Published in The Metropolitan Corporate Counsel, December 2004.

With careful planning and proactive measures, lenders can protect themselves from successful claims of lender liability in the leasing context.

Introduction

The dramatic increase in recent years in the number of lawsuits seeking damages for lender liability has significantly influenced the way lenders conduct business. Although leasing issues have not been a major focus of lender liability litigation, the legal theories behind lender liability claims do extend to leasing issues. Lenders should be aware of this in the context of the various leasing decisions that they make.

Leasing Issues And Lender Liability

In general, lender liability litigation tends to be based on claims that the lender made misrepresentations about the ultimate nature of the loan, that the lender added new conditions to a loan after the borrower accepted the original terms, or that the lender exercised control over or interfered with the borrower’s business.

The majority of claims against lenders are based on legal theories governing other areas of law applied to the lender-borrower context. Three general areas include claims based on contract theory (for example, that the lender orally promised to extend a loan but later reneged or added new conditions to the loan), claims based on tort theory (for example, that the lender interfered with the landlord/tenant business relationship by attempting to convince the tenant to modify its existing lease) and claims based on principal/ agent theory (for example, that the lender constructively "became" the landlord by exercising excessive control over leasing decisions).1 In addition, specific statutes applicable to financial institutions and bankruptcy cases, as well as governmental claims for environmental and other regulatory matters, are a growing area of lender liability litigation.

Within the leasing context, the small but growing number of lender liability claims typically concern allegations that the lender improperly exercised or abused its discretion during the loan negotiation process, or tried to control the borrower’s business after the closing of the loan.

Case In Point

In a situation involving this firm’s representation of a pension fund lender against lender liability claims, the borrower had permitted a retail tenant to commence business operations before a lease had been executed and before the lender had been asked for its approval. Exercising its express right to approve or disapprove tenants and leases contained in the mortgage documentation, the lender disapproved of the proposed tenant. When the borrower moved to evict the tenant, the tenant claimed that (a) it had an actual or a constructive lease based on its occupancy, the borrower’s financing of its leasehold improvements, and the exchange of detailed drafts of a lease between the borrower and the tenant; and (b) the lender had tortiously interfered with the lease contract by disapproving the tenant.

In an unreported decision, summary judgment was granted to the lender (and borrower) on all claims. Significantly, the judgment included a finding that the tenant could have no valid lease without lender consent because the tenant was on notice of the recorded (that is, public) mortgage documentation giving the lender the right to approve all leases and tenants. Notwithstanding the favorable outcome for the lender, this case is an example of the expanding nature of lender liability claims in the leasing area. It is also instructive of the ways in which lenders can, to a degree, protect themselves from successful liability claims on a proactive, rather than merely reactive, basis.

Existing Leases

In a typical non-recourse mortgage loan context, the importance of the rental income stream to the lender’s underwriting of the loan is paramount. As an adjunct to this, the lender will require confirmation of the existing leases. Prior to closing a loan, the lender generally would require that it have the right to review and approve all existing leases, that tenants provide estoppel certificates confirming the terms and status of their leases, and that select tenants enter into subordination and attornment agreements ("subordination agreements").2 After reviewing the existing leases, the lender may conclude that some lease provisions (for example, offset rights, rights of first refusal or early termination rights) require modification or are outright unacceptable. Modifications to existing leases between the lender and a tenant would most often be reflected in an estoppel certificate or subordination agreement.

Areas that are ripe for disagreement between a tenant and the lender include expansion of the tenant’s environmental liabilities and limitation of a tenant’s right to direct the use of insurance proceeds or require the landlord to complete building renovations. Most often the lease does not proscribe a basic form of an estoppel certificate or subordination agreement and, therefore, lengthy negotiations can ensue.

There are two important ways in which lenders can minimize the likelihood of successful lender liability claims in this context. One is to avoid direct contact or negotiations with the tenant. At times it might be expedient or even valuable for the lender’s representatives to be in direct discussions with the tenant’s representatives. However, this can lead to later contract claims to the effect that the lender made oral promises to the tenant that are not being kept, or tort claims to the effect that the lender interfered with the borrower/tenant business relationship. The lender should arrange for the borrower to contact the tenant to negotiate any required changes to existing leases.

Another way is to avoid any communication, including internal communications among the lender’s personnel, that is emotional or derogatory about the borrower or tenants. To the contrary, there should be ample internal communications that are businesslike and thorough in articulating the substantive reasons why a particular lease provision is unacceptable or falls outside the underwriting guidelines. Likewise, any letter of intent or commitment letter issued by the lender should be very clear and specific about the lender’s right to review and approve existing leases and to require estoppel certificates and subordinations as a condition of making the loan. Many lenders already include in their letters of intent and commitment letters extensive boilerplate provisions designed to make clear that the lender is not bound until all of the leasing conditions have been satisfied and definitive loan documentation has been executed and delivered.

New Leases

Once the loan closing has taken place, the potential for lender liability claims on leasing issues arises most commonly in the context of the lender’s approval rights over new leases. The unreported pension fund lender case mentioned above illustrates claims made when a lender exercises its right to disapprove a tenant. Similar claims could result from the lender’s disapproving the particular economic and other terms of a proposed lease. A lender would also be vulnerable to waiver or estoppel claims in situations where the lender approved (or failed to exercise its right to approve) prior tenants or leases of similar quality but wishes to disapprove the current proposal.

The two ways for lenders to minimize the likelihood of successful lender liability claims mentioned above with respect to existing leases have similar application to new leases. Lenders should avoid direct negotiations with the proposed tenant, and the lender’s communications, including internal communications, about the reasons for disapproval should be dispassionate, businesslike and thorough.

In addition, the lender’s approval rights should be clearly delineated in the recorded mortgage documentation. This is plainly borne out by the holding of the case mentioned above. To the extent possible, specific parameters for acceptable leasing criteria should also be spelled out. This might include statements about specific rental amounts, or references to fair market rentals, acceptable duration of the lease term, definitions of creditworthiness with respect to tenants and other material matters. 3 In situations where significant yearly leasing turnover and activity is expected, consideration should be given to requiring the borrower to submit an annual leasing plan for the lender’s approval. The leasing plan would conform to a general format for specificity and coverage provided by the lender prior to closing, and once approved for the current year it would serve to undermine many of the claims arising out of approval rights otherwise available to the borrower.

Conclusion

Lender liability claims generally and in the leasing context are here to stay. However, the prudent and proactive lender has mechanisms available to minimize its exposure to these claims.

Footnotes

1 This is to be distinguished from a claim of "equitable subordination," often faced by lenders in this situation, from third-party creditors who claim that the lender’s "controlling" conduct effectively subordinated the priority of the lender’s loan to the loans of the other creditors.

2 Complicating matters, these lender rights may exist in a negotiating environment in which the borrower believes it has an unqualified commitment from the lender.

3 It should be noted that such specific provisions may be viewed as undesirable from a commercial standpoint, because they would tend to limit the lender’s ultimate discretion over leasing decisions.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.