HOT TOPICS IN COMMERCIAL LEASING Copyright 2014 Nancy Ann Connery All rights reserved.

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1 HOT TOPICS IN COMMERCIAL LEASING 2014 Copyright 2014 Nancy Ann Connery All rights reserved. Nancy A. Connery Partner Schoeman Updike Kaufman & Stern LLP 551 Fifth Avenue, New York, NY (646) direct (212) main (212) fax

2 HOT TOPICS IN COMMERCIAL LEASING 2014 SELECTED ISSUES IN LEASES INVOLVING NOT-FOR PROFITS 1. AMENDMENTS TO NOT-FOR-PROFIT LAW a. Non-Profit Revitalization Act of The Non-Profit Revitalization Act of 2013 became effective July 1, 2014 (the 2013 Act ). b. Internal Consent Process. The 2013 Act facilitates the process of obtaining required consents. For example: i. Notices of meetings to members, member waivers of notices, member proxies, and member consents may be given by electronic mail. ii. Unanimous director consents and waivers of notices may now be given by electronic mail or in writing. iii. The provisions of the Not-For-Profit Corporation Law allowing directors to participate in meetings via conference telephone or similar communications equipment have been clarified and also expanded to add electronic video screen communication. c. Related Party Transactions. i. Related party transactions are now subject to strict scrutiny. Board members need to consider the related party rules if they are in any way involved in the transaction at issue. ii. In addition, many not-for-profit corporations must adopt policies governing conflicts of interest and policies protecting whistleblowers. d. Internal Approvals of Real Estate Transactions Involving the Sale, Lease, Exchange or Other Disposition of Real Property. i. Transactions Involving Less Than All or Substantially All of the Not-for- Profit s Assets. Board approval requirements for real estate transactions that do not involve the sale, lease, exchange or other disposition of all or substantially all of the corporation s assets have been relaxed. 1. Under the 2013 Act, the purchase of real property need only be authorized by a majority of the Board of Directors (or a majority of a Board-authorized committee) unless the purchased property would, upon purchase, constitute all or substantially all of the assets of the corporation. 2

3 2. Under the 2013 Act, the sale, mortgage, lease, exchange or other disposition of the corporation s real property need only be authorized by a majority of the Board of Directors (or a majority of a Board-authorized committee) unless the property constitutes all or substantially all of the corporation s property. ii. Transactions Involving All or Substantially All of the Not-for-Profit s Assets. If the real property, if purchased, would constitute all or substantially all of the corporation s assets, or if the real property being sold, mortgaged, leased, exchanged or otherwise disposed of constitutes all or substantially all of the corporation s assets, the old rules apply (a two thirds vote of the Board is required unless the Board consists of more than 21 people, in which case a majority vote is sufficient). e. Attorney General and Court Approval. If the transaction involves the sale, lease, exchange or other disposition of all, or substantially all, the assets of a charitable corporation, the corporation may now obtain the approval of either the Attorney General or the Supreme Court (formerly, court approval was required, with notice given to the Attorney General s office) unless the corporation is insolvent or would become insolvent as a result of the transaction (in which event Supreme Court approval is required) or unless the Attorney General determines that a court should make the determination. i. Note that the amendments to the Not-For-Profit Corporation Law with respect to Court approval did NOT modify the requirements of the Religious Corporation Law as to religious corporations. f. Financial Reporting. i. Financial thresholds for independent CPA audit reports and review reports have been raised. ii. New requirements are imposed requiring the Board or an Audit Committee of any corporation required to file an annual audited financial report to, among other things, oversee financial reporting and review audit results. 2. SPECIAL CONSIDERATIONS: LEASES BY AND TO NOT-FOR-PROFITS a. Negotiation Process 1. Decision making power is often exercised by a group. b. Due Diligence i. Internal Approval Process 1. Voting and decision making processes may be informal. 3

4 2. Charter documents may be old-fashioned, with voting requirements unclear or impossible to comply with. 3. If quorum requirement, as a practical matter, can t be met because of diminishing membership, the Supreme Court may be petitioned for a modification of the quorum requirement. N.Y. NPC Law 608(e). If quorum requirements, as a practical matter, can t be met because of the large size of the membership (in excess of 500 members), cost of mailing, and inability to send notice by , consider publication and posting. N.Y. NPC Law 605(a). ii. Consider whether amendments are needed to the Charter or By-laws. iii. Approvals: 1. Not-for-Profit Lease of Property from Third Party. a. No statutory requirement of a minimum Board vote or membership vote. b. Review corporation s certificate of incorporation and by-laws. 2. Not-for-Profit Lease of its Real Property Less Than All or Substantially All of the Corporation s Assets. a. Requires authorization by a majority of the Board of Directors (or a majority of a Board-authorized committee). N.Y. NPC 509. b. Review corporation s certificate of incorporation and bylaws. 3. Not-for-Profit Lease of its Real Property -- All or Substantially All of the Corporation s Assets: a. A two-thirds vote of the Board is required unless the Board consists of more than 21 people, in which case a majority vote is sufficient. b. If members are entitled to vote on the transaction, the Board must adopt a resolution recommending the transaction and submit the transaction to the members for vote. By two-thirds vote, the members may approve the transaction according to the resolution or may authorize the Board to modify the terms of the transaction. If members are NOT entitled to vote on the transaction, then Board approval (see subpar. (a) above) will suffice. 4

5 c. Review certificate of incorporation and by-law requirements. d. Attorney General or court approval required, unless the corporation is insolvent or would become insolvent as a result of the transaction (in which event Supreme Court approval is required) or unless the Attorney General determines that a court should make the determination. e. After authorization, the Board may, at its discretion, abandon the transaction (subject to the rights of third parties to the transaction) without further action or approval. f. See N.Y. NPC 509, Religious Corporation/Disposition of Assets (including a Lease of Church Property for a Term Exceeding 5 Years): a. General. i. Although the Not-For-Profit Corporation Law is generally applicable to religious corporations, not all of its provisions apply to religious corporations. RCL 2-b provides that the Not-For-Profit Corporation Law applies to every Religious Corporation, subject to specified exceptions. RCL 2-b further provides that if there is a conflict between the Not-For-Profit Corporation Law and the Religious Corporation Law, the Religious Corporation Law prevails. ii. Notices of Member Meetings and Proxies. Sections 603 (notice of member meetings) and 609 of the Not-For-Profit Corporation Law (proxies) do not apply to religious corporations. b. Court Approval/Notice to AG. i. Lease of Real Property By a Religious Corporation from a Third Party. Court approval and Attorney General approval are not required for leases by religious corporations of property. N.Y. RCL Section 6 specifically permits religious corporations to acquire property for, among other things, chapels, 5

6 mission houses, school houses, housing for ministers, property for a home for the aged, and property for a day care center. Any disposition, however, must be effected in accordance with the N.Y. RCL 12. ii. Approval Required. RCL 12(1) requires every religious corporation to obtain court approval pursuant to NFC Law 511 (with notice to be given to the Attorney General) for each of the following transactions: 1. Sale of any of the church s real property (except in connection with a foreclosure). 2. Mortgage of any of the church s real property. 3. Lease of any of the church s real property for more than 5 years. iii. Internal Approvals. 1. For certain hierarchical churches, designated bodies or parties must approve the lease. 2. Generally, for those churches whose trustees or governing body are elected by the congregation, approval of the members will be required. In re Beth Israel of Brownsville, 114 Misc. 582 (1921) (trustees of a religious corporation having a congregational form of government have not power to sell or mortgage real property without the consent of the congregation members, which must be given in accordance with legally adopted bylaws); see also Kroth v. Congregation Chebra Ukadisha Bnai Israel Mikalwarie, 105 Misc. 2d 904 (1980). c. Certain Churches. RCL Section 2-B (d-1) exempts certain churches from the requirement that notice be given to the 6

7 Attorney General, and RCL Section 12 (2) (6) requires additional consents from the bishops, Presbyteries, etc. with respect to those churches. The churches include the Protestant Episcopal Church, Roman Catholic Church, Ruthenian Catholic Church, African Methodist Episcopal Zion Church, Incorporated Presbyterian Church, and the United Methodist Church. iv. Real Property Due Diligence 1. Confirm that the not-for-profit actually owns the property it is leasing. 2. Are there any restrictions on the use of the real property? v. For religious corporations, will approval of the church hierarchy be required or desirable? c. Below Market Rents i. It s not unusual for a not-for-profit to grant a long term lease to a related not-for-profit whose activities support the activities of the owner of the real property. 1. Rent may be below-market. N.Y. RCL What if the tenant files for bankruptcy? a. If the rent is deeply discounted, the lease may be very valuable. Bankruptcy courts generally have the power to order an assignment of a tenant s interest in a lease without the landlord s consent to any entity, including a developer or for-profit entity. Generally, the not-for-profit landlord will be concerned about such a result. b. Thoughts: i. Set a fair market rent, with the tenant to receive a rent credit only for so long as the property continues to be leased by a not-for-profit tenant in accordance with the lease requirements. ii. Draft the court order authorizing the lease transaction to clearly limit approval to the tenant named in the petition and to require court approval of any assignment of the lease or sublease of all or substantially all of the premises. 7

8 iii. Arguably an assignment of an approved lease with a term of more than 5 years constitutes a new lease of the religious corporation s property requiring Supreme Court approval. Does the state law requirement trump the trustee s right to assign? d. Use Restrictions i. It s not unusual for a not-for-profit granting a long term lease to limit the uses to which the property can be put. This may be a function of the proximity of the leased property to the church s or not-for-profit corporation s property or may constitute a quid pro quo for a reduction in the base rent. ii. What if the tenant files for bankruptcy? 3. REAL ESTATE TAX EXEMPTION 1. The Bankruptcy Code voids any lease provision that gives the landlord the right to terminate or modify the lease if the lease is assigned by the debtor/tenant or its trustee in bankruptcy. Bankruptcy Code 365(f)(3). This provision has been interpreted to invalidate any number of restrictions on assignment, including narrow use clauses. E.G., Robb v. Schindler, 142 B.R. 589 (D. Mass. 1992) (court refused to enforce profit recapture clause, citing cases invalidating various restrictions on transfer, including narrowly crafted use clauses that impeded assignment and clauses that increased rents to market rate upon assignment). There is the risk, therefore, that a bankruptcy court would invalidate an overly narrow use clause in order to facilitate an assignment of the lease in bankruptcy. 2. Thoughts: a. Explicitly describe in the lease the nature of the special relationship, if any, between the tenant and landlord. b. Draft the court order authorizing the lease transaction to clearly limit approval to the proposed use. c. Arguably an assignment of an approved lease with a term of more than 5 years constitutes a new lease of the religious corporation s property requiring Supreme Court approval. Does the state law requirement trump the trustee s right to assign? d. Limit the property s use with a Declaration of Restrictions. a. Property Owned by Not-For-Profit. Real property owned by a corporation or association organized or conducted exclusively for charitable, educational, 8

9 religious, hospital, or moral or mental improvement (an exempt property owner ) that uses the property exclusively for such purposes is exempt from real estate taxes. N.Y. Real Property Tax Law 420-a. Other exempt purposes are set out in N.Y. Real Property Tax Law 420-b, 446, and 462. i. If the exempt property owner leases a portion of the property to a commercial enterprise, its exemption will be lost as to the portion so leased. 1. To avoid transferring the exempt owner s tax exemption to the commercial tenants, the lease will typically require each commercial enterprise to pay its share of increases in the building s real estate taxes (or its share of such taxes as a direct passthrough), computed as if the property was not benefitted by the property owner s tax exemption. ii.if the exempt property owner leases a portion of the property to another corporation or association organized or conducted exclusively for charitable, educational, religious, hospital, or moral or mental improvement for such tenant s exempt purposes, the exempt property owner may retain its exemption as to the leased property but only if the rent payable by the tenant does not exceed normal carrying, maintenance, or depreciation charges with respect to the leased portion of the property. b. Property Owned by a For-Profit Entity and Leased to a Charitable Corporation. i. Generally, a For-Profit entity that leases real property to a Not-For-Profit entity is not entitled to a real estate tax exemption with respect to the Not- For-Profit s occupancy. ii. Some Techniques For-Profit Landlords and Not-For-Profit Tenants Have Used to Allow the Not-For-Profit Tenant to Obtain the Benefit of Its Exempt Status: 1. Symphony Space. a. Symphony Space Inc. v. Pergola Properties, Inc., 88 N.Y.2d 466 (1996) b. Property owner conveyed office building to a Not-For- Profit for nominal consideration, was granted a lease at a nominal rent for the portion of the building not occupied by the Not-For-Profit, and was given an option to reacquire the entire building at the end of a specified period of time. The owner lost the building to the Not-for-Profit because of a Rule against Perpetuities issue that voided the purchase option. i. Very risky. 2. Leasehold Condominium Ground Lease. 9

10 a. For-Profit owner ground leases its property to a Not-For- Profit that constructs improvements. b. The Not-For-Profit converts its leasehold estate to a leasehold condominium with fee ownership of the improvements. c. Condominium units are separately assessed and taxed under NY Condominium Law 339-y. i. Note that there may be a lapse in time between the formation of the condo and creation of separate tax lots. d. See NYC Dept. of Finance Letter Ruling dated February 13, i. Lease was for 35 years with renewal options. ii. iii. Tenant owed in fee the building. Leasehold condo unit tax exempt if 420-a criteria otherwise met. e. What if Not-For-Profit Acquires Leasehold Estate Through a Non-501(c)(3) Entity Owned by a Not-For-Profit i. If a leasehold estate is acquired for use by a Not- For-Profit for its exempt purposes, but the leasehold estate is held in the name of a single-member limited liability company owned by the Not-For- Profit (e.g., for financing or liability reasons), is the leasehold condominium unit still exempt from tax? ii. There are a number of letter rulings from the New York City Department of Finance indicating that property owned in fee by a limited liability company (that is not a 501(c)(3) entity) owned solely by an exempt entity and used by the exempt entity for its exempt purposes, may be exempt from real estate taxes. Would the Department of Finance apply the same reasoning to a leasehold estate? iii. Note that the letter rulings set out a number of criteria that must be met, including the following: 1. The sole member of the LLC must qualify for a 420-a exemption; 2. The limited liability company s articles of organization and operating agreement must contain specific language relating to the company s not-for-profit purposes. 3. There must be commonality between the LLC and its member. 4. The property must be managed and maintained by the single member or leased to another not-for-profit entity that would qualify for an exemption. 10

11 11 5. The rent can t exceed carrying, maintenance and depreciation charges. 6. Upon termination of the LLC, the property must revert to its single member or another exempt entity. The LLC must continue to be owned by an exempt entity. 7. An annual affidavit must be filed with the Department of Finance.