CORONAVIRUS UPDATE FOR COMMERCIAL TENANTS

One of the first decisions new partners face in pursuing a new business venture is what type of business entity to form.  Options include forming formal business entities such as a corporation or limited liability company (LLC) which are registered with the State of California or forming a partnership.  While formal business entities offer many advantages (most notably protection of personal assets from liability), many new business owners prefer partnerships because of the ease of formation and the maximum flexibility in operations.  This article focuses on the partnership.  However, it is prudent to consult with an experienced San Diego partnership lawyer and accountant regarding the benefits of a more formal business entity before moving forward.  

1184018_business_team_-_vector_1.jpgAlthough California law does not require a written partnership agreement, there are significant risks associated with informal oral agreements to form partnerships.  If after careful consideration, the prospective partners opt to go with the partnership, there is little doubt that a written partnership agreement should be entered into. A written agreement of some sort is an essential part of any good business venture.  A well drafted written partnership agreement helps insure that there will be no future misunderstandings regarding each partner’s intent.  Often, partners rely on the default provisions governing partnerships under California law without realizing that many of these default provisions are inapposite to the partners’ expectations.  Or in some cases, the partners will merely rely on oral agreements to deal with key provisions.  However, enforcing oral agreements comes with a host of problems that can result in significant future conflict.  See “Why Oral Partnerships Are a Bad Idea“.  California’s Revised Uniform Partnership Act (RUPA) sets forth the default rules that govern oral partnerships.   

Important Provisions in Partnership Agreements

A complete analysis of every possible provision in a partnership agreement is beyond the scope of this article.  However, there are key issues that prospective partners should pay particular attention to:

  • Limitations on Outside Pursuits:   It is common for partners to commit varying amounts of time towards the operation of the business.  Some maintain full time employment while committing resources and after hour time towards operation of the partnership.  Others maintain partnership interests in other business ventures.  A well-written partnership agreement will address whether these options are permissible.   Whatever the case, the partnership agreement needs to clearly delineate each partners obligations and limitations with respect to time and resources towards business operations. 

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The terms of commercial leases vary significantly depending on the type of commercial property being leased and the specific business goals of both landlords and tenants. “Option clauses,” also known as “renewal terms,” are provisions in a commercial lease agreement that allow a tenant to extend the term of the lease for an additional term after the initial term has expired. Tenants prefer option clauses because they reduce the risk of having to relocate an established business after the expiration of the initial term.

nightshopping-130418-m.jpgWhile option clauses are prevalent in commercial leasing, most landlords would probably prefer not to have to deal with them. This is especially so where the rental rate during the option period is fixed. Option clauses prevent landlords from leasing the premises on the open market and ultimately obtaining the highest possible rent. Options give tenants a choice which necessarily reduces a landlord’s flexibility. Once a tenant exercises its right to the option term, the terms of the option clause govern regardless of how good the market is at the time. That is why most landlords prefer that the rental rate during the option period be determined by the actual market rate for the premises at the time the option is exercised. This is generally a fair approach for both landlords and tenants because each side is equally exposed to the vagaries of the market.

A market rate would benefit tenants if the leasing market is especially soft when it comes time to exercise the tenant’s option. Moreover, in soft markets, tenants may be tempted to explore better options leaving landlords with empty space. To hedge against this uncertainty and in exchange for including an option clause, landlords will usually require that there be a floor to the new rental rate during the option period (usually no less than a 3% increase over the rental rate immediately preceding the option period). This provides landlords with the best of both worlds – a minimum increase in rent even if the leasing market is dismal or an increase in rent equal to the higher market rate should the market be strong. In such circumstances, tenants are better off with predetermined fixed increases in rent usually consistent with the annual increases in rent during the initial term of the lease. Either way, option clauses are inherently valuable to tenants and how the rental rate is determined during any option period under the terms of the lease will depend on the tenant’s bargaining power during commercial lease negotiations.

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In general, shareholders are not permitted to sue corporations on their own behalf seeking damages for themselves. Instead, they are required to bring an action against wrongdoers (usually the officers and/or directors of the corporation) on behalf of the corporation in what is termed a “derivative” lawsuit. Where the corporation has a legal claim that the officers and/or directors refuse to prosecute on behalf of the corporation, the shareholders may do so derivatively. The damages recovered from a derivative lawsuit go to the corporation which in theory results in increasing share value. The idea of a derivative lawsuit may seem an oddity or even absurd to the average investor, especially shareholders in small closely held corporations where it’s officers or directors are stealing from the company.

944870_oak_tree.jpgThe public policy behind derivative actions is to protect corporations (especially publicly traded corporations) from the whims of fickle shareholders unhappy with share values. Even though it may be difficult for these fickle shareholders to win, the ability to bring actions without limitation can create significant waste. In essence, the goal is to reduce the number of frivolous suits and to encourage informal resolution, and there is a plethora of corporate law dictating the procedures necessary for bringing derivative actions. In general, derivative law requires shareholders to make a written demand on the corporate officers requesting that action be taken to investigate and if necessary file a lawsuit on the corporation’s behalf seeking to remedy the wrongs. This gives the corporation the opportunity to address the shareholders’ concerns in an effort to avoid costly litigation. The problem, especially for shareholders in smaller corporations, is that making written demands and allowing reasonable time for the corporation to act wastes important time especially if the officers and directors are all part of the problem. Nonetheless, where a derivative action is required, the demand is mandatory (except where the shareholders can show that due to the dominant control of the corporation by its officers, such demand would be futile). Pleading futility however requires more than simply naming all of the officers. The shareholders must be more specific. There are also potential bond requirements in derivative actions. If the corporation can show that there is no reasonable possibility that the lawsuit will benefit the corporation or its shareholders, the court may require the shareholders to post a bond up to $50,000. This can be prohibitory for many litigants. Moreover, because derivative actions are equitable actions, they are heard by judges and not juries. On the other hand, shareholders do benefit from derivative actions because they are able to recover attorney fees if they are ultimately found to be the prevailing party.

Derivative law for the most part isn’t necessarily ideal for small non-publicly traded or closely held corporations. This does not mean that shareholders in smaller corporations are without options. A shareholder may bring a direct action against an officer or director who committed fraud against the shareholder specifically – for instance, intentionally lying to the shareholder to induce him into purchasing shares knowing that the lies misled the purchaser regarding the true value of the company. Similarly, a shareholder may bring any other direct action against the corporation or its officers and directors where the injury is to the shareholder personally and not to the corporation. Stealing from the corporation, breaching fiduciary duties to the corporate shareholders and mismanaging corporate assets are all generally considered injuries to the corporation requiring a derivative action. As explained above, this matters because of the additional procedural hurdles required to pursue derivative actions.

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Indemnity clauses in general are designed to shift liability for claims asserted by third parties from one party to another. In the commercial lease context, tenants typically agree to both indemnify landlords and to defend and hold them harmless for all claims arising out of tenant’s operation of business on the leased premises, tenant’s maintenance of the premises and the negligence and/or misconduct of the tenant or its representatives, employees, agents and contractors (and sometimes even the tenant’s customers). In essence, the tenant agrees to defend the landlord for specified damages or claims. While it may seem absurd to a prospective tenant, commercial leases sometimes contain language requiring tenants to indemnify landlords for claims for liabilities arising out of occurrences in the common areas controlled by landlords and even for those liabilities arising out of the landlord’s own negligence.

outlet-center1-52397-m.jpgMost importantly, under California law, these types or indemnification clauses are generally enforceable, at least in the commercial lease context. Of course, there are public policy considerations even where commercial leases are concerned. For instance, landlords cannot contract against future claims for their own intentional misconduct or gross negligence. It is advisable, given this limitation, for tenants to seek reciprocal indemnification language for any intentional conduct or gross negligence by landlords. Moreover, depending on the parties’ relative bargaining power, some landlords may be willing to indemnify tenants for their own negligence and even the negligence of those under their control where the damages arise from occurrences in the common areas.

From the landlord’s perspective, the idea is to shift liability to the tenants who conduct business on the premises daily. This reallocation of risk is guided by the parties respective insurance coverage. From a practical standpoint, the shift in responsibility is a shift in insurance obligations. If the lease shifts liability for “any and all” claims arising out of anything to tenant, it becomes incumbent upon the tenant to insure against “any and all” claims. In fact, most commercial leases specifically require suitable coverage. As such, allocation and the actual procurement of adequate insurance coverage is essential for both landlords and tenants.

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Landlords routinely request estoppel certificates from their tenants. Tenant estoppel certificates are signed statements requested by third parties (typically lenders or prospective purchasers of commercial real estate) in order to verify certain terms between the current tenant and landlord of the commercial real estate property, things that cannot be ascertained by simply reading the commercial lease agreement.. The estoppel certificate confirms that a valid lease exists, that the lease remains in full force and effect, that neither the landlord nor tenant are in default and that the rent is paid up. This allows for instance a prospective buyer of a shopping center to better evaluate the shopping center’s performance. Once a tenant verifies these details in the estoppel certificate, they cannot be later disputed. Potential purchasers of the commercial property rely on the certificates to evaluate the risks associated with purchasing the property and to determine an appropriate offering price.

golden-pen-469098-m.jpgWhat Information is Included in a Tenant Estoppel Certificate?

Typically, an estoppel certificate will ask a tenant to verify the following:

  • The date of the commencement of the lease;
  • That the lease has been unmodified and is in full force and effect or that it has been modified;
  • The most current date in which rent is paid through; and
  • That there are no defaults by the tenant or the landlord.

Other information that may be requested in an estoppel certificate includes the financial health of a tenant, the amount of any security deposit paid, the tenant’s ownership structure, or whether there is any ongoing litigation related to the tenant. Most of the time, but not always, landlords will attach a form of the estoppel certificate as an exhibit to the actual lease agreement to help avoid disputes that may arise in the future regarding what information should be provided by the tenant. It is in a tenant’s best interest to negotiate which information should be included in the estoppel certificate prior to entering into the lease. For example, information that can be determined by reading the lease or statements that modify the lease agreement in any way should be avoided.

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When forming a California limited liability company (LLC) or corporation, it is important that the owners determine whether any of the ownership interests in the company will be treated as a security.  Under federal and state law, if one or more co-owners of a corporation (shareholders) or an LLC (members) seek to invest in the company for profit only, and do not wish to actually work for the company or take an active role in its management, the ownership interest will be treated as a security.  Essentially, a security interest is an ownership interest that is passive in nature (like investing in the stock market).  An ownership interest is not a security if all shareholders or LLC members actively participate in the company’s operations.  In such cases, there is no need for the owners to worry about qualifying for an exemption.  

courtroom-1-1207444-m.jpgRegistering with the SEC vs. Qualifying for an Exemption

LLCs and corporations with security interests are subject to securities laws governed by the Securities Act of 1923 and regulated by the Securities Exchange Commission (SEC). Registering securities can be a complex process requiring that the company provide investors various documents such as financial statements, documentation and other information designed to ensure that potential investors are able to make informed decisions prior to investing.  However, the SEC and state regulators have promulgated a number of exemptions allowing LLCs and corporations to avoid the complex process of registering securities. Once the owners of a company determine that the interest being sold is indeed a security, it must next determine whether the sale qualifies for an exemption.  State and federal exemptions are not identical but typically sales of securities that qualify for a federal exemption also qualify for state exemptions.  If the sale qualifies for an exemption, the next step is to apply for the exemption with the appropriate federal and state securities agencies.  This process is far less complicated than registering securities with the SEC.  

Summary of Commonly Used Federal Exemptions

The following is a brief summary of the most common exemptions to the federal registration requirement found in the Securities Act:

  • Government Securities: Any government treasuries or municipal bonds.
  • Non-Public Offering Exemption: Where the sale of the security is to “sophisticated investors” who have the financial means and have sufficient knowledge in business and investments.  The investor must have full access to information and agree not to redistribute the securities to the public.
  • Single State Offerings: Intrastate companies qualify for a federal exemption to the registration requirement.   An intrastate company is a company that does all of its business in a single state.  To qualify as an intrastate company, an LLC or corporation must:
    • Be incorporated or organized in the state the security is being offered or sold in; 
    • Have its principal place of business in such state; 
    • Be owned entirely by investors who are bona fide residents of such state; 
    • Maintain at least 80 percent of the company’s assets in such state;
    • Derive at least 80 percent of its gross revenues from such state; and
    • Use at least 80 percent of its net proceeds within such state.

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    Being served with a lawsuit can be one of the worst things that can happen to any business.  The specter of long drawn out litigation causes immediate anxiety and young and inexperienced owners worry that their business may collapse.  In short, panic sets in and panic is the worst response.  There are two very good reasons not to overreact to being sued.  First, most businesses are insured to protect against the risk of litigation.  In such cases, the insurance company (with some exceptions) will step in and defend the action.  Second, overreacting leads to bad decision making especially for those that are not insured or perhaps under insured.  Whatever the scenario, there is little doubt that the most prudent step any business owner can take after being sued is an immediate consultation with an experienced business litigator.  The second most prudent step is to act fast.  It is important that business owners are aware of the deadline to respond to the complaint.  They have thirty days from service to do so and need to be acutely aware of the deadline.  Otherwise, on-the-ball attorneys on the other side will promptly move for default which at worst will result in a judgment and at best require significant additional attorney time to cure.  If more time is needed to gather insurance documentation and/or obtain counsel, it is best to at least contact the opposing party or attorney and ask for an extension to “respond” to the complaint and confirm so in writing.  Using the word “respond” instead of “answer” will allow you to respond to the complaint in any manner available under the law.  Most attorneys will agree to this at least once.

    time-to-do-business-924991-m.jpgMost people would be surprised at the number of business owners (in San Diego alone) that choose to ignore lawsuits only to find out later that judgment has been entered against them for tens of thousands of dollars or even hundreds of thousands of dollars.  The existence of the judgment is often discovered only after bank accounts are attached or a Sheriff shows up one day to conduct a till tap (collecting money from the cash register at the end of the day to satisfy the judgment).  Others will rush to resolve the matter without the assistance of an experienced business litigator hoping that they can avoid the problem by agreeing to resolve the dispute informally.  While informal resolution is certainly preferable, signing agreements without legal representation is extremely risky.  The attorney representing the other side is armed with tools to maximize the benefit to their clients.  The harm to business owners under this scenario can be incalculable.  Usually, unrepresented business owners have no idea of the true extent of what they are agreeing to.  For instance, a business owner who agrees to pay off a debt in twenty-four monthly payments may unknowingly stipulate to forfeiting all of her shares in a corporation (a disastrous outcome) if she is late even one time on her payments.  An experienced business lawyer will build a cushion regarding late payments into any agreement settling the matter.

    After “not panicking”, the first thing any business owner should do upon being served with a lawsuit is to retrieve all insurance policies (including personal umbrella policies) that might in any way cover the business.  In fact, any experienced lawyer would first ask about insurance policies.  It would be malpractice to do otherwise.  Moreover, attorneys aren’t interested in spending time on lengthy consultation and evaluation if a case is eventually going to be turned over to an insurance company who retain their own attorneys to handle litigation.  Businesses pay considerable premiums to protect themselves from risk.  When sued, they shouldn’t hesitate to tender their claims to insurers.
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    A Tenant Improvement Allowance (TIA) is a landlord incentive designed to assist new tenants with the build-out of their space. Build-outs are improvements to leased space to make the space usable for a particular tenant’s needs. Whether or not a landlord will offer a TIA and how much the landlord will offer depends on a variety of factors including the relative bargaining power of prospective tenants, the current market for commercial space, the current condition of the premises, the extent to which the current condition suits a prospective tenant’s needs, the tenant’s desirability, the base rent and other key terms being negotiated. Often, new business owners are surprised when a TIA is offered and may over estimate its significance. While TIAs are important landlord incentives, landlords are careful to minimize the true costs. In most cases, tenant improvements are capital improvements that provide a long term benefit to the property. Even where the improvements are specific to a tenant’s needs, landlords most often build the cost of TIAs into the base rent. However one looks at it, TIAs are an important factor in commercial lease negotiation. If a tenant improvement allowance is being offered, the associated lease language is critical for both landlords and tenants. When negotiating TIAs and associated lease terms, it is important that the parties have a clear understanding of the improvements needed and their likely cost.

    old-bulilding-2-147832-m.jpgTwo Common Approaches – The Stated Dollar Amount Approach and the Turn-Key Approach:

    With a stated dollar amount, the landlord offers a fixed sum to the tenant for the build-out. The tenant must absorb any additional costs that exceed the fixed sum. In some cases, landlords will require any excess monies be returned after completion of the job. Where landlords do not require the return of excess funds, they are more likely to allow soft costs such as architectural and engineering fees. Again, ensuring that these issues are clearly addressed in the lease avoids any potential future conflict. The stated dollar amount method is fairly straight forward. The landlord knows the precise amount it will be responsible for and tenants (who typically oversee the build-out) retain control of the process. It is also possible for landlords to offer a fixed sum while retaining control of the build-out process.

    With the turn-key approach, the landlord allowance covers certain specified work which the landlord typically oversees (i.e. build out of a new kitchen or bathroom, erection of interior walls and partitions, installation of new doors and windows, new flooring and ceilings, etc.). Any additional work would be considered extra work to be absorbed by the tenant. Some new business owners may prefer the turn-key approach so that they may remain focused on other important aspects of forming their new business. Overseeing construction while simultaneously focusing on licensing, trademarks, dbas, incorporation, employees, inventory, insurance and other business responsibilities can be daunting. However, it’s important that new business owners understand the downside to landlord control of build-outs. When landlords control the process, they are motivated to limit expenses. They may not have the same quality goals and may take short cuts the tenant wouldn’t be willing to take. Tenants will want to ensure that they get the most work possible with the allowance provided, that the landlord warranty the work, that the work be completed by a specified date and that the tenant have a reasonable opportunity to inspect the work to be sure the work was done properly including retaining the ability to submit a punch-list of things that need to be completed after taking possession. In addition, it’s helpful to ask landlords to undergo a competitive bidding process where sealed bids are opened in the tenant’s presence.

    In some cases, landlords will allow tenants to control the build-out process choosing their own architects and contractors (subject to landlord approval). However, the tenant’s expenses would be limited by the allowance. If the tenant goes over budget, the tenant would be responsible for the excess costs.

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    Litigation can be divided into three relatively distinct phases: the pleading phase , the discovery phase and trial. While the distinction can sometimes be blurred, there is no doubt about these three significant areas of litigation. The average San Diegan has little understanding of the pleading phase. It involves the filing of a complaint followed by answers, cross-complaints and/or attacks on the pleadings (demurs, motions to strike and motions to quash) most of which require a response by the plaintiff and ultimately a hearing before the trial judge. This phase can be remarkably drawn out and complicated, and it is a topic for another article. Trial is, well, trial. It is of course the most well known phase in litigation. The discovery phase is no more or less important. A properly discovered case provides attorneys with the necessary tools to prove a litigant’s case at trial.

    stone-judge-778488-m.jpgThere is a school of thought in both the legal and non-legal communities that discovery can also be used as an effective bulldozing tool (often referred to as “guerrilla discovery”), and the sad truth is that this is indeed true. The idea is to propound so much discovery (whether via written requests or deposition testimony) and to provide as much resistance to discovery propounded on you that the other side cowers in response to the onslaught. Between attorney fees, court reporter fees, transcript costs and expert fees, the total cost for the discovery phase alone can be astronomical. Even in a relatively simple case between two San Diego business owners, an attorney can propound hundreds and hundreds of interrogatories, requests for production of documents and requests for admissions (a discovery tool that allows parties to ask the other side to admit certain important facts in the litigation). If the propounding party feels that the discovery responses are inadequate for any reason a round of negotiation and motions to compel follow. By the time all of this is accomplished, the opposing party’s attorney may spend fifty to one hundred hours dealing with this written discovery alone. Even the most affordable litigator whose fees are in the low $200.00 per hour range, fifty to one hundred hours for a single battle over written discovery adds up fast. In addition, a guerrilla campaign will include taking the depositions of every possible witness resulting in significant additional cost. It is not uncommon for a party to notice the depositions of twenty or more witnesses. Some of these depositions are of business owners or managers and can last for days. The above scenario is an example of what can occur even with the simplest of cases. In more complex cases like patent litigation, attorney fees can be hundreds of thousands of dollars (for the discovery phase alone). As one might imagine, this type of onslaught can be daunting to the opposing party.

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    Most commercial leases in California are triple net leases. With a triple net lease, tenants contribute to the payment of the landlord’s operating expenses, such as building insurance, taxes, repairs, maintenance, and utilities in addition to base rent. Typically, these expenses are referred to as Common Area Maintenance Expenses (CAMs). As one might imagine, what should and shouldn’t be included as an operating expense is an important part of lease negotiation. Depending on the parties’ relative bargaining positions, tenants are often able to negotiate for a list of CAM exclusions.

    420973_planning_for_construction.jpgUnder Generally Accepted Accounting Practices, capital expenditures are defined as the costs of obtaining items that last beyond the current accounting period and increase the value or the life of an asset. Capital expenditures include things like additions, improvements, renovations, repairs and upgrades to existing facilities, and can be thought of as investments that are intended to yield long-term benefits. Commercial leases deal with capital expenditures in a variety of ways. Many, but not all, commercial leases contain a general capital expenditure exclusion that excuses tenants from having to contribute to the costs of such expenditures with two major exceptions: expenditures necessary to comply with new laws and improvements that reduce operating expenses. In some cases, these lease exclusions will also exempt those capital expenditures when the costs of replacing equipment (an HVAC system for instance) would be greater than the replacement cost of the equipment.

    Negotiation in this area is important to both landlords and tenants because capital expenditures can be significant. The issue is often a point of heated dispute. Tenants contend that their contribution towards the capital expenditures unfairly confers a permanent benefit on the landlord. Landlords argue that tenants benefit from adequately maintained facilities, repairs to existing equipment and additions that make the property more attractive. For the most part, capital expenditures benefit the property overall. As such, it is generally accepted in the commercial leasing community that such costs should be built into base rents.

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