Fried Frank’s Janice Mac Avoy Talks Real Estate Disputes and ‘Bad Boy’ Guarantees

Ms. Mac Avoy: I do both litigation and transactional work. Because of that I think I bring a unique perspective to both. When I’m looking at a transaction, I know how courts tend to interpret things. Of course, I can’t predict what courts will do but I have the 20-something years of experience knowing how courts tend to read contracts, and I also know the kinds of things that are likely to give rise to future disputes. Real estate tends to be a longer-term investment so you have to look at things over many years. That’s helped me bring a fresh eye to issues for my clients on the transactional side. From the litigation side, having the transaction experience helps me understand the underlying dispute, to try and resolve it and explain the underlying transaction to a court.

What are some of the more interesting real estate disputes you’ve worked on in the last year?

There was a very interesting and complex issue with respect to air rights that had been transferred pursuant to ground lease structures. Prior to the 1997 amendments to the Zoning Resolution of New York City, there really wasn’t a standard way for air rights to be transferred from one parcel to another. At the time, they were done with ground leases, where one owner would enter into a ground lease with the adjacent owner. The Zoning Resolution said that if you have a ground lease with an adjacent parcel with a smaller building, you could use the extra air rights on that adjacent parcel to build your tall building. It’s come up twice this year—what happens when these leases expire? These were typically long-term leases that were entered into in the 1960s and none of them have expired yet. It’s a very interesting and complex issue to think about how a court will address a situation that they’ve never seen before.

Are many of the cases you’ve been working on joint venture and family disputes?

I’ve definitely developed a weird subspecialty in real estate family disputes. I see a lot of situations where either the father or grandfather amassed a sizable real estate portfolio and then the second or third generation begins to disagree about what should happen. There are significant tax consequences for separating real estate, which can be very difficult. If the property has been held in the family for many years, it could be a huge tax hit.

Trying to work out a resolution, a way in which the parties can separate, without incurring those large taxes is part of the challenge. And then you get the emotional overlay. You are working out both the complex psychological and emotional issues as well as the financial issue, which is trying to get a grasp on the value of the real estate and find a way to split it up without incurring the taxes. You also see situations where certain family members are trying to avoid conflict and trying very hard to bend over backwards and will leave value on the table in order to have family harmony.

What trends are you seeing with mortgage foreclosures in mid-2015?

I’m seeing a little bit more workout activity than I had seen in the past. In the last two years I really hadn’t seen a lot of foreclosure activity, but in the last year I’ve seen an uptick of not necessarily filed foreclosures, but potentially threatened foreclosures, in terms of primarily development sites. Developers will have initial acquisition financing and the idea is to go out and get permanent construction financing. I’ve seen a number of instances in which the developer hasn’t been able to get their act together and hasn’t been able to get the permanent construction financing.

I’ve also been involved in a couple of workouts now, representing both lenders and borrowers, where there have been losses of major tenants. Without the anchor tenant, you are no longer making the money to support the debt. I hadn’t seen that in a while, but now I’m working on three different situations where that happened. In one I’m representing the lender and in two I’m representing the borrower. In each instance we’re trying to work out something that makes sense for both the borrower and lender. Two are office and one is outer-borough retail.

One of the most talked about issues right now is the rising cost of rent in New York. What kinds of commercial fair-market rent cases are coming to the table?

There are two types of fair-market rent cases. The first is long-term office leases where a significant office tenant has, let’s say, a 20-year lease. The first 10 or 15 years of the rent will be fixed and then at some point it will reset to fair-market value. Typically, in a steady market, the landlord and tenant will agree what that rent will be and avoid an arbitration. In a market like you have now, where you have rapidly rising rents and resistance from tenants, you’ll go to arbitration. The same thing happens on ground leases where the ground leases are also resetting to a fair-market percentage of the fair-market value of the land. There have been a handful of instances in the last two years, something that I had never seen before, where ground tenants have gone through a rent reset, and the rent is just too high and they will turn the building back over to the owner.

I am seeing some situations where the landlord is not quite sure what they want to do with the site—is this a potential development site or is this an office building that I want to keep as an office building? We’ve seen so many interesting trends in the city in recent years about neighborhoods changing. Now that you have a more fluid market I think you see landlords or developers who want to reevaluate their assets. Is the highest and best use of this asset to stay as an office building or could they get more value converting it to condos or to a hotel? You can’t just decide that you want to convert an office building into a beautiful retail, condo facility. That’s going to take planning. It can be very advantageous to a landlord to keep a paying tenant in for a short time, and then the tenant also has a little more time to think about what its next move is.

When did “bad boy” guarantees become commonplace?

In downturn in the ’90s, when real estate values dropped precipitously and all of a sudden properties were underwater, borrowers started filing for bankruptcy. In many instances that would add up to an additional two years before the lender could get the asset. After that experience, when lenders were very badly burned by bankruptcy, they started including the bad boy guaranty.

What constitutes a “bad boy” act?

There are a series of above-the-line loss recourse and below-the-line full recourse. Mechanics liens, failure to pay insurance premiums, stealing security deposits, stealing rents—those types of things tend to be loss recourse. Whatever the lenders losses are from that specific event, the guarantor has to pay. Full recourse tends to be bankruptcy or bankruptcy-related events. You also sometimes see a transfer of the property as full recourse.

Can you speak to some of the other nuances of bad boy guarantees? What happens when mezzanine debt is involved?

There were instances in the last downturn where the first mortgage was covered, but the mezzanine loan went into default and the mezzanine lender foreclosed. Then the mezzanine lender tried to mess with the mortgage lender and they filed for bankruptcy. There were also instances in which lenders went after the original mezzanine borrowers because they had that guarantor on the hook. The guaranty didn’t say that if someone else causes the borrower to file for bankruptcy you were liable, it said if the borrower files for bankruptcy you were liable.

Borrowers have become much more sophisticated about that and lenders understand, too. There are now carve-outs to the carve-out, so if a mezzanine lender forecloses, the borrower is no longer liable for anything that happens after that time. Also, in the inter-creditor agreement between the mortgage lender and the mezzanine lender, the mortgage lender will not allow the mezzanine lender to foreclose unless a replacement guarantor is provided.