Best Wishes for a Happy and Prosperous 2010

It’s been some time since I’ve blogged, what with the Thanksgiving, Christmas and New Year holidays, but I suspect I’m not alone in breathing a sigh of relief that 2009 is past. (Of course, I hope that this time next year, we’re not looking back on 2009 as the “Good Old Days.”)

When people ask how Press, Potter & Dozier fared in 2009, my stock response is “We made a larger profit than GM and Chrysler combined.” Of course, that’s not necessarily saying much.

If you had asked me last October if I thought the commercial real estate market was showing signs of life, based on the sudden spike in first generation lease activity that kept me busy, I would have said “Yes.” But things slowed considerably in November and December and January has been somewhat of a roller coaster.

I’ve seen small spurts of activity, mostly with the renewals of existing leases, but nothing of long-term significance to suggest to me that the end of the downturn is in sight. As long as businesses tread water or, worse, contract, there does not seem to be any reason for the commercial real estate market to show any vibrancy.

And until consumers – which, in reality, are all of us – start to regain confidence and begin spending, there will be little reason for businesses to expand by increasing production or adding employees. In that sense, I suppose Pogo (the classic Walt Kelly comic strip character) was right when he said “We have met the enemy and he is us.”

I invite you all to return here regularly to see what my colleagues and I think is of interest to the real estate, general business and ADR and environmental law communities and, of course, I really, really, really mean it this time when I wish each of you a Happy and Prosperous 2010.

Intro to Lease Causes: For the Landlord and the Tenant

In my last two posts, I discussed commercial lease clauses that should be included from the perspective of a landlord or that of a tenant. This week I want to discuss lease clauses that are of mutual benefit to both the landlord and tenant. I’ll also answer last week’s puzzler question.

First, to lease issues. When a landlord is going to be providing extensive leasehold improvements, in addition to a clear mutual understanding of the scope and cost responsibility for the improvements, there should be a clear change-order procedure. Almost every construction job brings with it the attendant “while you’re at it” changes, as well as changes that only become apparent once actual construction is underway.

Without clear understanding of how to document those changes and the costs, both parties are asking for post-execution confusion and disagreement. A clear procedure for documenting changes should be included as part of the lease documentation.

In any lease having a term of five or more years, it is likely that sometime during the term of the lease the tenant is going to want to make decorating changes.
So long as these changes are non-structural and not visible from outside the premises, the landlord should be willing to let the tenant make them without the landlord’s consent so long as the tenant understands that, at the end of the term, the landlord has the right to require the tenant to restore the premises to their original condition, ordinary wear and tear excluded.

Any other type of change or alteration should be subject to the landlord’s prior consent, but that consent should be subject to a “not to be unreasonably withheld, conditioned or delayed’ standard.

If the premises are served by an HVAC system located within the premises, the lease should be clear on the maintenance responsibility. It is fair and reasonable for a landlord to require the tenant to purchase a service contract with a contractor acceptable to the landlord and to be responsible for minor, ordinary operating repairs but the landlord should bear the responsibility for replacing a unit if it fails during the term and for making major repairs.

Insurance requirements are important to both the landlord and tenant. In addition to the obvious need for both parties to carry adequate liability insurance, landlords have an interest in requiring their tenants to carry property insurance equal to 100% of their property in the premises.

Otherwise, the landlord and tenant could discover that, after a fire in the premises (regardless of who was at fault), the tenant no longer has sufficient financial ability to re-fixture the property, purchase inventory and the like.

One subject area that is often misunderstood is the distinction between a tenant’s “waiver of claims” and a tenant’s obligation to provide a “waiver of subrogration.” A waiver of subrogation is not a waiver of claims.

A “waiver of claims” is a lease provision in which one party to the lease waives all claims it may have against the other party for losses or damages suffered by the tenant (e.g., interruption of business due to a fire). So long as the waiving party insures against the claims being waived (e.g., property damage or business interruption) in the event of a loss, it will have recourse to its own insurance. If a party affirmatively chooses not to purchase adequate insurance, the other party should not have to bear the consequences.

A “waiver of subrogation” on the other hand requires the tenant’s insurer to agree that if, the landlord causes loss or damage to the tenant or its property or business and the tenant’s insurer compensates the tenant for such loss or damage, the tenant’s insurer will not take advantage of its legal right to be subrogated to the claims of its insured and pursue recoupment against the landlord.

One subject that causes landlords and tenants alike much angst are indemnity provisions. Both parties often mistakenly think that, absent an indemnity in their favor, they risk waiving recourse against the proposed indemnitor.

All an indemnity provides is that the indemnitor will step in upon notice from the indemnitee to defend a claim or satisfy a loss. If the indemnitor fails to act (and a clever attorney can frequently find a reason why the indemnity is inapplicable), the indemnitee typically still has the same recourse against the proposed indemnitor except that to realize upon that recourse it may have to bring a lawsuit.

Admittedly, indemnity clauses frequently go beyond the two parties to the lease and include their respective principals, partners, shareholders, directors, etc., but in most lease situations those “tag-alongs” are generally not at risk anyway.

It is always a benefit to both parties to a lease to have unambiguous provisions. Lease transactions generally result in long-term relationships and it is in everyone’s interest that the parties get along and not have needless disputes because respective rights and obligations are not clearly articulated.

Finally, as promised, the answer to last week’s puzzler, namely from whence the term “saved by the bell”? During the plague in medieval Europe, there was a rush to bury people. The problem was that some people weren’t dead; they were only in comas. Sometimes those people awoke from the coma during the funeral – or worse, after burial.

Worried that perhaps someone who appeared to be dead wasn’t, one solution was to tie one end of a string onto the "dead" person's hand and the other to a bell; if the person revived enough to pull the string and ring the bell, s/he would be unburied and would have been “saved by the bell. If a buried person pulled the string that rang the bell, s/he was a “dead ringer,” and, in some graveyards, a person was assigned to sit by the grave to listen for the bell – hence the term “graveyard shift.”

Intro to Lease Clauses: For the Tenant

Last week, I discussed commercial lease clauses that I think are important from a landlord’s point of view. I also posed the question, “Why are manhole covers round”? This week, I want to address leases clauses that I think are important from a tenant’s point of view. I’ll also answer last week’s question.

As a starting point, tenants should realize that in any negotiation with a prospective landlord, the tenant needs to apply the maxim “buyer beware.”

If the landlord is going to provide leasehold improvements prior to commencement of the lease, it is important that the tenant and landlord have a clear understanding of what those improvements will be and how they will be paid for. If the landlord is providing a fixed allowance for the construction of improvements, the tenant needs to independently determine if the allowance will be sufficient to complete the job as anticipated and, if not, whether any excess will be affordable.

This determination needs to be made prior to execution of the lease. I recently represented a tenant who relied on the landlord’s architect’s estimate of how far the landlord’s allowance would go. After lease execution, when the project was bid, the landlord’s estimate was off by more than $36/sf. Having already signed the lease, the tenant had little bargaining power to address this shortfall.

If the tenant’s rent is going to also include a portion of the building’s common area maintenance (CAM) and real estate taxes, the tenant should carefully review the items that will be passed along to tenants.

If the building is going to include a management fee and the manager will be an affiliate of the landlord, the lease should expressly specify that the fee will not exceed management fees charged by third-party managers of buildings similar in size, quality and location to the building in question.

In any such event, the landlord should not also be entitled to include an additional “administrative fee.” However, if that battle is lost and an administrative fee is included, it should be capped by an outside benchmark such as “administrative fees charged by landlords of buildings similar in size, quality and location to the building in question.”

A commonly included clause regarding CAM is a pet peeve of mine. It states that when the tenant is paying its pro rate share portion of CAM, the tenant loses certain rights if its negligence causes damage to either the premises or the building.

For example, a lease might provide that, following a casualty that prevents the tenant from using the premises, the tenant is entitled to rent abatement unless the tenant’s negligence caused the casualty. CAM charges always include the landlord’s casualty insurance premiums so, in essence, the tenant is paying for its share of the insurance and should get the benefit of the protection afforded by the insurance even if its negligence caused the casualty.

Think of this analogy: when a driver negligently causes an accident, it is the collision insurance that the purchased which pays for the repair of his own vehicle – and it is the driver’s liability insurance which pays for the damage to the other driver’s vehicle.

In negotiating the “permitted use” clause, tenants should seek general, comprehensive uses as opposed to limiting clauses such as “the operation of a law office.” A narrow clause can be used to justify denial of a proposed assignment or subletting.

If the lease includes a landlord’s lien, it should expressly exclude personal property of the tenant’s employees, as well as confidential client files. Any landlord’s lien should be expressly subordinate to bona fide lenders providing financing to the tenant secured by the tenant’s furniture, fixtures and equipment.

The tenant should not agree to any “self-help” provision (for anyone not familiar with legal terms, this is a provision which allows the landlord to evict the tenant without a court order) and should affirmatively obligate the landlord to use commercially reasonable best efforts to mitigate its damages. This requires the landlord to re-let the premises following a lease default.

Now for those of you who care, manhole covers are round because they are the only geometric shape that cannot fall in upon themselves.

Next week, I’ll discuss lease clauses that are mutually beneficial to the landlord and tenant and … for next week’s puzzler, ask you from whence the term “saved by the bell” (and no, it is not from that tweener Saturday morning show of the same name).

Intro to Lease Clauses: For the Landlord

Over the course of the next several weeks I’m going to discuss various lease clauses that should be included in commercial leases. But, as a lagniappe -– and as a way to find out if anyone is even paying attention -- like Click and Clack on Car Talk -- this week I’m going to include a puzzler that won’t be answered until next week. And for anyone who answers via a comment, you’ll have the psychic pleasure (or sadness) of learning whether you are right.

The question: Why are manhole covers round?

Now, on to the lease clauses. This week’s post will focus on those of importance to landlords.

First, of course, as a landlord, you need to decide what kind of lease to offer. There are three types customarily used in commercial leasing, namely,

a “full-service lease,” where the tenant pays basic annual rent but does not pay for any operating costs;

a “triple net lease,” where the tenant pays basic annual rent plus a pro rata share of the building’s operating costs and real estate taxes;

and a “base year lease,” where the landlord pays all operating costs and real estate taxes associated for a specific year - the “Base Year,” which is generally the first full calendar year following execution of the lease or the calendar year in which the lease is executed. The tenant pays a pro rata share of the increases in the building’s operating costs and real estate taxes for each year during the term following the Base Year.

Retail leases can also include percentage rent (i.e., a percentage of a retail tenant’s sales from its premises) but that will be a subject of a future post.

Second, landlords need to decide how Basic Annual Rent will be increased during each year of the lease term. Typically, increases can be based on a fixed percentage increase or tied to annual increases in a fixed benchmark, usually the Consumer Price Index (CPI).

If choosing the CPI, the landlord needs to be careful which CPI to use because there are several, e.g., the “All Urban Consumers” Index (“CPI-U"), the “Urban Wage Earners and Clerical Workers” Index (“CPI-W”), and the “CPI-U, US City Average, All Items”; these indices are available to measure both national as well as regional trends. Regional indices tend to be more volatile than the national indices but may be more indicative of inflation in the area where the building is located.

Another decision when using the CPI is whether a rent increase should be equal to 100% of the corresponding increase in the CPI or be a fraction of the CPI. Market factors will generally drive that decision.

And, finally, when using the CPI, there should be a concomitant minimum increase regardless of the increase in the CPI. But what’s sauce for the goose is also sauce for the gander - if a minimum is imposed, landlords should expect tenants to ask for a maximum cap regardless of the corresponding increase to the CPI.

Landlords should always include a provision that limits their possible liability for any type of claim made against a landlord to the landlord’s equity interest in the building. The personal assets of the principals of the landlord should not be placed at risk.

Next week I’ll discuss lease clauses of importance to tenants -- and answer why manhole covers are round.

Open Source Software & Its Legal Ramifications: What is Open Source Software?

I will be writing a series of posts that examine various issues related to open source software and legal ramifications for the average business owner -– not just those working in the IT field. Initially, I will address the main differences between proprietary software and open source software.

More and more software is being written to respond to the explosion of computer driver services in business operations. So it is important to understand how that software is created, and what –- if any –- limitations to its use may accompany its acquisition by an individual/or business.

Software is written by a programmer to operate a particular computer program. A business owner can either buy “off the shelf” software, like Microsoft Word or WordPerfect, or have some created for her special needs. What the business owner ends up with most likely is proprietary software. She pays for the use of the finished product -- and most likely is not given a version of the software to allow her to see “under the hood” of the program.

To know the inner workings of the software requires having access to the source code, i.e., the programmer’s instructions which have been compiled into a format that the computer can understand.

As part of the evolutionary process of writing software, a major path has emerged called open source software. So what does that term mean? It is software written by programmers to accomplish the same kinds of tasks as proprietary software. But using open source software means how the programmer obtained it, and how it can be further distributed may be subject to a set of requirements that are different from the proprietary version.

Proprietary software is often obtained for a fee, is used or distributed under an extensive license, and, most likely, does not give the user access to the source code. In contrast, open source software is obtained for free and the programmer/or user can see exactly how the software was constructed because the source code is revealed. In addition, the user may freely modify and distribute the modified software.

However, depending upon the originator of the software, there may be limitations placed on its further distribution. But unlike proprietary software, the object of such requirements is to advance the philosophical point of view of the author, rather than to seek an economic gain.

Next time I will discuss why open source software was developed. If you have comments on this topic or suggestions as to issues you would like me to cover, please let me know.

Choosing a Business Entity: Common Legal Entities

In my last post, I talked about the benefits of forming a separate legal entity for your business. Once you’ve decided to set up a separate entity, you’ll need to figure out which type of entity makes the most sense. While not exhaustive, the following are some of the most common forms of business entities. Each type varies in terms of its ease in creation and maintenance and the tax consequences to the owners.

Corporation:
The corporation has, until recently, been the most traditional form of business entity. A corporation is owned by one or more stockholders who are issued shares of stock in return for their investment. Although in small businesses and family-run corporations, the stockholders may have a role in running the business, their role as stockholders is strictly economic. Absent extreme circumstances, such as fraud, a stockholder of a corporation is not personally liable for the acts or obligations of the corporation.

The corporation is managed by a Board of Directors, which is elected annually by the stockholders. The Board appoints the corporation’s officers, including a President, Treasurer and Secretary, who are responsible for the day-to-day business affairs of the corporation.

A corporation is taxed as a separate entity, meaning that it files its own tax return and pays taxes without regard to the tax status of the individual shareholders. However, if the corporation distributes a portion of its after-tax income to its shareholders in the form of dividends, each shareholder will pay a separate tax on the dividend received. This “double taxation” can be avoided if the corporation makes an election under subchapter S of the Internal Revenue Code. It is critical to consult with a tax professional for the rules and requirements relating to corporate taxation.

Corporations must comply with many formalities (which, to the detriment of many shareholders, are often overlooked), including annual meetings of the stockholders, election of directors, keeping of minutes and a stock transfer ledger, all of which are typically set forth in the corporation’s bylaws. Some of the corporate formalities may be dispensed with if the corporation is set up as a “close corporation” pursuant to the provisions of Title 4 of the Maryland Corporations and Associations Act.

Limited Liability Company:
In recent years, an increasingly-popular alternative to the corporation is the limited liability company (“LLC”). An LLC is an unincorporated business organization with at least one “member.” Members may be individuals, corporations, partnerships, or other LLCs. LLCs have gained favor, especially among small businesses, because they offer the limited liability of a corporation but with fewer record keeping requirements and other formalities and, like a corporation, can be managed by non-member employees.

An LLC offers the same liability protection for its members as a corporation does for its stockholders. This means that, absent fraud, self-dealing and the like, a member is not responsible for the debts, liabilities and obligations of the LLC.

An LLC can consist of only one member. However, where there are multiple members, it is critical for the members to enter into an “Operating Agreement” which sets forth the relative rights and obligations of the members regarding contributions, distributions, allocations of profits and management of the business.

LLCs are also favored because they offer the streamlined “pass-through” tax benefits of a partnership. This means that the entity is not taxed separately but rather passes through its income, deductions, credits, as well as other items, to its members. Your tax advisor can provide you with more information on the tax implications of operating as an LLC.

Limited Partnership:
A limited partnership is a partnership which includes one or more general partners, who are responsible for the management of the business, and limited partners, who have an economic interest in the partnership, but take no part in the management of the business. Limited partnerships are most commonly used in real estate ventures (although, in recent years, LLC’s are becoming favored alternative entities). Limited partnerships must comply strictly with the provisions of the Maryland Limited Partnership Act, Md. Code Sec. 10-101, et seq.

General partners are personally liable for the obligations of the partnership. Limited partners, like corporate shareholders, are not liable for partnership obligations beyond their financial contributions. Unlike shareholders, however, except in unique circumstances, limited partners may not participate in the management of the partnership’s business –- another reason why LLC’s are becoming favored alternatives. There is no legal prohibition on the role of members in the management of the LLC’s business –- even if those members are merely passive investors.

Limited partnerships are treated the same as partnerships for tax purposes.

Again, this list is not exhaustive. There are other entities, such as professional corporations, limited liability partnerships and others, that may be more suitable for your business activities. A business attorney, working together with your tax advisor, can help you decide which form is most appropriate for your business.

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Choosing a Business Entity

Whether you are just starting a business enterprise or you’ve been running your existing business as a sole proprietor or as a partnership, you should consider whether it makes sense to form a separate legal entity for the business. This is important for accounting purposes, as well as insulating your personal assets from the liabilities, debts and obligations of the business.

If you are operating your business as a sole proprietor, then from a legal and tax perspective, you, as the owner, are inseparable from the business. Since a sole proprietorship and its owner are considered one and the same, taxes on a sole proprietorship are determined at the personal income tax rate of the owner. In fact, a sole proprietor simply reports all business income or losses on an individual income tax return.

Similarly, because they are the same entity, a sole proprietor is personally responsible for any liabilities, obligations and debts of the business.

If you have a partner, then you have formed a general partnership, which is defined under the Maryland Code as “an association of two or more persons to carry on as co-owners a business for profit.”

Each partner is personally liable to third parties for all the liabilities, obligations and debts of the partnership, as well as the other partners. In this context, the only difference between a sole proprietorship and a partnership is that a partner could find him/herself liable for liabilities, obligations or debts created by another partner in the business. The partnership is not taxed as a separate entity. Instead, taxable income, losses, deductions, and credits are passed through on a pro-rated basis to each of the partners. Each partner is taxed directly on his/her share of the partnership’s net income, whether that income is distributed or not.

Why Form a Separate Entity?

Most of us carry casualty insurance, which protects our business from the loss of assets in the event of a casualty (e.g., a fire) and liability insurance (which, by the way, should always include contractual liability coverage), which protects your business from liabilities asserted by third parties for acts such as negligence (e.g., a fire caused by your -- or your employee’s -- negligence in your leased space which damages or destroys the landlord’s premises). But there could be situations where the insurance proceeds either don’t cover the claim being asserted or where the limits of coverage are insufficient to cover the entire amount of the claim being asserted. Also, business and economic cycles could create financial pressures on your business operations, making it necessary to negotiate with lenders, landlords and other creditors.

Unless your business is a separate legal entity, your home and other personal assets could be at risk. Establishing a separate legal entity, maintaining its separate existence and using the entity’s name on your marketing materials, invoices, etc. will help protect your personal assets.

There are also tax and accounting benefits associated with establishing a separate legal entity. Each type of entity has different tax and legal implications so it is critical that you consult with your attorney and a tax advisor before forming a separate legal business entity.

Next week I will discuss the various types of common legal entities.

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