San Francisco Establishes Mandatory Seismic Retrofit Program For “Soft Story Buildings”

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Residential building owners must seismically retrofit their buildings, under a new law adopted by the City and County of San Francisco.

The law applies to wood frame buildings of three or more stories, or two stories over a basement or underfloor area that has any portion extending above grade.  Each building must also contain five or more dwelling units.  Finally, the focus is on older buildings where the permit to construct was applied for prior to January 1, 1978 and the building as not been previously seismically strengthened.

Why focus on these buildings?  Wood-frame, multi-unit residential buildings can have a soft, weak or open front wall line (a so-called “soft story condition”).  When the first story has perimeter walls that have large openings for garage doors or windows, few interior partitions, or is constructed of materials that have deteriorated over time, then the building is at a greater risk of damage in an earthquake.

Some buildings are exempt from the new law.  For example, a building that has been seismically strengthened within 15 years prior to the operative date of the legislation — June 18, 2013 — is exempt, but only upon the City’s approval of documentation showing that such work was properly permitted, completed and maintained as required.  (One has to question what standards the City will apply to determine whether the work was “properly . . . maintained.”)  Other buildings that have participated in City-approved, voluntary seismic strengthening programs are also exempt.

The legislation seeks compliance from building owners through a few mechanisms.  If the owner of a building is notified that its building is within the scope of the new law, the owner must engage an architect or engineer to submit to the City a “Screening Form.”  The form will require information on the compliance status of the property and a declaration from the owner stating whether the building is exempt from the law or the building’s applicable ”Compliance Tier.”   As of this writing, there is no fee payable for submittal or review of the “Screening Form.”

Alternatively, a building owner may submit an optional “Evaluation Form” to determine whether an existing building already meets the requirements of the new law.  It is also completed by an architect or a licensed civil or structural engineer.  The “Evalution Form” must describe the dates and scope of any seismic retrofit work as well as plans and other information that the City may require that are sufficient to support a declaration that the building satisfies the law.  The City will charge a fee for review of the optional Evaluation Form.

The City plans on sending a notice to each applicable building owner that it should comply with the seismic retrofit law.  However, some buildings may “slip through the cracks.”  In that case, the deadlines for compliance may be extended for property owners that do not have actual knowledge that their properties must be brought into compliance with the new law.

Each building that must comply is placed in a “Compliance Tier.”  All buildings, regardless of Compliance Tier, must submit a screening form or optional evaluation form within one year of the effective date of the law.

Tier 1 buildings are those that contain a Group A (assembly), E (education), R-2.1, R-3.1 or R-4 (various residential) occupancy on any story.  Permit applications for the seismic retrofit work must be submitted to the City within two years and the work must be completed within four years of the effective date of the new law.

Tier 2 buildings contain 15 or more dwelling units, with some exceptions.  Permit applications for the seismic retrofit work must be submitted for Tier 2 buildings to the City within three years and the work must be completed within five years of the effective date of the new law.

Tier 3 buildings are those that do not fall within the definition of another tier. Permit applications for the seismic retrofit work must be submitted for Tier 3 buildings to the City within four years and the work must be completed within six years of the effective date of the new law.

Tier 4 buildings contain a B (business) or M (mercantile) occupancy on the first story or in a basement or underfloor area that has any portion extending above grade, and buildings that are in mapped liquefaction zones, except for buildings in Tier 1. Permit applications for the seismic retrofit work must be submitted for Tier 4 buildings to the City within five years and the work must be completed within seven years of the effective date of the law.

For each non-exempt or non-complying building, the owner shall submit an application for a building permit for the proposed seismic retrofit.  A permit for the seismic retrofit work may include minor ancillary work, but generally shall be separate from any other permits for building alterations or repairs unless such work is triggered by or integral to the seismic retrofit work.  After the work is completed, the building will obtain a “Certificate of Final Completion and Occupancy.”  Any building that has been retrofitted under the law shall not be required to do another seismic retrofit for 15 years after June 18, 2013, unless damaged or further altered so it doesn’t meet the engineering criteria.  (Why wasn’t the safe harbor extended to 15 years after the property owner completes improvements complying with the law?)

If property owners do not comply, the City may post on the building, and record against the property, a notice that states:  “Earthquake Warning:  This building is in violation of the requirements of the San Francisco Building Code regarding Earthquake Safety.”  Other penalties may also apply.

Damaged buildings must be brought up to the new standards more quickly.  If a building suffers damage from an earthquake or fire caused by the earthquake that renders the building uninhabitable, results in structural damages that triggers the City’s retrofit regulations, or results in “disproportionate damage” as defined in the City’s code, the building must comply with the chapter within one year of the damage.

Special rules apply to historic buildings, if any portion of the seismic retrofit work will be visible from the exterior of the subject property.

How will property owners pay for this?  The costs have both building owners and tenants’ advocacy groups concerned.  (The costs of retrofit will be passed through to tenants through higher rents.)   The City announced that it has worked with real estate finance lenders and banks to make available seismic retrofit financing.  In addition, the City is considering the creation of a special tax mechanism to help finance the costs of the seismic improvements.  (In other words, the City may allow you to tax your own property to pay for the improvements, establishing an income stream for payment of up front costs.)  Of course, there is some relief for financially strapped landlords –  eligible landlords may file a hardship application with the City to seek temporary relief from compliance.

Achieving earthquake readiness is a laudable goal; however, it remains to be seen how property owners (and tenants) will respond when the economic costs of this new legislation impact their bottom line over the next few years.

Park District Need Not Comply with CEQA Prior to Taking Private Property

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A local government agency may start the process for condemning private property without first complying with the California Environmental Quality Act (“CEQA”), a California appellate court has held. Golden Gate Land Holdings, LLC v. East Bay Regional Park District (1st Dist. 2013).

The East Bay Park District (the “District”) proposed to take 2.88 acres of private property in fee title and a 4.88 acre perpetual, non-exclusive easement “. . . in order to construct, operate, and maintain a recreational trail . . . to be used by the general public for hiking, bicycling and equestrian use and other related uses.” The District authorized its special counsel to commence the proceedings necessary to acquire the property in the District’s name. The District filed a notice of exemption under CEQA stating that the District “has approved this project and found it to be exempt from CEQA.” The notice of exemption provided: “The subject parcels are being acquired for the purpose of open space protection and future public access.” As for the stated reasons why the project was exempt from CEQA: “This project consists of the acquisition of land in order to protect open space and to secure future public access to [Eastshore Park] and the . . . Bay Trail. . . . Any development of this property and land use changes would be subject to future CEQA review.”

The property owner filed a court action, asserting that the District had violated CEQA and the eminent domain law. The trial court found that the District had approved a CEQA ”project” — which consisted of both the proposed acquisition and the proposed trail improvements. For CEQA purposes, addressing the two parts separately would be improper piecemealing of the project, the court reasoned. The proposed improvements are sufficiently definite given the District considered three options for a trail site, selected one, has a design and price estimate for the improvements, and is now initiating the condominium proceeding. Nevertheless, the court determined that a public agency is permitted to initiate condemnation proceedings with “actual acquisition” conditioned on CEQA compliance. As a result, the court allowed the District to proceed with its eminent domain action before complying with CEQA, requiring the District to vacate only that portion of its resolution that provided that the project was exempt from CEQA.

The court of appeal turned quickly to the essential question: “when an EIR must be prepared in a case where CEQA and eminent domain law intersect.” Some California authorities suggest that CEQA review must be completed before a condemnation proceeding is started. However, the appellate court declined to follow those authorities. Instead, the appellate court held that a trial court did not have to vacate the entire resolution of necessity (a first step in an eminent domain proceeding) but could order a lesser remedy and vacate only a part of the District’s action. The appellate court relied on state statutes and equitable principles to give the trial court flexibility to fashion an appropriate remedy. Also, the court found “no evidence that, by continuing its eminent domain proceedings, the District was going to be prejudiced in its ‘consideration or implementation of particular mitigation measures or alternatives to the [proposed improvements].”

The District dodged a bullet in this case. When the appellate court agreed with the trial court that the District did not comply with CEQA, it should have been “game over” — particularly when the trial court found that the acquisition of the property was part of the CEQA ”project”! Even so, court of appeal held that the condemnation proceeding could continue. In my view, once the case was framed as whether a trial court had power and authority to fashion a narrowly tailored remedy, the property owner had an uphill battle. Courts are generally reluctant to limit their powers, particularly when the power that is being limited is one that allows a trial court to fashion a remedy that looks like judicial restraint. Nevertheless, CEQA played a big role in this case and it is a warning to local governments. Counsel for landowners will argue that this case continues the trend: public agencies must comply with CEQA before fully implementing a public project, even one that may have an “environmental benefit” like a park or trail. Counsel for local governments may be tempted to see this case as providing an “escape hatch” in litigation, arguing that a court can fashion a narrowly tailored remedy that allows “a portion of the action” to move forward while the local government complies with CEQA on an after-the-fact basis. Of course, CEQA requires analysis of “the whole of an action” and defines a “project” in that manner. When the “portion of an action” is something other than the eminent domain power and its well-developed statutory procedures and rich history in the case law, CEQA may very well require a different result.

Environmental Due Diligence In Real Estate and Company Acquisition Transactions

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Before a buyer purchases a company or a real estate asset, it should review and assess records and other information about the target for the purpose of providing input into potential environmental issues.  By performing environmental due diligence, a buyer can determine compliance risks, properly structure the deal, better value the target, and budget for integrating the asset into the buyer’s portfolio or operations.

Every buyer has an interest in identifying issues that will need to be resolved either prior to closing or after closing.  Up-front due diligence can quantify the costs to remedy a clean up or compliance problem or estimate a range of potential costs if further investigation is required.  If a property or product is contaminated beyond use thresholds, the presence of hazardous materials can rise to the level of preventing the business to operate.   A buyer can also be exposed to potential tort or civil liability for existing conditions at the property.  Finally, buyers are increasingly concerned about reputational risks, since many large corporations have corporate social responsibility (“CSR“) programs and reports.

Environmental due diligence can help value a target company or real estate asset.  Noncompliance with environmental regulations can be expensive to fix, as in the case of a company’s failure to install air pollution controls in its facilities.  The clean up of contaminated property can involve significant expense — in the millions of dollars — or interfere with the use or planned disposition of property.  For example, one company acquiring a target may desire to buy the target and then consolidate real estate assets and dispose of facilities that are no longer needed to efficiently operate the combined company.  If the assets of the target company that are to be disposed of are contaminated with hazardous substances, the property may have to be cleaned up prior to its sale as a separate asset, resulting in costs and delays in fully implementing a business plan.  Finally, the acquiring company may be unable to sell the target’s products legally if the target’s products do not comply with U.S. or foreign laws.

Fines and penalties imposed by the U.S. EPA can be as high as $37,500 per day per violation.  Because a myriad of federal, state and local regulatory authorities have jurisdiction over environmental compliance matters, noncompliance can trigger  conversations with regulators that impact the time, energy and financials of an acquiring company.

Early identification of environmental issues has several benefits.  First, the acquiring company can seek to avoid or resolve the issue prior to closing, through closing conditions and pre-closing covenants between the acquiring company and the target.  Second, due diligence can help business leaders appropriately value the target company or asset, if post-closing expenses will be incurred to bring the target into compliance.  Third, the parties can determine an appropriate deal structure.  For example, if a target company has numerous real estate assets and a few of them are contaminated, it may not make sense to structure a transaction as a stock purchase transaction, but rather as an asset purchase so that the contaminated assets can be excluded from the deal.  Fourth, the buyer and the seller can properly negotiate the amount of any escrow holdback from the purchase price for post-closing covenants or obligations, or determine the scope of any post-closing indemnity from the target (or a guarantor of the target).  Finally, an acquiring company can properly include post-closing environmental compliance costs into its integration planning and budgeting.  In this way, counsel and environmental health and safety professionals can engage business leaders in a conversation about the transition costs for bringing the target company or asset into compliance after closing, if necessary.

The environmental due diligence process is too complex to detail in a step-by-step way in this post, but a few essential elements should be mentioned.  It is very important to develop a due diligence strategy up front to assess compliance risks.  The more decision-makers have “buy in” on the strategy, goals and objectives of the model, the greater they will value the results of the investigations. A tiered approach to standard due diligence questions is a practical method, where general questions are followed by more specific questions once relevant issues are revealed.  This approach avoids unduly burdening the target with numerous potentially irrelevant questions.  Areas of concern can be explored either based upon publicly available information or upon the responses to due diligence questionnaires.  Representations and warranties should be included in the purchase and sale contract, customized in response to the results of due diligence.  Representations and warranties are frequently used to test assumptions and flush out accurate facts about a target.  Finally, among other things, the model should include guidance on how to deal with “red flags” and “deal breakers” that are identified during due diligence.

In today’s transactions, environmental due diligence often starts with access to a data room or electronic document depository.  As a condition to access, a buyer will likely have to sign a confidentiality agreement, which should be reviewed by counsel prior to execution.  Due diligence periods are often limited, so counsel should be consulted to determine a realistic amount of time to fairly collect, review and analyze information that will be useful for decision-makers.  To the extent that confidentiality concerns may limit the exchange of information, counsel for the buyer and the seller need to be focused  on the objective of consummating a deal that makes sense for both parties.  It may be necessary to think creatively to resolve confidentiality issues so that the deal can be properly structured and evaluated.  For example, the number of individuals with access to highly sensitive information can be strictly limited to those with a need to know.  Failing to reveal information that is material can result in future claims of fraud and concealment against a target — claims that cannot typically be avoided through the application of “as is” clauses or release provisions in a purchase and sale contract.

In addition to documents provided in an electronic data room, environmental due diligence may need to include a review of filings made with regulatory authorities.  Occasionally, the target company will have to consent to the release of this information, particularly regulations recognize that such filings may include trade secrets or other proprietary information, such as the chemicals used in a particular process.  The buyer’s coordination with the target company is crucial in order to maintain good relations with both the target and the regulator.

Finally, environmental due diligence typically involves the hiring of a third party consultant to enter and inspect the property.  Prior to the entry, a target will typically require an access agreement and proof of insurance.  It is important that counsel review the scope and limitations in the access agreement, so that the buyer and the seller understand the types of inspections that are permitted and a process is established for more extensive inspections should problems be revealed.  An inspection of the property can be merely visual or invasive.  A Phase I Environmental Site Assessment is an investigation designed to determine whether hazardous materials have been released on property and the potential for hidden liabilities for purchasers, owners, operators, insurance and financial institutions.  Proper compliance with the laws and regulations applicable to a Phase I Environmental Site Assessment is crucial to shielding the buyer from future liability under the federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA).  If the Phase I Environmental Site Assessment discloses matters of concern, a Phase II Environmental Site Assessment may be necessary which requires more invasive testing of the property. If the property is contaminated, consultants can characterize the extent of the release of hazardous materials and the potential remedial actions that may be required. Of course, any final corrective action would need to be approved by the applicable authorities who are becoming increasingly likely to impose “green and sustainable” remediation of sites. Hiring a consultant or counsel that has experience negotiating clean up solutions with regulators can help clients assess whether “green and sustainable” remediation will be required, which may be more costly than more traditional restoration methods.

Environmental due diligence is a complex process that requires coordination among buyer, seller, counsel and their consultants. Successful efforts rely on thoughtful preparation, open communication and strategic decision-making.

Managers of Delaware LLCs Owe Fiduciary Duties to LLC Members by Default

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A Delaware court has held that, in the absence of contrary language in an LLC operating agreement, the manager of a Delaware limited liability company owes fiduciary duties to the members of the limited liability company.

The court’s holding is significant because the Delaware Supreme Court has refused to expressly hold that such fiduciary duties apply. In fact, as recently as November 2012, the Delaware Supreme Court found that a lower court’s reference to fiduciary duties applying to LLC managers was “dictum without any precedential value.” Nevertheless, the lower courts in Delaware have not given up on the idea on imposing equitable fiduciary duties on LLC managers or managing members. As a result, until a final, express decision is rendered by the Delaware Supreme Court, real estate developers, operators, and investors should consult with counsel regarding fiduciary duties that may be imposed in the absence of other express language in their operating agreements.

The most recent case is Feely v. NHAOCG LLC (Del. Ch., CA No. 7304-VCL, 11/28/12). In Feely, the court allowed a fiduciary duty claim to move forward in a busted real estate development deal. The plaintiff, a member of the LLC, claimed that the manager “failed miserably” in his management role and his skills as a financier “proved to be illusory.” At the time of formation of the LLC, the manager told the members that he was “extremely well-connected in the world of financing” and that he had an extensive “book of business” that he would be able to employ to seek out and secure sources of debt and equity financing.

The plaintiff further alleged that a development project in Florida failed due to gross negligence, when the manager failed to provide the entire deposit called for by the written purchase agreement for the property and failed to fix the mistake during the cure period, even after the LLC’s counsel flagged the issue. The seller declared a default under the real estate purchase agreement and cancelled the contract. As a result, the LLC forfeited a portion of its deposit, became obligated to reimburse a co-investor for its investment, suffered financing penalties, and lost the fees that would have been earned had the deal closed. Finally, the plaintiff asserted that the manager of the LLC began “negotiating student housing deals for his own account” instead of presenting them to the members of the LLC.

The defendant manager argued that LLCs are creatures of contract and the managing member of the LLC owes only the duties expressly stated in the operating agreement. However, the court disagreed with the defendant manager’s theory. “Numerous Court of Chancery decisions hold that managers of an LLC owe fiduciary duties,” the court stated, “unless those duties are eliminated, restricted, or otherwise displaced by express language in the LLC operating agreement.” While the Delaware Supreme Court has not yet finally determined whether LLC managers owe fiduciary duties — and in fact had found that a lower court’s decision that such fiduciary duties were “dictum without any precedential value” — the court nevertheless reasoned “the long line of Chancery precedents holding that default fiduciary duties apply to the managers of an LLC . . . are appropriately viewed as stare decisis by this Court.” The court thus held: “Like the Delaware General Corporation Law, the LLC Act does not explicitly provide for fiduciary duties of loyalty or care; consequently, the traditional laws of law and equity govern.” The court goes on to say that the managing member of an LLC is vested with discretionary power to manage the business of the LLC and easily fits the definition of a fiduciary.

The court also dismissed an argument that the LLC’s operating agreement spoke to the issue of fiduciary duties, reasoning that an exculpation clause that shielded the manager “against liability for certain types of claims” did not “restrict, modify, or eliminate fiduciary duties.” The plain language of the provision eliminated monetary liability unless, among other things, “the act or omission is attributed to gross negligence [or] willful misconduct or fraud . . . .” As a result, the manager owed fiduciary duties to the other member of the LLC and may be held liable for damages if gross negligence or willful misconduct can be shown in the manager’s dealings in the real estate deal.

Delaware limited liability companies are often used as the entity of choice in real estate transactions in California and elsewhere. If a real estate developer or operator is the managing member of an LLC, it will be important to state in the operating agreement the extent of any fiduciary duties owed to the other members of the LLC when discharging its active responsibilities. The more clear the agreement, the better the understanding among the parties as to each party’s obligations under the LLC’s operating agreement. Without clear drafting, general equitable fiduciary duties under common law will apply, meaning that a body of case law will determine the parties fiduciary rights and responsibilities. Similarly, real estate investors that are “silent members” of an LLC or who typically only get involved in “major decisions” will want to have a very clear understanding of the duties owed in the transaction. Sometimes a fiduciary relationship will make sense for both the “sweat equity” and “money” in a transaction; in other situations fiduciary relationships are not necessary for one or more parties if each party’s rights and obligations are spelled out clearly. In either case, consulting with counsel will help to make sure that the parties are on the same page.