Attack of the Zombie Clauses!

So there’s a troubled asset.  A mixed use, mostly retail shopping center, for example.  It has a designer furniture store, a tile gallery, several boutique clothing stores, a reasonably successful midrange chain diner (serving breakfast foods all day), a vintage movie theatre, a fancy gym, a ladies-only spa, and several  empty storefronts (the bookstore closed; a small bakery died; a cards and wrapping paper shop just elected not to renew its lease).  There are offices above. Day traffic is pretty good, but the center needs to draw more people in after work and into the evening in order to thrive.

The project is underwater.  Way underwater.  The owner has had it:  it’s ready to give up the property because it can’t put any more money into it.  Or it fought foreclosure, and lost.

You are the lender or special servicer – or maybe you are the buyer of the owner’s note.  Perhaps you bought the note at a discount from a bank, or you are a fund, and bought it as part of a portfolio.

At any rate, it’s your turn to try to spin dross into gold.

You have one major advantage over the prior owner:  you either got the property back after a foreclosure, or will do so, or have acquired the note at a discount.  So you don’t have so much money in it, and with a little luck, you can rent it out and make it profitable.

You think that you’ve figured out the turn-around plan for the troubled asset:  you know how to reposition the center.  Adding a high end dinner and jazz club will attract traffic, will draw shoppers to the shops in the center, and will fill a gaping hole on the ground floor.  You’ve found a promising operator, who’s got a good track record creating buzz for his nightclubs, and sign a lease.  Then you announce the planned opening.  Shortly thereafter, your middle market diner sues you for violating its lease:  it has an exclusive right to a restaurant in the center.  Any restaurant. 

You’ve just been attacked by a zombie clause:  it does not matter that the trendy young things that will come to the high end jazz club would not otherwise have been knocking over senior citizens in a rush to the blue plate 4 pm dinner special at the diner.  In reality, there’s no conflict in the two restaurants’ demographics.  But the lease exclusive is written broadly.  Now you have litigation, or an expensive lease renegotiation, with your diner, and your jazz club owner, who is litigation averse, is also looking for a way out of his lease with you.  What a mess.

Zombie clauses don’t exist in leases alone, of course; but they are very commonly found there.  Zombie clauses are provisions in legal documents that are typically negotiated into the document as a concession to get the other party to sign – but are often drafted too broadly.  Though they are often ignored in good times, when all the parties are making money, in bad times they’re resuscitated and used to attack the deal, the other party, or to extract money or other concessions. 

Why are they so common in leases?  My theory is that in good times, no one wants to be (or to pay for) the killjoy (usually the lawyer) who thinks about (and plans for) how things might go wrong.  And when property values are going up, up, up, and properties are being flipped for big profits, it’s difficult to remember that all those tricky little provisions in a lease may actually affect cash flow in bad times.  When the game of musical chairs stops, a property owner is stuck with the leases it has in place – and the revenues they generate. 

In leases, zombie clauses are often hidden in the exclusive use restrictions, in go dark provisions, in parking provisions, and in restrictions on changes to the development by the landlord.  Zombie clauses come up in all sorts of real estate documents, however.  If you’re lucky – or careful – you find them in the course of your diligence on a property before you buy it, or before you complete a loan.  If you are less lucky, or less careful, you’ll likely find the zombies by waking them up when you go to foreclose or take other actions involving a troubled property. 

If you are foreclosing on a construction loan for a not-quite-finished condo project, for example,  you might find provisions hidden in the homeowners’ association paperwork that provide the original developer with overriding majority rights to vote for a time period between when the first condo is sold, and when 90 percent of them are sold.  In one case I saw (in a deal years ago), the lender had not focused on this when it made the loan – and the loan documents did not provide the lender with any security interest or other right to take the developer’s supermajority voting rights if it foreclosed.   If even one condo were sold, and if the lender foreclosed, it might own the condo project – but would be stuck with the developer (which might not be wildly friendly post-foreclosure) in charge of the homeowners’ association.

Change of control clauses often become zombie clauses, because they are often inserted into real estate documents without much thought about how they will work if the economics of the deal go south.  These are fairly common in leases.  They can seriously hinder rescue attempts if, for example, a large chain category killer store goes under, and a white knight is willing to buy it – but cannot do so without renegotiating all its leases which allow the landlords to recut the lease deals if there’s a change of control.  Change of control clauses can be just as problematic in real estate loans and guaranties – and can hurt either the lender or the borrower -- if they are not carefully reviewed to make sure they are flexible enough to adapt to the likely circumstances of the particular parties to the deal.

So how do you kill a zombie clause?  Just like in the movies, prevention is better than cure.  Doing thorough diligence when buying a property or making a loan secured by it will allow the buyer or lender to right-size its payment for the asset to the risks.  Paying careful attention to the terms of a lease or other deal document before signing it, is the equivalent of zombie-preventing vaccine.

Without it, you get stuck fighting off the undead – and you know, from the movies, that they are almost impossible to kill without a big and expensive battle.  So do your deal diligence, so that you find the zombies up front . . . before they find you.