Work Letter 'What Ifs'

The construction documents may be subject to change orders requested by the tenant or landlord. If the tenant is responsible for all or any portion of the tenant improvement costs, the Work Letter should expressly state that the tenant is responsible only for costs and expenses resulting from change orders approved in writing by the tenant. Any change order documentation presented to the tenant for approval should identify all increases and/or decreases (and the net increase or decrease) in the items comprising the approved cost budget and also the contractor's written determination of any delay which will result from any such change (such delay is typically treated as tenant-caused delay which extends the landlord's performance deadlines).

Landlords will want to ensure that any tenant right to approve pricing or changes to pricing is exercised as quickly as possible so as to minimize any delays in completing the landlord's work. For example, if the tenant has the right to modify the tenant improvement plans to achieve cost savings, that tenant should complete its value-engineering within a defined period of time (perhaps 10 days from the tenant's receipt of initial pricing). Also, if the tenant has the right to approve the contractor and/or construction contract, the landlord should obtain the tenant's consent prior to execution of the lease.

With respect to change orders, the landlord will want the tenant to be responsible for any increase in the cost of the tenant improvements caused by any change order. If the landlord is providing the tenant with a tenant allowance, the Work Letter should expressly state that the tenant is responsible for payment of all costs to complete the tenant improvements, including the cost of all change orders, in excess of the allowance provided by the landlord. Any failure by the tenant to pay any excess costs should be treated as an event of default under the lease, allowing the landlord to exercise its rights and remedies (subject to any negotiated notice and cure rights afforded to the tenant). In addition, any delay resulting from any change order requested by the tenant should be treated as a tenant delay and should extend all of the landlord's performance deadlines (for example, the estimated substantial completion date) on a day-for-day basis.

4. What if the Tenant Improvements Are Not Complete Even Though Substantial Completion Has Been Achieved?

Depending on the way “substantial completion” is defined in the lease, certain tenant improvement work may remain unfinished even though the parties have agreed that substantial completion of the tenant improvements have been achieved. Typically, at substantial completion, certain minor details, omissions, decorations and mechanical adjustments to the tenant improvements of the type normally found on an architectural “punch list” — the completion of which will not unreasonably interfere with the tenant's ability to utilize the premises for the permitted use defined in the lease — will remain unfinished. The “punch list” should be prepared jointly by the tenant and landlord during a walk-through of the premises (which may include the landlord's architect and the tenant's architect, if any). The walk-through should occur shortly after a party (usually the landlord) claims substantial completion has been achieved (perhaps within three business days). The tenant should require the landlord to complete all punch-list items as quickly as possible, but by no later than 15 to 30 days following substantial completion. The tenant may require the landlord to complete the punch-list items after normal building hours, and the tenant should require the landlord to minimize interference with the tenant's business operations in the premises while performing any such work.

If the landlord is responsible for the completion of punch-list items, the landlord will want to ensure any time period to complete such items is realistic; and if any work involves long lead items, that the landlord has additional time to complete such work. The landlord will also need access to the premises to complete the punch-list items and should resist agreeing to perform the punch list items during non-business hours in order to avoid additional costs associated with after-hours work. The lease should also make clear that the existence of punch-list items does not affect the commencement of the lease term or the tenant's obligation to pay rent.

5. What if the Tenant Improvement Allowance Is not Fully Utilized After Payment of all Construction Costs?

The tenant may negotiate a tenant improvement allowance (the “Allowance”) to be provided by the landlord and applied by the tenant to the cost of the construction of the tenant improvements incurred by the tenant. The Allowance is usually calculated based on the usable square footage of the premises, although the tenant should consider whether the rentable square footage should instead be the basis of this calculation. The Allowance is typically included as part of the overall concession package negotiated by landlord and tenant, and, therefore, has a profound economic impact on the lease.

The tenant and landlord must understand what the Allowance is intended to cover. The landlord may seek to limit application of the Allowance to the hard costs of constructing the the tenant's build-out and may permit the Allowance to be used to pay any construction management fee (bearing in mind that the construction manager may be affiliated with the landlord). However, a tenant should consider requiring that the Allowance be available to also pay for soft construction costs (such as design fees and permit costs, if the tenant is responsible for such costs); the tenant's finish work and installation of its furniture, fixtures and equipment; moving and other relocation costs; and change orders. The tenant should not permit the Allowance to be used to pay costs of base building work.

The tenant should also be mindful of the disbursement conditions contained in the lease. If the conditions to disbursement include the landlord's receipt of paid receipts and unconditional lien waivers, the tenant would be required to pay the costs of building the tenant improvements up front, and then request the Allowance from the landlord as reimbursement for those costs. The tenant may, instead, prefer to receive disbursements of the Allowance as the work progresses, in order to utilize the proceeds of the Allowance to pay the contractor as and when the work is being performed and such costs become due and payable under the construction contract. If the landlord allows for disbursements prior to receiving paid invoices and final unconditional lien waivers, the landlord will want to include protections against mechanics' liens. The landlord should also consider any applicable requirements of the landlord's mortgagee and ensure that such requirements are included as part of the conditions for disbursement of the Allowance in the Work Letter.

The landlord's initial draft of the Work Letter may provide that the tenant loses the right to any unused portion of the Allowance. The tenant, however, should consider requesting the right to credit any unused Allowance against base rent and additional rent becoming due under the lease and/or the right to apply any unused Allowance toward the cost of any change orders; the tenant's furniture, fixtures and equipment; and moving or relocation costs (or any other costs incurred by the tenant, including signage).

6. What if the Landlord And Tenant Cannot Reach Agreement Under Work Letter Provisions?

Work Letters are fraught with opportunities for disagreement between landlords and tenants. Here are a few examples:

1. The landlord has provided the tenant with notice that substantial completion of the landlord's work has been achieved, but the tenant disputes such occurrence;
2. The tenant has requested a change to the tenant improvements during the course of construction and disagrees with the calculation of the increased costs and/or delay resulting from the change;
3. To allow the tenant additional time to prepare the premises for the tenant's occupancy, the landlord provides the tenant and its contractors with early access to the premises while the landlord and its contractors are performing the landlord's work, but the landlord alleges a tenant-caused delay in the substantial completion date due to interference by the tenant's contractors with the landlord's completion of its work; and
4. The landlord fails to timely complete the landlord's work, which, pursuant to the Work Letter provisions, entitles the tenant to complete the landlord's work on the landlord's behalf and at the landlord's cost. The landlord disputes some of the costs incurred by the tenant to complete the work.

Alternative Dispute Resolution

To avoid unnecessary expenses and protracted delays inherent in litigation, the parties should consider submitting disputes arising under the Work Letter to alternative dispute resolution. One method is for the parties to designate a neutral third-party arbitrator with extensive experience and knowledge in real estate design and construction (for example, an architect), whose resolution of the dispute is binding on both landlord and tenant.

The parties could instead provide for the selection of a three-member arbitration panel, with each party selecting a qualified arbitrator and the selected arbitrators choosing the third arbitrator. The parties could either select and name the arbitrator in the Work Letter, or describe the qualifications of the arbitrator to be selected by the parties if and when a dispute arises.

In any event, the arbitrator should be neutral and should not have acted on behalf of the landlord or tenant or any of their respective affiliates in any capacity at any time prior to making any determination to be made by the arbitrator under the Work Letter. The parties should consider requiring the arbitrator to certify to each party that such arbitrator has not acted in any such capacity for either party or their respective affiliates.

The landlord or tenant may at some point want the right to request that the arbitrator be replaced, or the designated arbitrator may be unwilling or unable to act. In any such event, landlord and tenant should attempt to agree upon a different arbitrator who satisfies the requirements set forth in the Work Letter. (For example, the arbitrator must be a reputable licensed architect who has not served in any capacity for either Landlord or Tenant or their respective affiliates). If the parties are unable to agree within a certain period of time (for example, within five business days following either party's request for a new arbitrator or receipt of notice from the current arbitrator that he or she is unable or unwilling to act), then either party may request that the American Arbitration Association (or other appointing agency) appoint a new arbitrator meeting the qualifications set forth in the Work Letter, which appointment should be binding on the parties (and the costs of the American Arbitration Association or other appointing agency in connection therewith should be shared equally by landlord and tenant).

Landlord and tenant could agree to procedural rules that would apply to any dispute resolution, and could incorporate by reference the rules and procedures of administrative agencies such as the American Arbitration Association or JAMS. Both parties should, however, review the actual rules that would apply if a dispute occurs before agreeing to incorporate any such rules by reference. The parties could also allow for limited discovery prior to the hearing. To achieve a timely resolution and avoid construction delays, Landlord and Tenant should agree to reasonably cooperate with each other and the arbitrator to cause the arbitrator to issue its binding resolution of any dispute within a commercially reasonable time (perhaps not to exceed 10 business days) after submission of the dispute to the arbitrator.

Conclusion

Although often attached as an exhibit to the lease, the Work Letter and its provisions are significant and integral economic components of a lease transaction. Landlords and tenants alike should identify and carefully consider all possible problems relating to the design and construction of the building, premises and center in which the building is located, and then attempt to address and mitigate risks during their lease negotiations. The Work Letter should accurately reflect the reality of the work being performed on the ground, including the description of the work being performed, allocation of responsibility for completion of all required work and payment of all costs to complete such work, and the schedule to complete all work. The Work Letter should also include provisions attempting to mitigate any risks anticipated by the parties and also dispute resolution procedures in the event problems arise.

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Melissa Vandewater is a partner in the Real Estate Practice Group of Seyfarth Shaw LLP. Reach her at 312-460-5563 or [email protected].

Editor's Note: Landlords and tenants enter into agreements, known as “Work Letters,” delineating their respective rights and obligations with regard to tenant and landlord improvements. As with any other portion of the lease, complications can develop, so addressing potential Work Letter issues within the contract can pay dividends down the road. To illustrate some of the circumstances that may arise, and how one might deal with them at negotiation, the author has proposed six “what-if” scenarios, the first two of which were discussed in Part One of this article. She continues herein with Scenario number three.

3. What if Tenant Improvement Pricing Exceeds the Tenant's Expectations?

If the tenant is responsible for paying all or any portion of the tenant improvement costs, it will want as much control over those costs as possible. The tenant will want to ensure that:

1. the work is bid to multiple contractors and/or subcontractors for pricing;
2. the construction plans and documents that are used by the contractors and subcontractors to determine pricing are as detailed as possible to ensure that the bids will be as accurate as possible;
3. if the landlord is responsible for the tenant improvements, the tenant has the right to approve the contractor and also the construction contract (or, at a minimum, the type of contract, such as cost-plus-fixed-percentage or cost-plus-guaranteed-maximum-price); and
4. it has approved the construction budget (and attached a copy to the lease, if available prior to lease execution).

Once the architectural and engineering drawings and other construction documents are prepared, the tenant will want the right to approve the construction documents before they are submitted to the applicable governmental authority for approval. In addition, if the applicable governmental authority requires changes to the construction documents in order to issue approvals and permits for the work, and the changes would increase the cost of the tenant improvements, the tenant will want the ability to request revised pricing and/or “value-engineer” the design of the tenant improvements to reduce costs or otherwise keep costs in line with the approved budget.

The construction documents may be subject to change orders requested by the tenant or landlord. If the tenant is responsible for all or any portion of the tenant improvement costs, the Work Letter should expressly state that the tenant is responsible only for costs and expenses resulting from change orders approved in writing by the tenant. Any change order documentation presented to the tenant for approval should identify all increases and/or decreases (and the net increase or decrease) in the items comprising the approved cost budget and also the contractor's written determination of any delay which will result from any such change (such delay is typically treated as tenant-caused delay which extends the landlord's performance deadlines).

Landlords will want to ensure that any tenant right to approve pricing or changes to pricing is exercised as quickly as possible so as to minimize any delays in completing the landlord's work. For example, if the tenant has the right to modify the tenant improvement plans to achieve cost savings, that tenant should complete its value-engineering within a defined period of time (perhaps 10 days from the tenant's receipt of initial pricing). Also, if the tenant has the right to approve the contractor and/or construction contract, the landlord should obtain the tenant's consent prior to execution of the lease.

With respect to change orders, the landlord will want the tenant to be responsible for any increase in the cost of the tenant improvements caused by any change order. If the landlord is providing the tenant with a tenant allowance, the Work Letter should expressly state that the tenant is responsible for payment of all costs to complete the tenant improvements, including the cost of all change orders, in excess of the allowance provided by the landlord. Any failure by the tenant to pay any excess costs should be treated as an event of default under the lease, allowing the landlord to exercise its rights and remedies (subject to any negotiated notice and cure rights afforded to the tenant). In addition, any delay resulting from any change order requested by the tenant should be treated as a tenant delay and should extend all of the landlord's performance deadlines (for example, the estimated substantial completion date) on a day-for-day basis.

4. What if the Tenant Improvements Are Not Complete Even Though Substantial Completion Has Been Achieved?

Depending on the way “substantial completion” is defined in the lease, certain tenant improvement work may remain unfinished even though the parties have agreed that substantial completion of the tenant improvements have been achieved. Typically, at substantial completion, certain minor details, omissions, decorations and mechanical adjustments to the tenant improvements of the type normally found on an architectural “punch list” — the completion of which will not unreasonably interfere with the tenant's ability to utilize the premises for the permitted use defined in the lease — will remain unfinished. The “punch list” should be prepared jointly by the tenant and landlord during a walk-through of the premises (which may include the landlord's architect and the tenant's architect, if any). The walk-through should occur shortly after a party (usually the landlord) claims substantial completion has been achieved (perhaps within three business days). The tenant should require the landlord to complete all punch-list items as quickly as possible, but by no later than 15 to 30 days following substantial completion. The tenant may require the landlord to complete the punch-list items after normal building hours, and the tenant should require the landlord to minimize interference with the tenant's business operations in the premises while performing any such work.

If the landlord is responsible for the completion of punch-list items, the landlord will want to ensure any time period to complete such items is realistic; and if any work involves long lead items, that the landlord has additional time to complete such work. The landlord will also need access to the premises to complete the punch-list items and should resist agreeing to perform the punch list items during non-business hours in order to avoid additional costs associated with after-hours work. The lease should also make clear that the existence of punch-list items does not affect the commencement of the lease term or the tenant's obligation to pay rent.

5. What if the Tenant Improvement Allowance Is not Fully Utilized After Payment of all Construction Costs?

The tenant may negotiate a tenant improvement allowance (the “Allowance”) to be provided by the landlord and applied by the tenant to the cost of the construction of the tenant improvements incurred by the tenant. The Allowance is usually calculated based on the usable square footage of the premises, although the tenant should consider whether the rentable square footage should instead be the basis of this calculation. The Allowance is typically included as part of the overall concession package negotiated by landlord and tenant, and, therefore, has a profound economic impact on the lease.

The tenant and landlord must understand what the Allowance is intended to cover. The landlord may seek to limit application of the Allowance to the hard costs of constructing the the tenant's build-out and may permit the Allowance to be used to pay any construction management fee (bearing in mind that the construction manager may be affiliated with the landlord). However, a tenant should consider requiring that the Allowance be available to also pay for soft construction costs (such as design fees and permit costs, if the tenant is responsible for such costs); the tenant's finish work and installation of its furniture, fixtures and equipment; moving and other relocation costs; and change orders. The tenant should not permit the Allowance to be used to pay costs of base building work.

The tenant should also be mindful of the disbursement conditions contained in the lease. If the conditions to disbursement include the landlord's receipt of paid receipts and unconditional lien waivers, the tenant would be required to pay the costs of building the tenant improvements up front, and then request the Allowance from the landlord as reimbursement for those costs. The tenant may, instead, prefer to receive disbursements of the Allowance as the work progresses, in order to utilize the proceeds of the Allowance to pay the contractor as and when the work is being performed and such costs become due and payable under the construction contract. If the landlord allows for disbursements prior to receiving paid invoices and final unconditional lien waivers, the landlord will want to include protections against mechanics' liens. The landlord should also consider any applicable requirements of the landlord's mortgagee and ensure that such requirements are included as part of the conditions for disbursement of the Allowance in the Work Letter.

The landlord's initial draft of the Work Letter may provide that the tenant loses the right to any unused portion of the Allowance. The tenant, however, should consider requesting the right to credit any unused Allowance against base rent and additional rent becoming due under the lease and/or the right to apply any unused Allowance toward the cost of any change orders; the tenant's furniture, fixtures and equipment; and moving or relocation costs (or any other costs incurred by the tenant, including signage).

6. What if the Landlord And Tenant Cannot Reach Agreement Under Work Letter Provisions?

Work Letters are fraught with opportunities for disagreement between landlords and tenants. Here are a few examples:

1. The landlord has provided the tenant with notice that substantial completion of the landlord's work has been achieved, but the tenant disputes such occurrence;
2. The tenant has requested a change to the tenant improvements during the course of construction and disagrees with the calculation of the increased costs and/or delay resulting from the change;
3. To allow the tenant additional time to prepare the premises for the tenant's occupancy, the landlord provides the tenant and its contractors with early access to the premises while the landlord and its contractors are performing the landlord's work, but the landlord alleges a tenant-caused delay in the substantial completion date due to interference by the tenant's contractors with the landlord's completion of its work; and
4. The landlord fails to timely complete the landlord's work, which, pursuant to the Work Letter provisions, entitles the tenant to complete the landlord's work on the landlord's behalf and at the landlord's cost. The landlord disputes some of the costs incurred by the tenant to complete the work.

Alternative Dispute Resolution

To avoid unnecessary expenses and protracted delays inherent in litigation, the parties should consider submitting disputes arising under the Work Letter to alternative dispute resolution. One method is for the parties to designate a neutral third-party arbitrator with extensive experience and knowledge in real estate design and construction (for example, an architect), whose resolution of the dispute is binding on both landlord and tenant.

The parties could instead provide for the selection of a three-member arbitration panel, with each party selecting a qualified arbitrator and the selected arbitrators choosing the third arbitrator. The parties could either select and name the arbitrator in the Work Letter, or describe the qualifications of the arbitrator to be selected by the parties if and when a dispute arises.

In any event, the arbitrator should be neutral and should not have acted on behalf of the landlord or tenant or any of their respective affiliates in any capacity at any time prior to making any determination to be made by the arbitrator under the Work Letter. The parties should consider requiring the arbitrator to certify to each party that such arbitrator has not acted in any such capacity for either party or their respective affiliates.

The landlord or tenant may at some point want the right to request that the arbitrator be replaced, or the designated arbitrator may be unwilling or unable to act. In any such event, landlord and tenant should attempt to agree upon a different arbitrator who satisfies the requirements set forth in the Work Letter. (For example, the arbitrator must be a reputable licensed architect who has not served in any capacity for either Landlord or Tenant or their respective affiliates). If the parties are unable to agree within a certain period of time (for example, within five business days following either party's request for a new arbitrator or receipt of notice from the current arbitrator that he or she is unable or unwilling to act), then either party may request that the American Arbitration Association (or other appointing agency) appoint a new arbitrator meeting the qualifications set forth in the Work Letter, which appointment should be binding on the parties (and the costs of the American Arbitration Association or other appointing agency in connection therewith should be shared equally by landlord and tenant).

Landlord and tenant could agree to procedural rules that would apply to any dispute resolution, and could incorporate by reference the rules and procedures of administrative agencies such as the American Arbitration Association or JAMS. Both parties should, however, review the actual rules that would apply if a dispute occurs before agreeing to incorporate any such rules by reference. The parties could also allow for limited discovery prior to the hearing. To achieve a timely resolution and avoid construction delays, Landlord and Tenant should agree to reasonably cooperate with each other and the arbitrator to cause the arbitrator to issue its binding resolution of any dispute within a commercially reasonable time (perhaps not to exceed 10 business days) after submission of the dispute to the arbitrator.

Conclusion

Although often attached as an exhibit to the lease, the Work Letter and its provisions are significant and integral economic components of a lease transaction. Landlords and tenants alike should identify and carefully consider all possible problems relating to the design and construction of the building, premises and center in which the building is located, and then attempt to address and mitigate risks during their lease negotiations. The Work Letter should accurately reflect the reality of the work being performed on the ground, including the description of the work being performed, allocation of responsibility for completion of all required work and payment of all costs to complete such work, and the schedule to complete all work. The Work Letter should also include provisions attempting to mitigate any risks anticipated by the parties and also dispute resolution procedures in the event problems arise.

*****
Melissa Vandewater is a partner in the Real Estate Practice Group of Seyfarth Shaw LLP. Reach her at 312-460-5563 or [email protected].