Horack Talley

Legal Update

Winter 2008

from the office of Henry Pharr

Freedom To Contract Emboldened
Court of Appeals Strengthens New Rule Allowing Parties to
Contract for Rent Acceleration and No Duty to Mitigate Damages

In June, 2007, the North Carolina Court of Appeals upheld its previous
ruling allowing parties to a commercial lease to negotiate terms for
acceleration of rent/no duty for landlord to mitigate damages upon a monetary default by the tenant. In Kotis Properties, Inc. v. Casey’s, Inc., the Court of Appeals upheld the ruling of Sylva Shops Ltd. Partnership v. Hibbard from 2006 which held that “a clause in a commercial lease that relieves a landlord from its duty to mitigate damages is not against public policy and is enforceable.”

In addition, the Court appears to have broadened the scope of required language in order to remove the landlord’s duty to mitigate. Specifically, the lease in the Kotis case held that the landlord had the right, but not the duty to relet the premises on behalf of the tenant, but also included the following language: “Landlord will not be responsible or liable for any failure to relet the premises, or any part of the premises, or for any failure to collect any rent due upon reletting.” The Court explained:

We agree with Kotis that the provision under the “Reentry without
termination” subsection, providing that “Landlord will not be responsible or liable for any failure to relet the premises,” may only be construed as a waiver of Kotis’ duty to mitigate.

Details Count: Enforcing Lease Options To Renew

In Kennedy v. Gardner, 611 S.E.2d 480 (N.C. App. 2005), the North Carolina Court of Appeals examined a situation where the landlord and tenant had entered into a lease agreement containing a term of fifteen (15) years with two five (5) year options to extend the lease beyond the original term. The lease also provided that the options had to be exercised by written notice from the tenant to the landlord within 180 days prior to the expiration of the original lease term or the first option term. Despite this contractual requirement, the successor in interest to the original tenant attempted to exercise the first five-year option only 60 days prior to the expiration of the term of the lease.

The Court ruled that when the terms of a lease provide for an extension of a lease term by giving notice in a specific manner and within a specific time period, a tenant must follow those requirements as a condition precedent to the exercise of any option. If the tenant fails to give notice in the prescribed manner contained in the lease agreement, the option is lost and cannot be revived by any later unilateral acts of the tenant. In other words, an option to extend the term of lease cannot be “revived” or modified by any acts of the tenant that occur after the deadline date for giving notice of its intent to exercise the option.

Thus, even if the tenant contends that the landlord established a pattern of conduct or otherwise waived the option requirements by any conduct subsequent to the deadline for giving the option, the tenant will be bound by the contractual language contained in the lease agreement.

Again, it appears that the Court of Appeals is focusing its attention and rulings upon the contractual nature of the lease agreement and not common law rules or defenses related to waiver, estoppel, etc. This supports a continuing trend by the North Carolina courts to treat commercial leases more as contracts between the landlord and the tenant, rather than agreements for the use and enjoyment of real property, which would be ordinarily subject to all common law defenses.

Details Count, Part Two: The Dangers Of Generalized Language In Lease Negotiations

As with the situation described above, in a good faith effort to “get the deal done,”
parties to a Lease Agreement may not sufficiently define certain specific terms that
become crucial to the interpretation of the lease and other related matters during the term of the tenancy. In Kroger Limited Partnership I v. Guastello, the North Carolina Court of Appeals held that contrary to the landlord’s intention, a garden shop area adjacent to a building leased by a commercial tenant was not included under the term “building.” Thus when the commercial tenant demolished the garden shop in order to erect a post office, there was no default under the terms of the lease, despite strident protests by the landlord.

Under North Carolina law, the terms of a lease like the terms of any other contract are generally interpreted to achieve the intent of the parties at the time the lease was entered into. Where the language of a contract or lease is clear, that lease must be interpreted as written. However, where a non-technical word is not defined in a lease, the courts are left to interpret the word consistent with its plain dictionary meaning (which may not coincide with the landlord’s original intent or understanding of the same).

In Kroger, the tenant leased commercial premises located in Raleigh known as “Builder’s Square.” In the lease, the real property in question was defined as “tenant’s completed building, as well as site improvements, to be constructed as hereinafter specified by landlord, at [tenant’s] expense, as well as land compromising not less than seven acres described in “Exhibit A, attached hereto.”” The lease also provided that the tenant must obtain the landlord’s prior consent to drawings and specifications or any structural alterations, additions or changes provided to the demised premises.

Roughly three years into the lease term, the defendant demolished an area that had been labeled as the “Garden Shop” on the Exhibit to the lease. No consent was obtained by the landlord prior to demolition. After the landlord filed suit arguing that the demolition of the garden shop attached to the leased building affected the structural integrity of the building, the Wake County Superior Court, and subsequently the North Carolina Court of Appeals determined that since the Exhibit to the lease did not include the Garden Shop area, the landlord could not enforce any obligations or prohibitions by the tenant relating to the demolition of the same.

It is therefore important that the parties take care to specifically define the basic
terms of the lease and reflect their intent not only within the body of the lease, but also within any exhibits or riders attached thereto. Otherwise, any dispute that may arise will not be controlled by one or more of the parties, but will be left to the discretion of a judge or a jury.

A Dangerous Combination: Lease Options And Acceptance Of Rent During Holdover Periods

Under North Carolina law, a landlord who allows a tenant with an option to extend the
term of a commercial lease may be deemed to have waived any notice requirements
for exercising that option if it allows the tenant to hold over after the initial term of the lease and accepts rent from the tenant. Spruce Pine Industrial Park, Inc. v. Explosive Supply Company, Inc., 634 S.E.2d 264 (2006).

In Spruce Pine, the lease in question required written notice of intent to renew the lease by the tenant for a second twenty (20) year term. However, at the expiration of the initial term of the lease, the landlord allowed the tenant to hold over, continue business operations and accepted rent in the same amount as had been paid previously by the tenant. When the landlord attempted to sell the property to a third party, the tenant filed suit arguing that the twenty-year lease option had been formally exercised and that it was in good standing under the terms of the original Lease Agreement. The Court held that the landlord had in fact waived any notice requirement for the option to extend by accepting rent and allowing the tenant to hold over past the initial term of the lease.

The lesson to be drawn from Spruce Pine is that the North Carolina courts may broadly interpret a waiver of any term of the Lease Agreement, even when it creates a draconian result for the landlord. Obviously, this rule would also apply in a situation where a landlord found a prospective tenant who it desired to place in the premises, believing that the term of the lease had expired and its existing tenant was merely a holdover on a month-to-month basis or “at will.”

Look Before You Leap: Entering Into Contracts With Corporate Entities

In the rush to enter into a new lease with a tenant or an assignment or sublease, it is often easy to overlook certain due diligence items such as the current corporate status of any LLC, corporation, professional association, or other recognized legal entity that is the prospective Tenant. Unfortunately, this may lead to negative results when it is determined at a later date that the corporate entity is actually completely controlled by another corporate entity or individual(s) who may not be parties to the agreement or subject to service of process.

Specifically, the North Carolina appellate courts have held for many years that where a sole shareholder or a related corporate entity exercises total autonomy and control over the tenant, the tenant’s corporate status will be disregarded.

In a recent case entitled East Market Square, Inc. v. Tycorp Pizza IV, Inc., the North Carolina Court of Appeals ruled that although the main tenant under a lease agreement for a pizza franchise operation had observed all corporate formalities of public record, the tenant’s corporate status would be disregarded and the sole shareholder would be responsible for all obligations under the Lease Agreement. In Tycorp Pizza, the parties had entered into a commercial lease for the operation of a franchise pizza restaurant in Greensboro. At the time the lease was negotiated, the president of the tenant represented that Tycorp Pizza IV, Inc. “was a viable and legally valid corporation.” From the records of the Secretary of State and other public sources, it appeared that this was the case.

However, when the tenant defaulted and the landlord brought a collection action, the landlord discovered that the president of the company had essentially set up the corporation as a sham in order to do business personally with both the landlord and the franchisor. Unfortunately for the owner, there were apparently no other guarantors and the president and sole shareholder of Tycorp Pizza IV was essentially judgment-proof.

The Court outlined seven circumstances in which the corporate entity would be disregarded and the individual(s) or other corporate entities who maintain complete control and autonomy over the operations of the tenant could be found liable for the obligations of the tenant under the parties’ Lease Agreement:

1. One individual or a related corporate entity essentially makes all the decisions regarding the corporation’s finances, policies and business practices.

2. There is only one individual to answer to “in transactions relating to the tenant.”

3. The corporation never elected a Board of Directors, nor created any bylaws.

4. The corporation never held any annual meetings of shareholders or directors.

5. The corporation owns no real or personal property and its assets were essentially
pledged to or controlled by a separate entity or individual.

6. The corporation never had any independent business operations and was formed solely to hold the lease.

7. The corporation was not sufficiently capitalized with funds or other assets that were
controlled by the corporation.

Obviously, “piercing the corporate veil” can also be used as a sword in order to obtain individual or extra-corporate liability in these situations as well. However, this process involves the initiation of a lawsuit against the sham company, obtaining a judgment, followed by depositions and discovery to determine the true owners and operators of the same.

The costs of litigation in this area are extensive and depending on the location and financial viability of the true persons or entities controlling the tenant, the landlord may be left with no potential to recover back rent, CAM charges or other expenses related to the Lease Agreement and the premises.

Not Asked, Not Told: Landlord Tort Liability For Acts And Omissions Of Tenants

Until 2006, the North Carolina courts had recognized a general legal duty of a landlord
to undertake reasonable efforts to make sure that its tenant did not cause damage to
adjacent property owners. However, in Waldon v. Morgan, the Court of Appeals restricted this duty substantially by holding that if a landlord does not have actual or imputed notice of a dangerous condition created by its tenant which causes damage to adjoining property owners and related parties, the law will not hold the landlord responsible for the costs and expenses of the results of such damage.

In Waldon, the landlord of a gas station was not on notice that the tenant had scheduled the transfer of a large amount of gasoline from the premises on a particular day, which resulted in a fire and explosion that damaged the plaintiff’s land, homes and personal property. The leased property in question contained a commercial building and an above-ground tank used to store gasoline. Although the plaintiffs argued that the landlord knew or should have known that its tenant was engaged in dangerous activities related to the transfer of fuel to and from the storage tank, the Court held that since the gas station landlord did not retain control over the leased premises and was not physically present on any routine or regular basis on the property, it could not held to be responsible for the damages caused by the fire and explosion.

Thus, even in situations involving tenants who are engaged in activities involving dangerous chemicals, explosives, etc., the North Carolina courts will not allow an adjacent property owner who is damaged by the acts of a tenant or a third party to hold an off-site landlord responsible for damages.

Although indemnity and insurance provisions are usually inserted to delineate the parties’ responsibilities relating to the events described in the Waldon case, this new court ruling provides additional protection to the landlord in the event that those provisions do not describe the scope of certain dangerous conditions that result in damage to others.

Choosing Remedies: Dangers of Mixing Procedures in Arbitrations and Court Actions

Under established North Carolina law, if the parties to a lease or other contract have
negotiated a mandatory arbitration clause, the courts will closely scrutinize any
allegation of the waiver of the right to arbitrate alleged by any party.

Nonetheless, in Capps v. Virrey, the Court of Appeals determined that despite this strong public policy favoring arbitration, the plaintiff had waived his right to demand arbitration by filing pleadings in a court action and also engaging in discovery which would not normally be available under the arbitration provision contained in the contract. Although the North Carolina Uniform Arbitration Act contains certain specific rules for discovery, discovery and arbitration proceedings are normally allowed at the discretion of the arbitrator. Because the plaintiff’s discovery request exceeded the scope allowed by the Uniform Arbitration Act, the Court determined that the plaintiff waived its right to compel arbitration after filing a complaint in a lawsuit, serving written discovery requests, and appearing for a deposition.

Capps is one of the few cases in which the North Carolina Court of Appeals has deemed that a party’s conduct can waive a state’s strong public interest in enforcing mandatory arbitration clauses and other proceedings that promote settlement of disputes without the filing of a lawsuit in state or federal court.

That's all for now,

Henry

Thea Grace Morgan is Practice Development Director and acts as marketing and PR liaison at Horack Talley. She can be reached at tmorgan@horacktalley.com and at (704)716-0887.