landlord (or knowledge party) had knowledge. Since it is likely that the landlord will disclaim knowledge, the possibility of a prolonged lawsuit with commensurate discovery is real. While this is a risk that both parties may have to take, sometimes the parties will agree that the landlord's representation may be qualified by the words “the Landlord has not received written notice that” a state of facts exists. Although this will not necessarily eliminate the risk of a prolonged lawsuit, it does offer a measure of objectivity in determining whether the landlord has knowledge.

Survival

It is also important for the parties to agree upon whether or not the representations of the landlord will survive past the date the lease is executed, and if so, for what period of time. Note, however, that a different analysis is used in negotiating a lease from what would be used if this were a transaction to sell the property. For example, if a purchase and sale agreement does not state that the representations survive, then they merge with the deed and do not survive the closing. This means that once the closing occurs, the seller has no further liability under the representations, and the buyer may not bring an action against seller if they are breached. If the purchase contract states that a representation survives the closing and does not provide a time limit, then that representation survives, and, subject to relevant statutes of limitation, the seller may bring an action on it at any later point.

In leasing transactions, the representations may survive for a limited period of time. Typical periods include 90 days, six months or one year, but can be any period that is mutually agreed by the parties. For example, the landlord may represent that the air conditioning system shall be in good working order during the first six months of the term and that Landlord will maintain and repair same if that is not the case. Similarly, only some representations may be designated to survive, and different representations may be agreed to survive for different periods of time.

The utility of a representation to a tenant, and the risk to a landlord, is obviously affected by whether the representation survives and for how long. The length of survival should generally depend on the ability of the tenant to determine whether the representation has been breached. For example, a representation given in the winter about the working order of the air conditioning should survive until it is warm enough to determine whether it is true. In the alternative, a representation may conditionally survive until confirmation is received.

Finally, it would be inappropriate for certain representations of the type are outside of landlord's control to survive the date they are made. A good example of this would be a representation stating that the property has not been condemned by the municipality in which it is situated. If it has not been condemned as of the date the lease is signed, then a future condemnation after tenant has executed the lease cannot be viewed as the landlord's problem. Note that this would be not be the case if the representation was that landlord has received no notice of a pending condemnation, since in the case of that representation there is the possibility that the landlord could have breached the representation.

Conclusion

While every transaction is different, depending on the levels of risk aversion and relative bargaining power, for nearly every leasing transaction it should generally be possible to negotiate a mutually acceptable deal by weighing several factors including the landlord's level of knowledge of the facts covered by the representations, whether those representations are really necessary to protect the tenant, and the tenant's ability to gain knowledge by alternative means.

Mark Morfopoulos, a member of this newsletter's Board of Editors, is an attorney in the real estate department at Wachtel Missry LLP. Reach him at [email protected]. Avram E. Posner is partner at the firm. He can be reached at [email protected].