Uhlig Transactional Blog

Earlier this month, the Colorado Supreme Court ruled in a 5-2 decision that binding arbitration agreements are valid in condominium construction defects cases and binding on homeowners’ associations that do not receive written consent to remove the arbitration provisions.  The case, Vallegio at Inverness Residential Condo Association vs. Metropolitan Homes Inc., is the most recent in a series of pro-condo-developer developments in Colorado law.  House Bill 1279 also passed this session.  The Bill requires the majority of homeowners, instead of a homeowners’ association board, to decide whether the raise a claim against a condominium developer for construction defects.  Backers of the bill said that it is more fair to homeowners to give them a voice in a dispute that could affect their homes’ resale value.

Colorado law has one of the most permissive statutes of limitations on construction defect cases on the books—only two years within the time the claimant or claimant’s predecessor in interest discovers, or should have discovered, the physical manifestations of a defect in the construction improvement that causes an injury.  C.R.S. § 13-80-104. Taken together, it seems as though the current climate in Colorado is shining warmly on encouraging condominium development, which has dropped from 20% of new development in Colorado in 2007 to about 3% today. 

This attitude only makes sense because of the increasing number of transplants to Colorado in recent years—almost 101,000 new residents between 2014 and 2015 alone.  Current numbers show the population influx evening out somewhat but it takes one glance at the property market in Denver alone to see what a challenge these newcomers present to a market so hot, the inventory of existing homes for sale is at historic lows.  The demand for affordable housing in Denver continues to go up but supply is down, which drives prices up. 

Condominiums and multifamily developments are an obvious solution to the problem.  If we can build up instead of out, residents in Denver will be able to stay in desirable areas without breaking the bank and possibly realize the American Dream of property ownership.  But is the best way to encourage condo development to deregulate and make it more difficult for homeowners to sue their developers?

Those in favor of the decision in Vallegio and HB 1279 would argue that these decisions put more power in the hands of homeowners.  The Bill makes it impossible for an HOA board to decide to bring a case without the consent of homeowners.  While the obvious consequence of this rule makes it more difficult to sue developers (majority of 100 unit owners is much more difficult to receive and calculate than a majority of a 10-person HOA board), it also purports to be in the interest of condo owners.  After all, why should they have to worry about changes in their property value based on a lawsuit brought by a sue-friendly HOA?  Then again, a well-settled rule of property law is predicated on sellers disclosing material defects as an exception to the general rule of caveat emptor.  So, if a homeowner wishes to avoid litigation to keep property value up, he or she would still have to disclose known issues with the property at the time of sale.  It is anyone’s guess whether making it more difficult to sue developers for condominium construction defects will be better or worse for homeowners in the long run but hopefully it will serve its purpose of encouraging development of much-needed multifamily housing in highly-populated areas of Colorado.

Vallegio seems at first blush to be more protective of developers than warranted but really, the decision simply upholds another well-settled rule of Contracts—that parties can and often do contract around any number of rights in their agreements.  After all, the court did not say that binding arbitration clauses are the norm in construction defects litigation for condos—merely that, since the HOA in the case agreed to a binding arbitration clause, it cannot sidestep the agreement and sue anyway, regardless of the injuries suffered. 

As litigation costs rise and the process is a dice roll in terms of favorable decisions, there is a trend in real estate and business law matters toward requiring arbitration in lieu of trial.  Deciding whether to acquiesce to arbitration over court is a decision to make at the start of a deal, not in the middle.  This is the heart of the Colorado Supreme Court decision in Vallegio, and a good rule to remember when embarking on any kind of project.  Because courts in Colorado hold parties to their word and require all parties to have a seat at the table if renegotiation is on the menu.  Regardless of the policy considerations or arguments about protectivism toward questionable real estate construction, the purpose of a contract is to keep deals consistent regardless of the direction in which they go.  And that, at the end of the day, is a strong reassurance for anyone engaged in construction or contract in Colorado. 

Sources and Additional Resources: http://www.cpr.org/news/story/why-is-denvers-housing-market-still-on-fire-supply-and-demand; http://www.denverpost.com/2016/07/07/colorado-second-population-growth-2015/; C.R.S. 13-80-104; http://www.denverpost.com/2017/06/05/colorado-supreme-court-construction-defects-battle/.

     During my day to day, I draft and negotiate my fair share of commercial lease agreements.  They range from office leases, to retail leases and industrial leases but in almost every case, especially with new clients leasing their first space, the conversation begins the same; they say "I am going to send you a simple lease that my Landlord drew up, take a quick look and let me know it all looks good"; and I respond, "Send me the lease and I'll take a look."

     Most real estate lawyers are familiar with this elusive document, the simple lease, so often described by clients eager get their business up and running and turning a profit.  Unfortunately, Landlord leases are typically one sided at best and the clauses invariably tilt to the Landlord's advantage.  

     One example of a lease clause that can be surprisingly expensive for tenants is the clause governing operating expenses.  Most tenants understand the difference between a triple net lease and a gross lease; the former is structured so that in addition to base rent, tenants are responsible for a share of operating expenses (the landlord's real estate taxes, insurance and costs to operate the building in which the premises are located) and the latter is structured so that tenants pay a single rental payment that includes everything.  In the commercial setting, triple net lease forms are very common and tenants often sign these leases without legal review and counseling.  Operating expense provisions seem simple - the tenant pays its share of the operating costs, but, oftentimes the lease language is overly generous with what may be included in the operating costs.  An example of expenses that should be excluded or at least carefully limited are capital expenses.  Furthermore, it's ordinary for tenants to ask for a cap on annual operating cost increases so they can budget for the worst case scenario during each lease year.  If there is no cap on operating expenses, they may expand and increase without limit and Landlords have little motivation to keep their costs down when they can be passed through to tenants.  Another important concept when it comes to operating expenses is language allowing the tenant a right to audit the Landlord's books.  A fair audit provision should provide that if the audit reveals overcharges exceeding a certain percentage, the Landlord will be responsible for paying the audit costs. Experienced real estate attorneys understand which expense categories are inappropriate to pass through to the the tenant and can negotiate to limit ballooning expenses and excess expense pass throughs.

     The key to providing effective legal counsel to tenants in commercial lease negotiations involves picking one's battles.  A typical commercial lease agreement contains upwards of 50 clauses and its possible to negotiate each one, however sending proposed revisions to all or nearly all of the lease clauses is sure to cause delays (which neither side wants) and sometimes, it can blow a deal.  Evaluating which clauses will be most important to a client begins with understanding the nature of their business and then focusing on the clauses that relate to their business and those which may cost them additional money above and beyond rental payments.  The expense clauses in triple net leases certainly qualify there.  

     Before signing that "simple lease" have an attorney take a look and help you try to balance the important terms.  Its very difficult to help a tenant after they've signed the document!

     This is the last of a series of three posts covering LLC basics.  In two prior posts (March 21st and May 19) we discussed the necessity of a good operating agreement and taxation basics for LLCs.  In addition to pass-through taxation, most LLC owners form LLCs intent on insulating their personal assets from exposure to liabilities incurred by the business.  In a lawsuit against an LLC, a plaintiff's attorney may ask the court to hold LLC members personally responsible for the debts, obligations or liabilities of the LLC; this is referred to as "piercing the corporate veil."  Colorado law concerning this topic, and the grounds for disregarding the liability shield afforded to business owners by LLC is somewhat befuddled.  Many owners are exposed to personal liability for the debts and obligations of their LLCs because they make a common mistake; after creating the LLC and opening for business, they quickly forget all about the entity and operate their companies informally and inconsistently.  Their perception is that registering the entity with the Colorado Secretary of State and paying the annual fees is all they have to do to enjoy the limited liability of operating under the guise of an LLC.  That perception is wrong.  Their LLC is form over substance and as such is susceptible to being viewed as the alter ego if its owners rather than a truly separate entity.

     In deciding whether to pierce the corporate veil and impose personal liability on LLC owners, Colorado courts apply what is known as the alter ego test.  As the name implies, the initial analysis centers around whether the business entity is truly a separate "entity" or is in fact the alter ego of the owner.  In Colorado this involves an 8 point balancing test.  Factors courts consider include: whether the the LLC is operated as a distinct business entity; whether assets and funds are commingled; whether adequate corporate records are maintained; whether misuse by an insider is likely due to the nature and form of the LLC's ownership and control structure; whether the LLC is marginally capitalized; whether the LLC is a mere shell with no real assets; whether owners disregard legal formalities such as meetings, minutes, approval resolutions and consents in accordance with the LLC's operating agreement and whether corporate funds or assets are used for non business purposes.  No single factor is determinative or holds more weight than another.  That is reflected by the Colorado statute on point, C.R.S. 7-80-107(2) (2016) which states, "the failure of a limited liability company to observe the formalities or requirements related to the management of its business and affairs is not, in itself, a ground for imposing personal liability on members for liabilities of the limited liability company.    

     In Colorado, traditionally, in addition to proving an LLC fails the alter ego test, plaintiff had to establish that the LLC was used to carry out a fraud or overcome an otherwise rightful claim.  However, in recent years, Colorado courts seem to have adopted a looser standard for piercing the corporate veil and done away with this second requirement.  In Martin v. Freeman (Colo. App. 2012), the Colorado Court of Appeals reasoned that "neither wrongful intent or bad faith" are not necessary to satisfy the second part of the piercing test.  The practical effect of this is that by being a party to litigation where the plaintiff seeks to pierce the corporate veil, an LLC is exposed to liability if it fails the alter ego test.  In 2009, in Sheffield Services Company v. Trowbridge (Colo.App. 200), the Colorado Court of Appeals extended personal liability of an LLC to an LLC's managers in addition to the LLC's owners.  It should be noted that the Martin case concerned a single member LLC but logic dictates that it should apply to all manner of LLC's.  The Sheffield case was a clear extension of the applicable law as the relevant statute, cited above, is expressly limited to members.  

     From a practical standpoint, all of this means that in Colorado its easier than ever for the liability shield afforded by LLCs to be disregarded if the LLC's owners treat the entity as a mere alter ego and fail to operate it as a truly separate and independent entity from themselves.  As lawyers, its imperative for us to advise our clients that creating an LLC is merely the beginning and proper operation as truly separate entity is essential to maintain the liability shield that they assume is in place by virtue of operating their business as an LLC.  In addition to creating the LLC and drafting an operating agreement, clients need sound advice on proper procedures, safeguards and formalities in the day to day operation of their business so that they do not unintentionally expose their personal assets to the liabilities and debts of the LLC.

     Earlier in my legal career I worked with a large law firm representing a popular and rapidly expanding restaurant chain; those years afforded me a baptism by fire in the negotiation of restaurant leases.  It may be related to those early years fighting for the big chain tenant, or maybe its because I spend so much time enjoying and relaxing in restaurants around Denver, but, I've always enjoyed working on restaurant leases.  In the universe of lease agreements, they are almost always the most interesting.  Since I just finished one up, this seems like a great opportunity to kick off a series of blog posts focusing on restaurant leases and issues tenants need to know about, especially new owners and entrepreneurs without a lot of leasing experiences.

     The issue of exclusivity is often at the center of restaurant lease negotiations.  In shopping centers or other multi-tenant environments,  tenants should try to lock down assurances they will not face harmful competition from other tenants.  The easiest way to do that is to include an exclusive use clause in the lease.  Its best if the broker helping a tenant find a space sets the expectation that exclusivity is a part of the deal by including the concept in the letter of intent (LOI).  In most cases, landlords and tenants agree on a non-binding LOI laying out the basic terms of the deal before proceeding to draft and negotiate the lease document. So, what level of competition is actually "harmful?"  In shopping centers or other retail settings with multiple buildings, tenants should consider whether an exclusive within the building their space is located in is sufficient, or is an exclusive covering the entire retail center appropriate? Further, many retail centers are governed by CC&Rs or Declarations and in such cases, its important to confirm nothing in those documents limits the new tenant's plans for its space or grants another tenant an exclusive use pre-empting the tenant's planned use.  Restaurant tenants should also carefully consider the nature and scope of the exclusive rights they desire; does the tenant want to be the only restaurant in the building/center or, is it acceptable (or even better) for them to allow other restaurants users so long as they have exclusivity based on certain food types (for example, Mexican food) and/or operational type (for example, fast-casual versus a sit down, full service restaurant with table service)?  Does the tenant want to be the only fast casual restaurant in the building serving alcoholic beverages?  A properly drafted exclusivity clause is very specific and leaves no room for argument or interpretation.  With respect to restaurants and bars, different types of operators can often co-exist and feed off of one another (no pun intended!) quite nicely, so it might not necessarily behoove one to be the "only" restaurant in a particular setting.  While thinking about exclusivity clauses for restaurants in multi-tenant settings, one frequently overlooked point is signage on the exterior of the premises; depending on the situation, it may be important for tenants to lock down the exclusive right to display their signage on the exterior of the space. 

     Another important consideration for restaurant tenants negotiating exclusive use clauses is the practical effectiveness of these clauses.  Often tenants focus on obtaining the exclusivity language they need but neglect addressing how they'll actually enforce that language if the landlord disregards it, or if another tenant disregards it and assigns or sublets their space to a competing business.  In addition to the exclusivity clause, its a good idea for tenants to try to push for language discouraging landlords from ignoring the exclusivity restrictions and also requiring them to take action in the instance of renegade tenants.  There are several ways to do that, including expressly providing that a tenant may pursue equitable remedies such as an injunction or even granting the wronged tenant a substantial rental reduction or abatement during the period their exclusive use protection is compromised.  If unaddressed, a tenant may be left with no recourse except for an expensive lawsuit against a landlord who may have deep pockets.  A tenant's ability to obtain adequate exclusivity protection is often proportionate to their bargaining power with respect to the landlord (is the tenant a highly desirable addition to the center?) and other tenants, and is also related to how the desired protective language relates to the overall negotiation of the lease.

    Next time this series of posts will address building out restaurant lease spaces and common issues surrounding landlord and tenant construction obligations.  Until then, contract safely and remember, everything is negotiable.