Restaurant Law Blog

Monday, January 15, 2018

Crowdfunding; Multiple Investors and Commercial Real Estate Lease Issues

The concept of investing using an internet crowdfunding model is a fairly recent development and commercial leases often are behind the curve.  A business owner planning to raise capital through an online equity crowdfunding platform would be prudent to pay close attention to restrictions that are often contained in the assignment provision of its commercial lease agreement.  Generally, clauses governing a tenant’s right to assign or sublet are some of the most detailed, complex and extensively negotiated provisions of a commercial lease, partly due to the fact that a tenant’s covenant that it will not assign its lease cannot be implied.  Landlords who want to maintain control over the identity of their commercial tenant, are therefore expected to include within the lease explicit language restricting those types of transfers which cannot be performed without first obtaining landlord’s written consent. Additionally, because New York courts disfavor assignment prohibitions, viewing them as a restraint on alienation, clauses intended to restrict lease transfers must be clear and precise in order to pass judicial scrutiny. 

Most landlords employ an evaluation process to vet prospective hospitality tenants, and this process includes rigorous screening of each prospective tenant’s financials, credit and rental history, experience, food and beverage concept, as well as other intangibles such as business acumen, management style, and industry reputation. Landlords are justifiably cautious when it comes to selecting who will occupy their space and, therefore draft commercial leases to expressly prohibit, or limit, a tenant’s ability to assign its lease to an unknown third-party without landlord’s blessing. The most common transfer restrictions are those that address direct assignments (i.e. the transfer of a lease from one tenant to another).  Less common, but no less impactful, are transfer restrictions which regulate indirect assignments.  In this Section, we limit our discussion to indirect assignments resulting from the sale and issuance of stock and the admission of new shareholders into a corporation which, is already bound by a commercial lease.  It is in this scenario that equity granted through crowdfunding campaign proves to be the most problematic.

The lack of sufficient capital is a major reason why many restaurants fail.  All too often inexperienced restauranteurs underestimate the capital requirements of their intended business, while others start with nothing more than a nickel and a shoestring but have no actionable game plan outlining how additional capital will be secured when necessary.  A recurrent byproduct of this head-in-the-sand approach is the failure to properly review and negotiate critical lease terms such as the circumstances under which a future change in the tenant entity’s stockholdings will require landlord’s approval.

Many landlords believe that a change in corporate holdings, or control of a commercial tenant, should be regulated as though it were an assignment. If not regulated, a tenant could effectively achieve the parallel of a lease assignment (and skirt the limitations thereof) through a successful reorganization that shifts the governing authority of a tenant, and by extension the premises, to an unvetted third-party.  Notably, in the context of commercial leasing, a shareholder in a tenant entity has an absolute right to sell his or her interest to a third-party and a corporate tenant has the absolute right to issue additional shares in the corporation to existing or new shareholders in the absence of lease language explicitly requiring landlord’s consent to any proposed change of control or stockholding.  As such, most commercial leases contain some form of limitation over a tenant’s ability to alter its corporate structure or stockholdings.  The justification for this is that publicly traded corporations lack the ability to control the purchase and exchange of its shares which are freely traded on the open market.  The consequences of proceeding without such an exemption could prove not only difficult for the imprudent public corporation that executes a commercial lease under these circumstances, but also a reasonably foreseeable fiscal and legal catastrophe for both parties to the lease. In this regard, attorneys representing a pass-through entity which is wholly owned by a publicly traded company, or a pass-through entity that intends to go public, or sell its business to a public company, in the relatively near future, would be wise to insist on the inclusion of a similar exception.  

Similar to the manner in which direct assignments are handled, indirect assignments often require landlord’s prior written consent to any corporate reorganization or amalgamation with another entity, often irrespective of affiliation.  While it is common to see indirect assignment restrictions contained in your standard hospitality lease, the wording of such restrictions can vary appreciably.  Many commercial leases contain over simplified language intended to limit, but necessarily define, changes of control occurring with respect to the tenant entity itself, while others contain exhaustive language defining ‘control’, and describing in exacting detail what constitutes a ‘change of control.’   Still others require that any change in stock holdings, regardless of its corresponding ownership percentage or whether it comes with any voting rights, be pre-approved by the landlord.   

Astute tenants aim to preserve their assignment rights, both to ensure that necessary capital raises and reorganizations can be undertaken, but also as a general exit strategy should the tenant elect to sell its business or business assets. A well-crafted and equitable indirect assignment provision will balance the parties’ competing interests, but the norm, at-least in New York City, is that most indirect assignment provisions favor the landlord.  A typical transfer restriction might read:

For the purposes of this Article, a transfer of 51 percent or more of the beneficial interest in Tenant, at one time or in a series of transactions, and whether of the issued and outstanding capital stock, partnership interest, or otherwise, shall be deemed to be an assignment of this Lease.

A less favorable (albeit common) transfer restriction, might read:

If Tenant is a corporation or limited liability company, any dissolution, merger, consolidation or reorganization of Tenant, or any sale, assignment transfer, pledge, encumbrance or other disposition of any of the corporate stock or membership interest of Tenant, or, if Tenant is a partnership, any sale, assignment, transfer, pledge, encumbrance or other disposition of any interest in such partnership, shall constitute an assignment of this Lease. With respect to any assignment of this Lease to an assignee, Tenant, all of Tenant’s principals at the time of the assignment and any guarantor(s) of Tenant’s obligations hereunder shall remain jointly and severally liable (as primary obligor) with the assignee, and with any and all subsequent assignees, for the performance of Tenant’s obligations under this Lease during the balance of the Term, and, without limiting the generality of the foregoing, they shall remain fully and directly responsible and liable, jointly and severally, to Landlord for all acts and omissions on the part of any assignee subsequent to Tenant for a breach or violation of any of the obligations of this Lease.  

The latter provision is noticeably more restrictive since all transfers, regardless of scope and size, are deemed to be an assignment of the lease, while the former provision at-least exempts those transactions in which less than 51 percent of the tenant entity changes hands.  Arguably, the second provision should be viewed as more tenant friendly, but that does not necessarily mean it is equitable. 

The actuality of how many small hospitality businesses operate is frequently ignored in the game of tug of war that occurs when a landlord and tenant negotiate a commercial lease.  As previously mentioned, it is not uncommon for a lease to inadvertently omit a provision defining “control”, leaving the parties to argue that their respective interpretation should be incorporated into the lease.  Within the hospitality industry, many closely-held corporations are exclusively managed and controlled by a minority class of shareholders, and others, by a board of directors and appointed officers.  The degree of control vested in any particular shareholder, class of shareholders, board member or officer, is dictated by state regulation and through the by-laws of each corporation, and where applicable, the shareholders agreement.  It is common to see control defined as the ownership of the majority of a corporation’s shares, but it is equally common to see it defined by the right to cast a majority of the votes of a tenant’s entity, or a right exclusively vested in the board of directors, authorizing it alone, to control and manage a tenant entity and its day-to-day business affairs, notwithstanding the majority ownership of all issued and outstanding shares.  Stated simply, when it comes to the governance and operation of a corporation (or an LLC or partnership for that matter), control and majority ownership, are not always synonymous.  Consequently, boilerplate provisions designed to restrict indirect transfers often have the unintentional effect of limiting a company’s ability to secure additional capital or strategically reorganize, should the need or desire arise.  This is where crowdfunding becomes difficult. 

In many ways similar to a public corporation, small, closely held companies engaged in a crowdfunding campaign are, relatively speaking, unable to regulate the persons who might acquire an equity interest in their business.  While a landlord may agree to not unreasonably withhold its consent to the admission of new shareholders or the transfer of shares among existing shareholders, the mere act of seeking landlord’s approval of potentially hundreds of small, crowd-sourced investors is impractical, especially given that most lease agreements require tenant to either pay landlord a fee to review the proposed transfer, or at-minimum, cover landlord’s expenses which are connected to their review of the proposed assignment. 

Furthermore, depending on the sophistication of the landlord and the equity being granted, irrespective of voting rights, most tenants should expect some level of required disclosure for each new shareholder, meaning that the logistics of obtaining necessary material for a landlords’ consideration, could be a daunting task in and of itself, particularly if certified financials are being requested. 

While it is unlikely that most landlords would stand in the way of a corporate reorganization where only a small percentage of equity is issued to a pool of crowd-sourced investors, the likelihood for complication nonetheless exists and becomes exponentially greater as the equity offering increases.

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