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"Give me the Plasma TV" - Tenant Improvements -
Issues and Answers
 

By Brock Johnston                    December 9, 2003 

The Story

Iím a tenant. I want it all. Carpets, cabinets, countertops, built-ins, spiffy ceilings, wall coverings, granite toilet bowls and a plasma TV. Oh, and I want the Landlord to provide it, or enough money to let me do it. I also need to borrow money for my business, and I need my premises and my property as security for my bank . I will need to lease some stuff too.

Iím a Landlord. I love ya, but I need to finance what you want and I need security for what I provide . Oh, and Iím going to want my money back, and rent too.

Good, itís a deal.

[Nine months later] "Whereís the rent?"ÖÖÖ "I donít have it."

Who's on First?

When a business fails, the debate begins. A landlord can seize goods to collect rent arrears, but insolvency or bankruptcy of a tenant can severely limit the amount which may be recovered. What if somebody else owns property on the premises? Maybe thereís a subtenant or franchisee. Does any other creditor of the tenant have some kind of security? Maybe government or an unpaid trade or supplier has a lien. What property of the tenant is affixed to the premises, and how? Different rules govern claims against unattached personal property and fixtures. These and other variables have produced extensive litigation and a great deal of frustration among landlords, lenders, equipment lessees, building trades and suppliers.
 

Tenant Improvements

Ordinarily, when negotiating a commercial lease, a tenant will try to have the landlord provide or finance improvements to the premises over and above the base building standard. For instance, the tenant may seek to have the landlord provide carpets, cabinets, built-in furniture, upgraded ceilings and lighting and, generally, seek to have the landlord build out the premises to the tenantís specifications. The tenant may also seek funds to acquire furniture, fittings and equipment and otherwise assist with the move.

Of course, the landlord does not provide free work and materials or a tenant improvement allowance out of the goodness of the landlordís heart; the landlord expects to recoup the cost of such tenant inducements on an amortized basis over the term of the lease, either as a component of base rent, or less commonly, by way of a loan to the tenant which is repaid during the term.
 

Competing Interests

It is not just the landlord who may finance improvements to the tenantís premises or the tenant's furniture, fittings and equipment.

The tenant may obtain financing from a bank or other conventional lender and, if the tenant is a corporation, the tenant may obtain funding for these purposes from its principals or related companies. The tenantís lenders may provide financing of the tenantís business generally or the lenders may provide financing for specific items or categories of items. The lenders may secure their loans by way of general security agreements or charges on specific items.

The tenant may also obtain equipment and other items by way of lease.

In order to protect their interests in goods which have not been paid for in full, lenders and lessors may perfect any security interest they have by registering a financing statement in the Personal Property Registry. If the financed or leased item is physically attached to the tenantís premises, a lender or lessor should protect its interest by filing a fixtures filing against the landlordís title under Section 49 of the Personal Property Security Act.
 

Tenant Failure - Where Do The Chips Fall?

Obviously, there is ample room for confusion and conflict in respect of competing claims for reimbursement by the landlord and the tenantís creditors when the business of a tenant fails.

Matters are further complicated by the fact that a landlord has a right to distrain the tenantís personal property (the act of seizing the goods of someone to enforce performance of an obligation) in respect of rent arrears. As well, the rules under the Bankruptcy and Insolvency Act, which can stay a landlordís remedies and severely limit the amount which a landlord may recover on a tenantís bankruptcy, can have a very dramatic effect on a landlordís claims.

The property on a tenantís premises may belong to third parties, such as subtenants or franchisees of the tenant. Some or all of the goods a tenant is selling may be on consignment. Furthermore, some of this property on a tenantís premises may be affected by claims by unpaid trades and suppliers under the Builders Lien Act. When it comes to competing claims with landlords, the rights afforded to the holders of purchase money security interest (security interests in relation to credit provided to acquire specific items) is different than that afforded to general secured creditors.

Finally, the rules which govern claims against unattached personal property are different from those which affect fixtures, which are somehow attached. The timing and extent and purpose of attachment of equipment to leased premises may be very significant when it comes to who has the best claim to the equipment. In particular, was an item attached to the premises to permit the tenant to better carry on its business (a trade fixture) or is the item merely an ornamental item or an item of domestic convenience? Trade fixtures and items of ornament or domestic convenience are tenantís fixtures and treated differently from landlordís fixtures - fixtures which are intended to permanently improve the premises.

The result of all these variables in the context of a defaulting tenant is an extremely complex area of the law which has produced extensive litigation and a great deal of frustration among landlords, lenders, equipment lessees and trades persons and suppliers.
 

What to Do?

It is in the interest of a landlord to avoid the morass which can arise in relation to tenant improvements. It is not possible to avoid the issues entirely, but some general principles should be borne in mind and documented in agreements with the tenant and third parties:

"Notice of Interest"

The landlord should file a Notice of Interest under the Builders Lien Act disclaiming responsibility for any work undertaken for or materials supplied to the landlordís tenants. Such a filing is extremely simple to do and will go a long way to protect the landlord from buildersí lien claims for work which the landlord is not doing itself. In addition, the landlord should not pay out a tenant improvement allowance unless satisfied that all trades and material suppliers have been paid in full or will be paid from the allowance.

"Prohibit Financing"

The landlordís lease can prohibit financing by the tenant of improvements, fixtures and equipment which are paid for or provided by the landlord. The landlord may also prohibit the financing of fixtures, regardless of who has paid for them. Note that, absent a covenant to the contrary by a tenant, there is nothing to stop the tenant from arranging financing on its interest in fixtures and other property, regardless of who has provided or paid for such items. If the items are fixtures, the tenantís secured creditors can file a fixtures notice in respect of the fixtures against the landlordís title, without notice to the landlord. Arranging for the release of a fixtures filing in respect of tenantís fixtures can be nuisance for the landlord.

"Identify The Owner"

The landlordís lease should be clear regarding ownership of tenant improvements Presumably, most tenant improvements, such as carpets, partitions, HVAC systems and plumbing and electrical systems will be the property of the landlord and will be left on the premises at the end of the lease, perhaps with a right on the part of the landlord to require the tenant to remove such improvements if the landlord so elects. But especially if these items have not been provided by the landlord, this understanding should be made explicit in the lease. With respect to tenantís fixtures (being primarily trade fixtures or decorative fixtures), it should be clear that if the lease is terminated for any reason, the tenantís trade and other fixtures cannot be removed unless the tenant is not then in default; if the tenant is in default, these items should be the sole property of the landlord to do with as the landlord may desire.

"Prohibit Security"

The landlord can provide in its lease that the tenant is prohibited from granting a security interest on any property of the tenant on the premises. The reason for such a prohibition would be to ensure that if the landlord levies distress for rent arrears, that the landlord is not met with competing claims from the tenantís creditors. On the other hand, in many circumstances, such a prohibition is unrealistic and is likely to be ignored in practice; most commercial tenants have loans in place in respect of which they will have given some sort of security to their banks and third parties over their inventory, equipment and other property. Note that even if the tenant has promised not to grant security on the tenantís property (commonly called a negative pledge), if the tenant breaches this promise, the security granted to third parties is likely to be effective.

"Letters of Credit"

Another means of securing the position of the landlord is to obtain a letter of credit from a financial institution. Sometimes these letters of credit reflect the value of leasehold improvements or tenant improvement allowances provided by the landlord. The face amount of the letter of credit may decline as these amounts are amortized. As a result of the current, somewhat confused case law in respect of letters of credit in relation to landlord and tenant matters, if the landlord obtains a letter of credit, it is imperative that the letter of credit be characterized, not as security for the performance of the tenantís obligations, but rather as an indemnity in respect of any loss suffered in the event of the tenantís failure to perform its obligations under the lease. Ideally, the letter of credit would be issued on behalf of a co-covenantor, rather than the tenant itself. This is because, if a tenant becomes bankrupt, all claims against the tenant are stayed and its liabilities will be extinguished, save for a preferred claim for three monthsí rent. If the tenantís ongoing obligations are extinguished, then there is nothing for the letter of credit to secure. In this event, the courts have held that recovery on a letter of credit posted on behalf of a tenant may constitute "unjust enrichment".

"Security Interest"

The landlord may seek security for performance of the tenantís obligations, including in respect of recovery over the term of the lease of the cost of tenant improvements and any other inducements. In the lease, the landlord may claim a security interest in the tenantís goods for these amounts, but if the landlord does so, it is necessary for the landlord to perfect the security interest by registration of a financing statement under the PPSA and this is likely to trigger discussions with the tenantís lenders who are likely to require that the landlord postpone its security interest. Furthermore, in light the limitations on landlordís right of recovery under bankruptcy legislation, such security may have limited value if it purports to go beyond what is permitted by legislation. It is for these reasons that, even when a landlord claims a security interest in a tenantís goods and fixtures in the lease, it is not uncommon for the landlord not to bother to perfect its security interest by filing a financing statement under the PPSA.

"Waivers"

As noted above, the landlordís remedy of distress and any security interest granted to a landlord in a lease may conflict with the interests of third party secured creditors. Where items have not been financed by the landlord, it is not unreasonable for a lenderís security interest to have priority over a landlordís remedy of distress or a landlordís security interest. Accordingly, landlords are often approached by tenants with the request that the landlord enter into an agreement (commonly called a landlordís waiver) pursuant to which the landlord agrees outright not to levy distress or seize the tenantís goods. If the landlord claims an actual security interest, the landlord will be asked to postpone it. Such agreements also commonly provide that even if the tenant defaults, the landlord will notify the lender and allow the lender or a receiver a period of time to occupy the premises to liquidate the property of the tenant before the landlord exercises its own remedies.

While all of this is unattractive to a landlord, the reality is that for many tenants, if they do not obtain such an agreement from their landlord, they will not obtain financing and will not be able to operate as viable tenants in the first place. As well, if a tenant becomes legally bankrupt, the landlord is prevented from exercising remedies and must allow the trustee in bankruptcy to remain in possession for up to three months to liquidate the tenantís property and decide if the tenantís lease is to be disclaimed or preserved. As a result, the landlord is often prepared to enter into landlordís waivers as there may be little to lose. In such event, the landlord should use the landlordís waiver to clarify that the lender will pay rent if, after the tenantís default, the lender or a receiver is to occupy the premises. It also would be worthwhile to identify which tenant improvements and fixtures the lender has no claim against. Presumably, the landlord would insist that improvements, fixtures or equipment not financed by the lender cannot be seized by the lender.

If the landlord intends to enforce remedies against any tenant, the landlord should consider if a landlordís waiver or similar agreement is in existence. The landlord should ensure that, as a matter of course, all such agreements are maintained with the tenantís file for quick reference.

"Expiration of Lease"

The landlord should consider what is to happen to leasehold improvements and tenantís fixtures at the expiration of the lease. Ordinarily, the lease permits the tenant to remove trade fixtures if the tenant wishes without compensation to the landlord, so long as the tenant is not in default and repairs any damage. The landlord may require that such items be replaced with items of equal value. However, it may be worth considering if the tenant should be required to leave certain trade fixtures on the premises even if their cost has been recovered during the lease term. Restaurant equipment, for example, may be more valuable if left in the premises for a future tenant than if removed at the end of the term. Conversely, the landlord will likely want to retain the right to require that all trade fixtures and tenant improvements be removed at the end of the term, if the landlord so chooses.

It should be clear that the tenant is to repair any damage incurred by removal of fixtures or improvements. The cost of demolishing and removing tenant improvements can be significant, and this can also be the case for some tenantís fixtures, such as bank vaults or extensive cabling. The landlord and tenant should consider at the time of the lease if there are specific items which should definitely be left in place or removed in any event.

"Income Tax"

From an income tax point of view, a tenant inducement is ordinarily a taxable expense to the landlord in the year paid, and is taxable income to the tenant in the year received. However, if the inducement is used to acquire depreciable or capital property, as is likely to be the case for many tenant improvements, rather than include the inducement in income for the year, the tenant may elect to reduce the capital cost of the acquired property in the year the inducement is received, during any of the three prior years and in the year subsequent to the year in which the inducement was received. On disposition of such property, including upon surrendering such property with the premises at the end of the term, the tenant would be subject to recapture, based on the fair market value of the property at the time. Note that if, pursuant to the terms of the lease, the property which constitutes a leasehold improvement never belongs to the tenant in the first place but only to the landlord, it is the landlord who would claim depreciation expense.

So far as possible, the landlord should take into account the above principles on a standardized basis and be reasonable and pragmatic in its approach. While it is possible to craft provisions which are extremely favourable to the landlord on all of the above points, if these provisions are unduly onerous, they will lead to unnecessary negotiations. Or what is worse, if unreasonable terms are nominally accepted by a tenant in its lease, these terms may be ignored in practice. Experienced counsel can be helpful in suggesting reasonable compromises in respect of the various competing interests noted in this article. When a dispute arises, the advice of experienced counsel is essential to avoid unnecessary and costly mistakes and resolve the dispute on a timely, cost effective basis.

- Brock Johnston

 

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