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Take Caution Before Transferring Portions of a Project (Especially to Affiliates)

Xavier L. Gutierrez
Commercial Leasing Law & Strategy
May 1, 2008

Introduction.

The challenges facing a developer multiply when it no longer owns the entire project, so careful planning and documentation are required in advance of any transfer. While this article will address issues that arise when different portions of the project are owned by different parties (transfers in general), the main focus is on the issues that arise when different portions of the project are owned by affiliated parties (transfers to affiliates), primarily because those are easy to overlook because of the relationship.

Who is the Declarant under the Declaration?

The document that spells out the purpose of the project and sets forth rules for its development and operation may have one of several acronyms, such as CC&R’s (covenants, conditions and restrictions), REA (restrictive easement agreement) and RAGE (Restriction Agreement and Grant of Easements). We’ll call it the Declaration.

Typically, the developer is designated as the declarant under the Declaration, which declarant is excluded from most limitations imposed on other parcel owners, but which retains significant approval rights. Its goal is to retain as many of the rights it would have enjoyed if it had remained the sole owner of the project. Given the significant rights held by the declarant, it is important to consider who the “declarant” is under the Declaration.

At least initially, the “declarant” is the entity that owns the land, but circumstances may require the initial owner to transfer portions to affiliates. Perhaps the most common reason for transferring portions to affiliates is financing. For example, a lender may require transfers to newly formed single purpose entities and/or the developer may subdivide the project to finance only those portions of the project that are constructed and leased. Portions may also be transferred to different affiliates when multiple uses are contemplated or for estate planning purposes. If a portion of the project is transferred to an affiliate, will such affiliate have the same omnipotent authority that the declarant enjoys under the Declaration?

Under most forms of Declarations, the affiliate will not be considered the declarant, and the affiliate may have to obtain certain approvals (and give certain concessions), which the declarant itself would not have had to obtain (or give). To avoid this predicament, one could define the “declarant” to include the initial owner and its affiliates, but this could lead to other problems. For example, it is cumbersome to draft provisions to deal with the rights and obligations of multiple declarants, and a lender’s attorney may worry that broadly defining “declarant” to include the initial owner and its affiliates contradicts the separateness covenants and increases the likelihood of consolidation in bankruptcy. To help avoid such issues, the Declaration can appoint the initial owner as the “declarant”, and include a separate provision giving the declarant’s affiliates the same rights that the declarant enjoys under the Declaration so long as the affiliate obtains the declarant’s consent.

Use Restrictions (Including Exclusive Use Rights).

General use restrictions or prohibitions on undesirable uses (such as thrift stores, gambling and adult-type stores), and on industrial uses (and office and residential uses, in some cases) are fairly standard in a Declaration. Since the Declaration predates most leases within the project, the Declaration will not address some use restrictions included within such leases. As a result, a tenant with some leverage will insist upon recordation of a memorandum of its lease setting forth the use restrictions.

Once portions of a project are transferred, problems may arise since an owner of only a portion of the project cannot bind the entire project. Transfers to affiliates may further complicate matters since people may not be as cognizant of the different ownership within the project among affiliates as they normally would have been if an unrelated third party was involved.

The landlord risks that it may mistakenly agree to a use restriction that binds the entire project (that is owned in part by affiliates and not entirely by such landlord) and/or that it may damage a relationship with a tenant who may incorrectly believe that the landlord owns, and that it was getting the benefit of an exclusive over, the entire project (but then later finds that some of its customers are shopping at a competitor within the same project). There is also a risk that the landlord (or its affiliates) may violate agreements with third parties. For example, if the loan documents prohibit the financed portion from being encumbered with a use restriction and the borrower agrees to burden its land with a use restriction over the affiliated developer’s parcel, then such borrower may find itself in default under the loan documents.

To avoid such risks, the landlord might insist on restricting only the portion of the project that it owns from time to time, and seek to avoid liability for violation by owners or tenants of any portion that is transferred after the lease is entered into (such as by limiting its obligations in the lease to recording a Declaration or amendments thereto, and using reasonable efforts to enforce such restriction). The Declaration might contemplate a streamlined amendment process to address new use restrictions. However, recorded amendments to the Declaration cloud title and may be difficult to later remove from title. Moreover, it may not be practical to record an amendment to the Declaration each time a lease is entered into and each time a lease ends. An alternative might be to include general language in the Declaration to provide notice of the existence of restrictions and rely on the manager of the project to maintain details of the restrictions and furnish them to those making inquiry.

Site Plan Restrictions.

Site plan restrictions may create issues that are analogous to those created by use restrictions, and the solutions may be similar. That is, the parties will often cause a memorandum of lease to be recorded with specific site plan restrictions, or will (either in the memorandum of lease or in the Declaration) refer to the site plan restrictions generally and rely on the manager to keep track of such restrictions.

Additionally, since the design and appearance of the project are crucial to the developer, the Declaration will often prohibit any changes to the project unless the declarant first approves such changes. However, the declarant will typically lose its rights (that is, will cease being the declarant) if it is no longer the owner of any parcel in the project. Therefore, it should consider retaining the right to appoint a successor declarant (e.g., to an owner that is affiliated with the existing declarant) if the declarant no longer is an owner within the project.

If the declarant does not plan ahead and no longer owns a portion of the project, the consent of all owners may be required. In any event, some major owners or tenants of the project will probably insist upon being approving parties, whose consent will also be required prior to any party (including the declarant) being allowed to make any changes to the project. These approval rights can result in time consuming (and perhaps costly) negotiations and risks. These risks can be reduced if approval standards are provided for, such as reasonability or materiality standards, deemed approval if there is no response within a specified time, and a geographic limitation on approval rights.

Co-Tenancy Matters.

Perhaps the most difficult issues that arise from transferring a portion of the project deal with co-tenancy requirements and related matters, such as tenant mix and operating covenants. The issues are often exacerbated since owners of different parcels in a project are likely to be driven by different incentives.

One issue is that by transferring a portion of the project to a third party, the developer will substantially limit its ability to control the tenant mix within the project. While the developer owns a substantial portion of the project, it will have an incentive to maximize the profitability of the project as a whole, while an owner of a single pad has an incentive to maximize the profitability of its pad only. Therefore, the owner of a single pad may enter into a lease that duplicates an existing use within the project when the developer would not have chosen to do so. While a developer may prefer that the Declaration require owners to obtain the approval of the declarant prior to changing the uses within a parcel (beyond the general use restrictions and exclusive uses), these provisions are seldom seen in a Declaration and would probably be viewed as unreasonable.

A developer with a tenant having the benefit of a co-tenancy requirement can find itself powerless when trying to influence the owner of a single pad to find an acceptable replacement co-tenant if the pad co-tenant should terminate its lease (or go dark). While (prior to any transfer) a savvy developer will want to require successors-in-interest to recognize and obey the co-tenancy requirements in other leases, buyers will often dismiss this as not being market.

Another issue is that the developer may lose the power to enforce lease provisions like operating covenants. For example, if a tenant of a third party owner goes dark, the developer will find itself unable to enforce an operating covenant even though it may have normally wanted to avoid having dark space within the project. (For example, it will not have the right to place the tenant in default or recapture the premises.) At the same time, a third party pad owner with a tenant that continues paying rent, but has gone dark, will have very little incentive to place the tenant in default or recapture the premises. Similarly, while a third party pad owner may be content to collect rents from a dark tenant, the developer, in addition to having dark space within the project, may find itself entirely frustrated if one of its other tenants is entitled to remedies (for example, payment of reduced rent, cessation of operation, or termination of its lease) if a co-tenancy provision within its lease is violated by virtue of the dark tenant. While one solution is for the developer to give itself enforcement power in the Declaration over a tenant that goes dark, a developer will be hard pressed to convince a tenant with any leverage to enter into a lease with such restriction (as well as any buyer).

While the co-tenancy matters above are addressed in the context of transfers to third parties (and while transfers to affiliates may create fewer problems than transfers to unaffiliated third parties), it is important not to overlook the fact that affiliates may have different ownership percentages, resulting in very similar issues as those arising with unaffiliated third parties. Moreover, the affiliate may one day transfer to an unaffiliated third party.

Conclusion.

This article is meant to highlight some of the often unanticipated issues, but does not include an exhaustive list of issues that can arise when transferring a portion of the project. Each project may have a set of unique issues including the delineation of rights and obligations with regard to shared space within the project beyond standard common area. (For example, if a monument sign located on the portion being transferred identifies occupants on the retained portion, the rights and obligations should be delineated prior to the transfer.) Also, it is important not to overlook the general mechanics involved when transferring portions of a project (which may be unintentionally disregarded when transferring to affiliates) such as having appropriate assignment documents with releases of liability, and/or transferring insurance coverage (including title insurance) to the new affiliated owner.

Since there are often solutions to the various issues, it is prudent to consider the possibilities and to attempt to deal with them within the Declaration and in record keeping. In short, a developer should take caution before transferring portions of a project and address the issues (or knowingly accept the risks) to avoid unpleasant surprises in the future.

Xavier L. Gutierrez is an associate in Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago.