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Inheriting Tenants in Default?
If you currently own or are looking to acquire a shopping center, office building or other commercial property, these transactions may bring with them some time consuming surprises and costly legal fees if existing tenants owe unpaid rent. An Illinois Appellate Court recently addressed this issue in 1002 E. 87th St. LLC v. Midway Broadcasting Corp., 2018 IL App (1st) 171691 (June 5, 2018), and ruled in favor of a commercial tenant after a new owner acquired a commercial building and attempted to collect accrued unpaid rent owed to the previous landlord. In affirming the lower court's ruling, the court held that a subsequent landlord did not have standing to sue for unpaid rent that had accrued prior to the conveyance and explained that such standing is a right remaining with the original landlord to whom the unpaid rent is owed. Additionally, unlike other debt obligations, the court differentiated rent accrual as a chose in action that is not assignable. The decision raises questions about the strength of assignment and non-waiver lease provisions and also rights of succeeding landlords. Further, it raises concerns about the applicability of certain non-waiver lease provisions, in particular, the assignability of lease rights and obligations. Landlords, tenants, and lenders alike are now questioning whether this decision may facilitate tenants' evasion of contractual duties upon acquisition or disposition of real estate.
|Background
The court's decision stems from a dispute between 1002 E. 87th Street LLC (87th Street), the commercial landlord, and Midway Broadcasting Corporation (Midway), the commercial tenant, along with Midway's guarantors. 87th Street had recently purchased the property that Midway was leasing and demanded full payment for past due rent Midway owed to the previous landlord. 87th Street claimed a right to that unpaid rent by virtue of an assignment of the lease from 87th Street's predecessor. When Midway did not comply with the request, 87th Street began eviction proceedings.
87th Street first argued that the original lease gave 87th Street standing to sue. Its second argument was that the assignment provisions transferred to it the right to receive accrued rent from the previous owner. In response, Midway argued that 87th Street did not have standing to bring suit for the unpaid rent because 87th Street was not the owner of the property at the time when the past due rent accrued. Midway also argued that the assignment provision should be held invalid because the previous landlord could not have intended to assign its rights to collect unpaid rent to the succeeding landlord.
|Standing
In order to have standing in a case, the plaintiff must have an interest in the action and the potential outcome. Unifund CCR Partners v. Shah, 407 Ill. App. 3d 737 (2011). Generally, a landlord has standing to sue for unpaid rent. Dasenbrock v. Interstate Restaurant Corp., 7 Ill. App. 3d at 302 (Sept. 1, 1972). It also remains undisputed that the conveyance of property includes the conveyance of a lease along with the rights to receive rent. However, the new landlord does not obtain rights to pursue past rent that was due prior to the landlord's owning the property. 87th Street pointed to a provision in the lease which stated that “[n]o failure of landlord to exercise any power *** or to insist upon strict compliance *** and no custom or practice of the parties *** shall constitute a waiver of Landlord's right to demand exact compliance with the terms ***.” 87th Street made the point that, as landlord, it should be able to enforce the lease through this non-waiver clause regardless of the previous landlord's inaction to collect the unpaid rent.
Despite this clause in the lease, the lower court, in a decision affirmed by the appellate court, ruled in Midway's (tenant's) favor, stating that 87th Street only has standing to sue for delinquent rent owed to it that has accrued after acquisition of the property by 87th Street. The court emphasized that a demand for compliance with the lease does not create a new right to collect rent due before the landlord seeking the back rent was the owner of the property. The court further noted there are presently no cases which state that a new owner can use a non-waiver clause to enforce a tenant's obligations to a previous owner. In short, the ruling in the case meant that 87th Street has no standing to sue for unpaid rent under the non-waiver provision in the lease.
|Assignment
87th Street next pointed for its argument to an assignment of lease provision, which stated that the“[t]enant agrees to attorn to such new owner.” Additionally, the lease provided that all liability and obligations “shall be binding upon the new owner.”
However, the court held that rent in arrears is not assignable to a new property owner. While it is uncertain what the entire assignment provision within the purchase and sale agreement stated, it is possible that the court may have come to a different conclusion if the right to pursue rent in arrears was specifically assigned to the new landlord. 87th Street attempted to distinguish its case from the facts presented in A.M. Realty Western v. MSMC Realty, LLC, 2012 IL. App (1st) 121183, where debt accrued by the tenant during the landlord's ownership of property. Subsequently, the landlord sold the property and filed a suit against the previous tenant for the cost accrued during the tenant's occupancy. In that case, the appellate court held that the landlord had standing to sue the previous tenant because the debt accrued before the property had been sold. Further, the debt which accrued before the property was sold does not pass to subsequent owners of the property, even with an assignment provision. The court held that 87th Street was unsuccessful in distinguishing itself from the A.M. Realty Western case because it was not suing for debt that accrued during its tenure as landlord, rather, rent that accrued prior to its tenure.
|The Need for Protection: Purchasers, Clarify the Obligation to Collect
In addition to impacting purchasers, 1002 E. 87th St. LLC v. Midway Broadcasting Corp. also affects sellers preparing the rentable property to be sold. Sellers should be conscious that if they have delinquent tenants, the potential sale price of their property may be negatively impacted due to the perceived risk that those tenants will continue to be delinquent in paying rent. Assuming this is not an issue, sellers still need to determine whether they want to retain the right to collect unpaid rent from their former tenants after the closing or if they would instead be willing to allow purchasers to collect and retain unpaid accrued amounts under the lease. In most cases, contracts will be drafted to allow sellers to collect the delinquencies and pursue remedies against tenants without the right to evict the tenant, and impose obligations on purchasers to make reasonable efforts to collect delinquencies from tenants without the obligation to bring any proceeding against the tenants. Purchasers should make sure their contracts provide that any delinquent amounts are first applied to current amounts due from tenants and only afterwards applied to extinguish older unpaid rent obligations.
All of the above referenced provisions should be set out in the original purchase and sale agreement, where both parties can acknowledge agreement to such terms. Purchasers should also be allowed to deduct actual out-of-pocket expenses, or possibly a fee, before paying any delinquency to sellers.
|Use the Due Diligence Period
It is important for a purchaser to use the due diligence period to enter onto and inspect the property. This includes verifying whether there are tenants, leases, or other important details regarding current leasehold interests that are attached to the property. The purchaser should protect itself by requesting, at a minimum, that the seller provide a certified rent roll that lists the tenant names, last paid rent amount, any security deposits, and the term of the leases on the property. These disclosures will provide the purchaser with knowledge of any delinquent rent and any potential legal fees that the purchaser may be required to spend should tenants need to be evicted.
The purchaser should also insist the that seller not be allowed to use the value of any security deposits to satisfy unpaid rent if such security deposit is not previously applied prior to the execution of the contract. If the purchaser expects to be able to collect delinquent rents, and keep the amounts collected, both the contract and the assignment document should specifically state this right of the purchaser.
|Analysis
It is not discussed in 1002 E. 87th St. LLC v. Midway Broadcasting Corp. whether or not the new owner was aware of the unpaid rent prior to the acquisition of property; however, even if a tenant is clearly delinquent in paying rent to the current landlord, a purchaser will not have standing to bring suit for any unpaid rent accrued prior to the closing date. Unless a purchaser specifically receives the right to do so in the contract and in the actual assignment document, the purchaser should not expect to receive the unpaid rent from the delinquent tenants.
Ultimately, without the correct contractual language, the purchaser may not even receive the necessary information required for deciding whether or not to engage in the acquisition of the property or in negotiating a fair purchase price. It will be interesting to see if other courts follow the holding in this case or take a more liberal view in encouraging buyers to proceed with acquisitions without restricting enforcement of leases following such acquisitions.
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Ira Fierstein, a member of this newsletter's Board of Editors, is a partner in the real estate group at Seyfarth Shaw LLP. Michelle Palka is an associate in the firm's real estate group.
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