DEFAULT AND REMEDIES IN THE PORTFOLIO SALE A portfolio sale agreement, for either land or loans, ( Portfolio Agreements ) resembles in many respects the agreement for purchase and sale of one or two loans or parcels of real estate ( One Off Agreements ). We are all familiar with the defaults, remedies and damages generally included in One Off Agreements. (As used herein the terms Agreement or Agreements shall refer collectively to Portfolio Agreements and One Off Agreements.) Because Portfolio Agreements encompass a number of loans or parcels of real property (collectively referred to herein as Assets ), we may assume that Portfolio Agreements are more sophisticated than One Off Agreements. This assumption is usually true in the due diligence and representations and warranties sections of the Portfolio Agreement. It is generally not the case with respect to defaults, remedies and damages. However, in Portfolio Agreements, the remedies available may not be as effective as such remedies are in a One Off Transaction. This analysis will set forth the defaults, remedies and damages available in portfolio transactions and evaluate the effectiveness of remedies. I. THE AS IS VERSUS THE FULL REPRESENTATION TRANSACTION. The first rule of the trade is that the As Is transaction is never totally As Is. Even in As Is Transactions, the Seller represents the authority and due formation of the Seller, that Seller is not prohibited by any agreement, judgment or organizational documents to consummate the transaction, the valid and binding effect of the Agreement on the Seller and the like. Portfolio Agreements with representations and warranties may include the detailed representations and warranties attached hereto and depending upon the transaction, more complete and specific warranties and representations for specific Assets. 1 Prepared by Mark A. Asmar and Julie Herbst. Ms. Herbst is an associate in the Boston office of Brown Rudnick Freed & Gesmer. 1 Although the phrases generally used in purchase and sale agreements is representations and warranties this presentation will refer to the same as representations
It is much less likely that a representation or warranty will be breached in an As Is Agreement than a Full Representation Agreement. The breach of a representation in an As Is transaction will more likely be a significant breach as it will involve the ability of the Seller to perform. There may be no means to cure a default in the Seller s ability to perform short of termination of the Agreement. By way of example, the representation that Seller is not prohibited from delivering the Agreement and consummating the transaction set forth in the Agreement, whether the breach occurs at the execution of the Agreement or the Closing, undermines the Seller s very ability to complete the transaction. In the instant case, notwithstanding notice and cure periods and/or a specific performance rights, the ability to correct the default will probably require the consent and cooperation of a third party. As that party may have no incentive to consent, the only practical resolution may be to terminate. If an Asset specific representation is breached in a Full Representation Agreement, the remedy may be within the control of the parties. The parties may have (should have) provided in the Agreement for the adjustment of (or the manner of determining the adjustment of) the purchase price if an Asset is removed from the portfolio or if an Asset fails to meet monetary and performance representations. Other solutions such as a master lease for underperforming Assets and indemnification against loss, cost and damages (for matters such as environmental or title) as set forth herein are available. Full Representation Agreements should include a method to resolve incorrect Asset specific representations. II. UNTRUE OR INACCURATE REPRESENTATIONS. A. At Contract Execution: Representations which are breached at the time of the execution of the Agreement afford the parties a greater opportunity to cure or to resolve the issues raised by the breach. Representations which are untrue at the time of execution of Agreement have the luxury of time in which to be resolved. The applicable party should be afforded notice and the opportunity to cure within a specific timeframe. 2
In some instances the discovery of an untrue or inaccurate representation can result in an extension of the due diligence period and/or the closing date. It is not unreasonable for the Seller to agree that the Buyer should not incur additional costs for due diligence, title, survey and financing until the breach is cured. The remedies available in the event of an untrue representation are discussed later in this presentation as are the remedies for the other defaults and terminations discussed herein. B. At Closing: Representations which are breached at Closing are more problematic. As a general rule having a notice and cure period even for a representation that can be cured by the party making the representation causes a timing problem for the Buyer. The Buyer and its lender are ready to close. There may be additional costs involved to extend the financing commitment or the Buyer may have engaged personnel to manage and/or operate the Assets. Therefore, the remedy section of Agreements should distinguish between a breach at execution and a breach at closing. As a representation can only be breached as of the time the representation is made, contracting parties should not agree that a representation will survive the Closing. This phrase is, in this writer s opinion, a misnomer, as what the parties really mean is the right to make a claim for damages or other remedy for a breach discovered after closing survives. In Agreements where such rights survive, the claim that a representation is untrue or inaccurate must be made within a defined period after closing. As it is very difficult, if not impossible to undo the transaction, the remedies available for a post-closing discovery are more limited, generally restricted to damages. How do you unwind a property sale? If the transaction has closed, the parties have less flexibility to negotiate a resolution. The Seller has received the funds and has no desire to repay some or all to the Buyer. The Buyer has taken control of the Asset and has incorporated the Asset into its portfolio and strategy. Each party has gone on with its life. 3
III. FAILURE TO COMPLY WITH A COVENANT OR FAILURE OF A PARTY TO PERFORM UNDER THE AGREEMENT. A. Failure to Comply With A Covenant may include: (i) Seller s breach of the covenant not to enter into new leases; or (ii) Seller s breach of the covenant not to agree to terminate any lease or one of the other numerous covenants in the Agreement. The breach of a covenant can result in a substantial adverse effect on the value of the portfolio which is the subject of the Agreement. The resolution of a specific breach of a covenant will present opportunities for a specific resolution, e.g. a master lease of the vacated space or a payment of the amount of rent required for space pursuant to the Agreement versus the amount required to be paid pursuant to the prohibited lease. In drafting the Agreement, counsel must be cognizant of the potential failures and attempt to deal with as many potential defaults as is possible in the Agreement. B. Failure of a Party to Perform is much less complex. The traditional remedies such as termination, specific performance and liquidated damages are generally available to the non-defaulting party. If the Buyer fails to close, Agreements usually provide that the Seller will receive the deposit or a portion thereof as liquidated damages. In some instances the Seller may have bargained for a right to Actual Damages, as hereinafter defined, or consequential damages. IV. POST CLOSING INDEMNITEES. In every transaction the possibility exists that a matter will arise which the parties resolve by an indemnity being given by the Seller to the Buyer which survives the closing. Examples of such matter are boundary line disputes, monetary liens or encroachments. If the issue cannot be resolved by the Closing, the Seller may indemnify the Buyer against any loss, cost or expense incurred by Buyer in connection with the matter. In some instances the indemnity is supported by Seller placing in escrow the amount estimated by the parties as necessary to resolve the matter including costs, fees and expenses. 4
As discussed in the section regarding untrue representations first discovered after Closing, the parties, particularly the Seller, has little incentive to resolve the issue or to pay any costs and expenses in connection with an indemnification. Therefore, an escrow is most appropriate. V. TERMINATIONS. The Buyer usually has the right to terminate an Agreement for any one of several reasons. Termination rights which relate to due diligence and similar issues generally result in Buyer receiving the Deposit back and do not provide for cost and expenses. Termination rights which relate to the (i) failure of the satisfaction of conditions imposed upon the Seller, (ii) the Seller s default or breach of the Agreement and (iii) the failure of a representation or warranty at the time of the closing generally result in the Buyer receiving the deposit and either agreed upon damages or Buyer seeking direct and consequential damages. The following are examples of a Buyer s right to terminate for reasons discovered during the investigation period. A. Due Diligence Termination: All Agreements will permit the Buyer to terminate in the event that the results of the due diligence investigation are not satisfactory to Buyer. In As Is Agreements, the termination rights are more generous than the termination rights granted to the Buyer in a Full Representation Agreement. Since the Seller is making no representation with respect to the Assets, the Agreement should provide for the ability of Buyer to terminate the Agreement in the event the due diligence reveals any matter unacceptable to Buyer. In Full Representation Agreements, the Seller will negotiate to restrict the Buyer s right to terminate the Agreement to a breach of representation, a breach of a convenant or other uncured defaults by the Seller under the Agreement. B. Title and Survey Terminations: Agreements will usually permit the Buyer to terminate in the event of a title defect or encumbrance which is not acceptable to the 5
Buyer. Once again, there is a dichotomy between what the As Is Agreement will provide and the Full Representation Agreement will provide. As set forth above, since the Seller in the As Is Agreement does not make representations or warranties or in many instances set forth the existing encumbrances, the Agreement must permit the Buyer to obtain a title search and to prepare a survey. Buyer will then have the right to notify Seller of objections to title and survey. If the Seller fails to satisfy or resolve or remedy the unacceptable encumbrance or survey matter, then the Buyer should have the right to (i) terminate, (ii) accept what Seller can convey without reduction in the purchase price or (iii) use the purchase price to satisfy monetary encumbrances. Again, this is a reflection of the fact that Seller makes very few under the Agreement. In an As Is Agreement the Buyer must have wide latitude to terminate for items which are discovered during the title search and the preparation of the survey. Title and survey issues raised in connection with a Full Representation Agreement are usually limited to those matters which are not set forth on the title exhibit attached to the contract and/or the survey delivered with the Agreement. The Buyer is expected at the time of execution of the Agreement to accept the encumbrances and the survey matters set forth in the Agreement. As title and survey are very sensitive issues in the purchase of Assets, the Buyer must be extremely careful in Full Representation Transactions to investigate the title and survey matters disclosed in the Agreement. This requires the Buyer to undertake a significant amount of work prior to the execution of the Agreement. The title analysis for permitted matters must be completed prior to execution of the Agreement as the permitted matters will not be reasons for the Buyer not to perform. For some of the Assets, the issue of insurable versus marketable title will arise. The Buyer should only accept marketable title as insurable title may result in issues being raised at the time Buyer elects to sell the Asset. By requiring marketable title, Buyer may negotiate with respect to one of the Assets if Buyer determines the encumbrances which is being resolved by insurance will not have a serious adverse affect on the value of the portfolio or the Asset. 6
C. Survey matters are more difficult to addressing the Agreement and should be reserved as matters to which the Buyer can object whether it is a Full Representation or an As Is Agreement. Even though a survey is available at the time of execution for the Buyer to review, the quality of the survey and the date of the survey may make it required that the Buyer reserve the right to obtain a new survey and retain the right to terminate as a result of matters which appear on the survey. For example a survey shows an encroachment of a fence or other object on to the Asset from the adjoining property, the encroachment may not have presented a problem to the existing owner but may present a problem for the Buyer, or the encroachment may have arisen after the last survey. The new Buyer may want to use the area of the encroachment for some purpose. The Buyer will have to determine two things: (i) if there is an incursion and (ii) if so, how long the incursion existed. The Buyer should insist on a right to do its own survey to determine survey matters because the Buyer has no recourse against the surveyor who prepared the prior survey. Only by completing an accurate survey of the Premises can a Buyer determine whether or not the Property to be purchased conforms to the description and acreage represented by the Seller, whether or not the property is affected by encroachments or has portions of its buildings and improvements which are off the property. D. The As Is and the Full Representations Agreement will permit the Buyer to conduct due diligence investigations, such as, structural, engineering and mechanical testing, compliance of the Asset with laws and environmental investigation. The Agreement will permit the Buyer to terminate the Agreement in the event that the Buyer is not satisfied with these inspections. Depending upon the representations contained in the Agreement, it may be more difficult to terminate a Full Representation Agreement than an As Is Agreement. However, with regard to inspections and investigations, in particular engineering, mechanical and structural, the Buyer may only have the right to terminate if the systems are not in good condition and repair and/or not in good working order. A number of Full Representation Agreements provide that the utility systems and other systems serving the building are in good operating condition and 7
repair and in good working order, however, that representation will not relieve the Buyer of the obligation to do its inspection during the due diligence period. In addition to the permitted terminations discussed above, most Agreements will provide for a termination upon failure of a covenant or failure to perform by either party. This termination right will benefit both the Buyer and the Seller as either party will have a right to terminate if the other party does not honor to the terms and conditions of the Agreement. However, as the Seller is only concerned with the Buyer posting the deposit at the appropriate time, closing on time and delivering the payment of the purchase price it is unlikely that the Seller will be overly concerned with other breaches, so long as the Buyer closes. The Buyer has a number of issues it must deal with, such as, a representation which was true at the time of the execution of the Agreement being false or becoming false during the term of the Agreement, or the Seller failing to correct an encumbrance or defect in the title which the Seller is obligated to cure under the Agreement, or the Seller failing to correct a survey defect or the Seller being in breach for any other reason. A number of these issues can be addressed within the Agreement by giving the Buyer the authority and power to correct such defects at the cost and expense of the Seller. This solution is not very practical as there are few Sellers who would agree to give the Buyer this remedy. Therefore, in order to bring the discussion of the foregoing together, the presentation will next review the remedies and damages available after a default. VI. REMEDIES. A. Permitted Terminations: Agreements usually provide that in the case of a permitted termination, the Buyer will receive a refund of the deposit and the parties will each bear their own costs and expenses. In a portfolio transaction where there are so called partial permitted terminations, that is the Buyer may terminate with respect to certain Assets but cannot terminate the Agreement unless a certain threshold is reached, terminating as to an Asset may not be an adequate remedy. Should the due diligence reveal that certain of the properties of the 8
type of nature, which Buyer is particularly seeking in the transaction, do not meet the criteria of the Buyer, the Buyer s sole right may be to terminate the Agreement with respect to those particular properties. This will result in the Buyer purchasing a portfolio which does not meet the criteria the Buyer established in making the bid on the portfolio. In As Is Agreements, the Buyer has little recourse to the Seller as the Seller has not made any representations. In the Full Representation Agreement, the Seller will have made certain representations and if those representations are untrue and those are the issues cause the Buyer to elect to terminate the Agreement with respect to the noncompliant properties the Buyer should have the right to additional damages, costs and expenses, or a right to terminate the entire transaction and receive the deposit plus the Actual Costs, as hereinafter defined. B. Specific Performance: In the event of a default by the Seller under the Agreement specific performance will generally lie. Most courts have not permitted the Seller to seek specific performance against the Buyer as money is a fungible asset. In a portfolio sale, specific performance may not be a practical remedy as there can be an issue of what is to be specifically performed. Should the Seller simply refuse to honor the Agreement to sell the properties, the issue is very simple. The Buyer seeks to have the Seller s performance and its obligations enforced. When a representation is breached, it may not be practical to seek to force specific performance by the Seller as it may be totally outside the power of the Seller to correct the breach. For example, if there has been an intervening bankruptcy of the Seller or the general partner of Seller or if an action had been brought which affects some of the Assets, the cure of that breach is not entirely within the Seller s control and therefore the Buyer may not be able to obtain specific performance of the Agreement. VII. DAMAGES. There are several measures of damages which can be incorporated in an Agreement, including liquidated damages, consequential damages, general damages and Actual Damages. Although the courts have sometimes held that the term actual damages includes both general 9
and special damages such as consequential damages 2, as used in this presentation, the term Actual Damages shall refer to reimbursement by the defaulting party of the costs, fees and expense incurred by the other party in working through the transaction. A. Liquidated Damages. A significant majority of Agreements will provide that in the event of a breach of the Agreement by the Buyer, the Seller is entitled to retain the Deposit, or a significant portion of the Deposit, as liquidated damages. In order for the Buyer to be comfortable with a liquidated damages provision, the provision must provide that the liquidated damages are the Seller s sole and only remedy with respect to a default by the Buyer under the Agreement. Courts have generally concluded that a valid liquidated clause in the contract for the sale of land generally restricts the vendor to recovery of the stipulated amount in the event of the purchaser s default, and the vendor is precluded from seeking his actual damages. 3 The liquidated damage clause should meet the following criteria: 1. the anticipated damages are uncertain in amount or difficult to prove; 2. the parties intend to liquidate the damages in advance of default; and 3. the amount specified is reasonable in that it is not greatly disproportionate to the presumed loss or injury 4 Courts have restricted claims for other damages when the Agreement contains a valid liquidated damages clause because the courts consider the liquidated damages 2 See ISTI Del., Inc. v. Townsend, 1993 Del. Super. LEXIS 146, *10 (Del. Super. 1963), app. dismissed, 1993 Del LEXIS 232 (Del. June 11, 1993), citing 77 Am.Jur. 2d, Vendor and Purchaser, 474 and 489. 3 39 ALR 5 th 33 (1999); see, e.g. Kelly v. Marx, 428 Mass. 877 (1999); McMaster v. McIlroy Bank, 9 Ark. App. 124 (Ark. 1983); Camp v. Cohn, 151 Conn. 623, 626 (1964). 4 See Sorenson v. Connelly, 36 Colo. App. 168 (Colo. 1975). 10
clause an attempt by the parties to avoid disputes over actual damages which are difficult to ascertain. The clause also prevents unjust enrichment to the Seller. 5 The use of the terms sole remedy or exclusive remedy has been shown to be important in a number of court cases. The parties must make it clear that it is their intention that the liquidated damages are the sole and exclusive remedy and that there is no further recourse for other damages in order for the liquidated damage provision to be held to be the exclusive remedy. 6 Some courts have held that the simple use of the word shall or must indicates the parties intention that the liquidated damages be the only remedy. 7 B. Consequential Damages. Consequential damages are generally defined as damages not directly flowing from the breach of the contract, but which the defendant was aware would occur. 8 Consequential damages include but are not limited to the cost and expenses incurred by a party in preparing to complete the transaction including in but not limited to costs and expenses, attorneys fees and Buyer s anticipated return anticipated profit. Note that the test is the defendant was aware the damages would occur not could occur. 5. 39 ALR 5 th 33 (1999); see, e.g., Hearrell v. Rogers, 7 Ark. App. 230 (1983) (holding that even where damages are capable of ascertainment, the liquidated damages clause prevails in order to preserve rule certainty); Germany v. Nelson, 677 S.W.2d 386 (Mo. Ct. App. 1984) 6. See, e.g., Woodhull Corp. v. Saibaba Corp., 234 Ga. App. 707 (1998); Lerner v. Perry, 61 App. Div. 2d 754 (N.Y. 1 st Dept, 1978). 7 See, e.g., Entergy Services, Inc. and Entergy Arkansas, Inc. v. Union Pacific R.R. Co., 35 F.Supp. 2d 746 at 754 (1999) (the use of the word shall indicates intent of the parties to a mandatory remedy); c.f. Steinhoff v. Fisch, 847 P.2d 191 (Colo. Ct. App. 1992) (use of the word may indicated a permissive remedy which does not bar an action seeking other remedies); but see also Nichols v Williams, 1995 Ark. App. LEXIS 580 (Ark. Ct. App. Nov. 29, 1995) (although parties used shall the court found that the context indicated parties intent to give additional right and not an intent to limit remedies). 8 See, e.g., ITSI Delaware Inc., 1993 Del. Super. LEXIS at *11. 11
For the reason set forth in the previous paragraph, projected profits as a measure of damages varies throughout the fifty (50) states. Some states permit recovery without an agreement to sell a property or a portion of the property which other states hold that such profits are speculative and not recoverable, that is would versus could. In order to preserve the right to consequential damages, the parties must provide in their document that there are no liquidated damages and that the non-defaulting party is entitled to recover its general and special damages including consequential damages. C. General Damages. General damages for the Seller are essentially the equivalent of specific performance for the Buyer. Most jurisdictions do not permit the Seller to bring an action of specific performance against the defaulting Buyer as money is considered fungible. The Seller is usually limited to the liquidated damages or other damages permitted under the Agreement. General damages is an amount equal to the difference between the contract price and the market value of the Assets if the market value of the Assets is less than the sales price of the Assets. If the agreement provides for general damages for the Buyer the measure is excess of the market value of the assets over the purchase price. D. Actual Damages. The term Actual Damages refers to the reimbursement by the Seller of the costs, fees and expenses incurred by the Buyer in connection with the transaction should the transaction fail because of a default by the Seller. In this writer s experience, it is an alternative which came into Agreements eight to ten years ago. In Connecticut it has become one of the more prevalent remedies for a Buyer in a transaction. The Agreement should provide that in the event of a default by the Seller under the Agreement, the Buyer will receive a return of the deposit and payment by Seller of the amount actually incurred by the Buyer in connection with due diligence, title search, preparation of surveys, environmental testing and the like including time spent by in-house personnel. The obligation to pay the Actual Damages may be secured by an agreement to permit the same to be a lien on the property in the 12
event the Seller fails to pay the amounts. This protects the Buyer for its out of pocket costs and expenses. It does, however, do anything with the issue of the Buyer s potential profit As discussed in the section below, the damages and agreements are subject to the practical realities. E. Practical Realities. In the end, how defaults, remedies and damages are determined and applied is often determined by factors outside of the Agreement. Anyone who has negotiated an agreement for the purchase and sale of a home, let alone a portfolio, knows that the leverage of the parties will play a key role if there is a default. Which party wants the transaction? Is it a good price for the Seller, for the Buyer? Does the Buyer need the Assets for a new securitization? These and other matters will effect each party s ability to walk from the transaction. Each party may be too invested, in time and money, to have the sale fail. Is there a quick means for resolving disputes and/or determining defaults and remedies? As a practical matter, the parties will be more receptive to resolution if there is an expedited method to determine defaults and remedies and to resolve disputes. There are a number of dispute resolution mechanisms which are available and one or more of the mechanisms can be incorporated into the Agreement. A baseball arbitration clause might be incorporated to determine the adjustment in the purchase price if an Asset does not meet the Buyer s criteria, while an ADR provision might be included as a means to resolve disputes under the Agreement including a determination of whether or not a default exists and who has defaulted. The well crafted Agreement should provide for a number of methods of resolution in the event that only a portion of the Assets do not meet the criteria of the Buyer, separate provisions with respect to redetermination of purchase price if some of the 13
representations and warranties are not true and the Buyer elects to go forward, general defaults and remedies and a well thought out damage provision. In summary, what you write is what you get, but be careful what you write. #40084436 v\1 - asmarma - v5ck01!.doc - 1/5817 14