Chapter 1 Commercial Real Estate Contracts

• Library: Practical Guide to Commercial Real Estate in South Carolina (SCBar) (2024 Ed.)

Chapter 1 Commercial Real Estate Contracts¹

Joshua O. C. Lonon

A. Scope of Chapter

The subject of commercial real estate contracts could easily take up an entire book or multi-volume treatise.² Because the format of this publication does not lend itself to a complete treatment of the subject, the author has chosen to organize the chapter as a nuts-and-bolts guide for practitioners with the hope that the presented materials will reinforce certain important concepts and principles in contract drafting.

The goals of this chapter are twofold: (1) to be a basic source of information for those who do not necessarily devote a substantial percentage of their practice to commercial real estate; and (2) to provide conceptual reinforcement for the lawyer who has spent too many 12-hour days at the office trying to meet skin-tight deadlines or who has been staring too long at the twelfth draft of a complex agreement.

B. Introduction — Guiding Principles

As attorneys, we have all internalized the basic law school mantra that a valid, binding contract requires offer, acceptance and exchanged consideration between the contracting parties. However, in the throes of a lengthy or contentious negotiation, after dozens of drafts and mark-ups exchanged by the contracting parties, it is sometimes easy to forget the overarching goals of all contracts: (1) to identify issues present in this particular contractual relationship and plan for those issues as carefully as possible; (2) to clearly set forth rights, obligations and expectations to ensure orderly performance by the contracting parties; and (3) to ensure that the contract is enforceable in the event of a breach.

In an ideal world, contracts are short, sweet and simple. In the context of commercial real estate, however, simplicity is often a rare commodity. Whether the deal involves acquisition of a 50-tenant shopping center with complex financing or a ground lease and new construction, the scores of moving parts in a "typical" commercial real estate transaction, if there is such a thing, virtually ensure that the understandings reached by the parties will not be papered by simple documents. But if "simplicity" cannot be our watchword, "clarity" certainly should be.

The following are some core principles, the consideration of which may facilitate a more effective representation of a client's requirements in the documents underlying a commercial real estate transaction.

1. Who is Your Client?

The identity and characteristics of a client will drive a significant portion of contract drafting and negotiation. Specifically, lawyers should consider the client's role in a transaction, the client's level of sophistication, and the client's risk tolerance in formulating a drafting strategy.

a. Client's Role in the Transaction

Lawyers rarely draft documents from the ground up for a complex business transaction. For quality control and billing efficiency reasons, the starting point for most contracts is either a "form" of agreement or an agreement used in a past similar transaction. The selection of the appropriate initial starting document is very important and can save time in the end. One consideration in selecting the starting document is whether your client is the purchaser or seller in a particular matter.³ Although it is a commonsense notion that parties on opposite sides of a transaction often have diametrically opposed goals and requirements for a contractual negotiation, choosing the correct initial document as a starting point (if one bears the good fortune of having initial control of the document) may provide very significant practical advantages.

First, starting with a document that is as closely aligned as possible with the client's role in a transaction, taking into account the relative power each party has in the prospective deal, may cut down on the amount of modification to the initial document necessary to achieve the client's goals. Making fewer modifications likely will lower the probability of unintended consequences, namely that the edits to the initial document might cause other provisions in the contract to function improperly. Secondly, choosing a starting point that is closer to the intended finish line is an effective means of keeping client costs to a minimum.

Of course, understanding a client's role in the transaction goes beyond the client's mere classification as purchaser or seller. The lawyer must also help the client make an honest assessment of the client's bargaining power so that the client can make informed choices about contractual provisions. For example, if a seller is attempting to sell a property that has some unique value to the purchaser, seller's counsel may be perfectly justified in presenting a strongly seller-favorable first draft to the purchaser for consideration. On the other hand, if the seller is attempting to sell property that the purchaser views as fungible, the seller may decide that a more party-neutral approach in the draft agreement is necessary to keep the prospective purchaser at the bargaining table.

At a minimum, if a pre-existing document form will serve as the starting point for a particular contract negotiation, a lawyer should analyze the appropriateness of that document relative to the client's profile before making changes specific to the current transaction.

b. Client Sophistication

The level of client sophistication should also bear on the terms of a contract and the lawyer's approach to negotiation. For example, a Real Estate Investment Trust staffed with a cadre of engineers, in-house counsel, and leasing specialists may be perfectly comfortable with a two-week due diligence and inspection period, whereas a client who has only a few commercial properties and little or no staff may not reasonably hope to complete its diligence within two months. Likewise, a mom and pop selling their store in a rural farming community may neither feel comfortable with nor reasonably be able to provide the warranties and representations that a larger, more sophisticated client might gloss over as a cost of doing business. In either event, attention to this aspect of the client's profile will allow a lawyer to focus negotiations and to prioritize the importance of certain contractual provisions.

c. Client Risk Tolerance

How much risk a client is willing to bear in a particular transaction should heavily influence the content of the underlying agreement. Client risk tolerance depends both on a client's intrinsic attributes and the situational factors particular to a contemplated transaction. For example, a well-funded and highly sophisticated purchaser may be generally willing to concede requiring certain warranties and representations of sellers to ensure that its prospective acquisitions close. From a situational standpoint, a distressed seller may be willing to provide stronger warranties because of the potential benefit of selling the property quickly. In both scenarios, accounting for the client's needs and risk tolerance may foster the ultimate goal of getting the deal done.

2. Contract Drafting and Management of Client Expectations

a. Issue Spotting and Risk Allocation

Transactional lawyers wear the hat of issue-spotter. Certain issues in a commercial real estate transaction are often known at the time of entry into the contract (for example, the transaction might be subject to the jurisdiction of a bankruptcy court as the seller is liquidating its assets), and other issues may be unearthed during due diligence (for example, an easement which prohibits construction where a building is planned).

The contract serves as the mechanism for addressing the known issues and an approach to discovering and then dealing with the additional issues discovered during due diligence. Unfortunately, every issue does not have a perfect "fix," so the lawyer's goal under such circumstances is to allocate the risks of the unresolved issue in as favorable a manner as possible for the client or have a way for the client to walk away.

b. Contracts Provide No Guarantees of Performance

Lawyers recognize that contracts provide a roadmap for performance but no guarantees that the contracting parties will follow that map. Clients, especially clients who do not have significant experience in commercial transactions, do not necessarily come into a transaction with this realization. A client may unreasonably expect a contract not only to identify all terms and expectations, but to ensure that the counterparty will perform to the letter of the contract.

Lawyers should educate their clients that the best drafted contract cannot guarantee performance. The education process is especially important when the client harbors concerns regarding the trustworthiness of the party sitting on the other side of the table...