Prerogatives Provisions and Efforts Covenants in Commercial Real Estate Finance, The Practical Real Estate Lawyer
MICHAEL J. HURLEY, JR., managing partner of Cassin & Cassin LLP, represents institutional lenders in all aspects of commercial real estate finance including loans intended for sale, syndication, or securitization.
In addition, Mr. Hurley handles commercial transactions encompassing the sale and disposition of real property and equity interests, mortgage and mezzanine loan originations, and formation of entities for acquisition, ownership, development, operation, and/or management of real property.
He is admitted to practice in the State of New York and is a member of the American Bar Association, Community Bankers Association of New York State, Mortgage and Real Estate Finance Committee, CRE Finance Council, Mortgage Bankers Association of New York, where he served as President from June 2008-2010, National Multifamily Housing Council, and New York State Bar Association, Real Property Law Section.
BRET R. SALZER, a partner at Cassin & Cassin LLP, has more than 20 years of experience in executing complex real estate acquisitions, financings, joint ventures, and other development and operating agreements, preferred equity transactions, fund investments, buyouts, and dispositions.
Mr. Salzer represents investment banks, asset-based lenders, private equity funds, and developers as outside counsel. In addition, he has also acted as in-house counsel to leading real estate developers and operators.
In both capacities, Mr. Salzer has conducted numerous mortgage and mezzanine loan originations, acquisitions, dispositions, participations, restructurings, and workouts covering term, bridge, construction, and other financings of every real estate asset class, as well as other corporate, fund, and asset-level loan facilities.
RYAN M. VINES is an associate at Cassin & Cassin LLP. In this role, he focuses his practice on representing institutional lenders in closing commercial real estate loans intended for securitization or other sale on the secondary market.
He received his Juris Doctor from the Benjamin N. Cardozo School of Law and his Bachelor of Science, cum laude, from the University of South Carolina, Darla Moore School of Business.
During law school, Mr. Vines was Editor in Chief of the Cardozo Journal for Conflict Resolution, in which he published his Note, Developing Improved Tactics for Advance Pricing Agreements to Decrease Negotiation Lead Time, 19 Cardozo J. Conflict Resol. 191 (2017).
He is admitted to practice in the State of New York.
This article addresses prerogatives provisions and efforts covenants in commercial real estate transactions, primarily under New York law. Two of the more ubiquitous and interesting widgets of contracting technology, they play roles throughout the commercial world.
Since our practice focuses on commercial real estate, and especially commercial mortgage finance, we’ll tend to use examples from that arena (with a few useful detours). It so happens that prerogatives provisions are extremely common in mortgage loan documents, but efforts covenants much less so. By comparison, efforts covenants are a lot more common in commercial leases, sale/purchase agreements, joint ventures, and certain other transaction categories, both in the real estate world and beyond, as we’ll touch on below.
WHAT ARE PREROGATIVES PROVISIONS?
So — what are prerogatives provisions? A prerogative is simply any right, power, or privilege, and in real estate deal-making, typical examples of prerogatives provisions are those pursuant to which:
Party A’s consent is to be given (or not given) to Party B’s action (e.g., a lender’s consent to a borrower’s execution of a lease).
Party A has the power to make a determination of law, fact, and/or contract interpretation (e.g., an interest rate formula, financial ratio or loan balancing calculation, a funding shortfall, substantial completion of a project, qualification of a replacement guarantor or property manager, satisfaction of funding conditions, etc.).
Party A has the power to approve a deliverable (e.g., a rate cap agreement, a legal opinion, a budget, a title policy endorsement) as to matters of form and/or substance.
Party A has the power to choose whether to enforce or waive a right, option, or remedy.
Party A has the power to choose whether to perform or not perform an action (e.g., a lender’s decision to fund or not fund a construction advance, or a protective advance).
As the list suggests, one of the remarkable things about prerogatives provisions is how many of them there are and what a wide range of circumstances they touch on and concern in a commercial (and particularly a real estate finance) context.
Another is how much they vary in impact. Some concern routine, immaterial procedural determinations, while many others — if exercised to their fullest — can confer on lenders life-or-death powers over borrowers. People tend to think of consent provisions as a placeholder for this category of concepts, but prerogatives provisions cover a lot more ground.
Prerogatives are commonly expressed either as being exercised “in good faith,” “reasonably” or “in the holder’s discretion,” or some variant or combination of the three. (Commercial custom, plain language definitions, and the New York courts all seem to generally agree on the meanings and therefore the functions of these seemingly vague terms, as we will discuss below.)
What are efforts covenants?
Efforts covenants are those pursuant to which one party has an obligation to use a certain level of effort in furtherance of satisfying or achieving a condition, state of facts, other result that is vague, uncertain, and/or partially or potentially out of that party’s hands. In the real estate finance context, one sees obligations on the borrower’s part to use “reasonable,” “commercially reasonable,” or “best” efforts (or some variant thereof) toward a wide range of uncertain and contingent outcomes including:
Completing a project by a target date;
Enforcing the contractual obligations of a tenant, property manager, construction manager, or other counterparty;
Causing specified rentable space to be leased on market terms or in accordance with specified parameters;
Obtaining specified insurance policy clauses or endorsements that may or may not be available;
Obtaining an estoppel from a tenant or other counterparty not required to provide one;
Obtaining specified licenses, permits, approvals, or the like;
Ensuring that the lender’s lien is not adversely affected by a potential future license or franchise expiration/replacement process;
Ensuring a favorable and speedy disposition of a theoretical future contested injunction against construction; or
Cooperating with a loan sale process.
One also occasionally sees efforts obligations binding on lenders. For example, a loan application might obligate the lender to use reasonable efforts to close the loan by a specified target date, or a loan agreement might obligate the lender to use good faith efforts to fund a draw request on the requested date. Finally, a borrower’s ability to receive a refund of a good faith deposit might hinge on its having exercised commercially reasonable efforts to perform its obligations under the application.
How are prerogatives provisions built?
Having described and illustrated our terms with a few examples, let’s next articulate how they’re typically constituted and formulated, sticking with our commercial mortgage lending context.
Focusing first on prerogatives provisions, the fundamental topic for debate — whether the context relates to a lender’s right to grant or withhold a consent, make a determination, approve a deliverable, enforce or waive a right, and perform or withhold an action — is almost universally the standards that will apply to the lender’s exercise of its right. What are they? And are there any?
And lenders, in their standard form lending documentation, typically make use of shorthand language — up to and including “in lender’s sole, absolute, and unfettered discretion” — to describe the standard; whereas in the course of transactions, borrowers sometimes successfully negotiate for some form of reasonableness standard instead.
How are efforts covenants built?
Next, let’s consider how efforts covenants are typically constructed.
Whenever loan documents obligate a borrower to act in furtherance of an outcome that it can’t fully control, the basic question implied is always, “What standards will apply to the borrower’s performance of its obligation?” By way of opening bid, lenders’ standard form loan documents typically use phrasing up to and including, “Borrower shall use its best efforts” to describe the standard in shorthand, whereas, again, borrowers sometimes successfully (just how successfully, we will return to consider) negotiate for some form of reasonableness standard instead.
WHAT DO THE PARTIES THINK THESE CONSTRUCTS MEAN OPERATIONALLY?
Of course, all of this is just the start. These widgets fit into many different niches and play many different roles within our world of complex contracting technology. Sometimes they stand alone, and may by themselves constitute major deal points, and other times they play silent or supporting roles.
With all their versatility, it’s not surprising that both of these constructs are renowned for the degree of negotiation that goes on around them — to such an extent that one not infrequently hears expressions of weariness about it all.
In fact, given all the vagueness of the terms and the complexity and variability of their roles, what is surprising is that people seem to have such strongly held ideas about what’s at stake with the negotiations.
In other words, there seem to be well-established expectations and a broad degree of agreement in the marketplace as to how the terms, once settled by negotiation, actually function to govern borrowers’ operational conduct.
WHAT HAPPENS IN COURT?
How does all of this play out if a dispute over someone’s exercise of a prerogative, or failure to exercise sufficient efforts, puts these concepts to the test in litigation?
New York’s case law supports the conventional wisdom among parties and counsel regarding the application of prerogatives provisions but confounds the conventional wisdom as to the application of efforts clauses.
Prerogatives
Whenever Party A makes a choice that it has the right to make in its sole discretion, and Party B is aggrieved by that choice, one of Party B’s most typical arguments is that state law implies a covenant of good faith and fair dealing on Party A’s part, and that Party A’s choice violates that covenant. In some states and under certain conditions, this argument has prevailed, but in New York it doesn’t seem to be viable, at least within the limited scope of situations described in the opinions.
New York’s courts have consistently shielded sole discretion-based prerogatives provisions from implied covenant attack to such an extent that such provisions lend certainty and therefore stability to real estate transactions: People know what they mean and act accordingly. Certainly, some of those who subject themselves by contract to discretionary prerogatives end up aggrieved when the prerogative holder succumbs to moral hazard and abuses the leverage built into the prerogative. In those cases, the line is bright — there is no implied consent-based relief to be expected from New York courts.
Exceptions are made perhaps for certain cases of unfair asymmetry in bargaining power or some other equitable reason, but generally speaking, people able to fend for themselves in the commercial marketplace know where they stand with “sole discretion” and know what they have to do in order to avoid it — either successfully bargain for a reasonableness standard (such as “consent will not be unreasonably withheld”) or do not proceed with the transaction.
For example, in Transit Funding, LLC v Capital One Equipment Finance Corp., a commercial line-of-credit loan case, the loan agreement gave the lender the right to decline any request for a loan advance in its “sole and absolute discretion,” the court held that the implied covenant of good faith and fair dealing was no basis to force the lender to make an advance, and also not a basis for a damage claim by the borrower. In the court’s words, “motivation…is irrelevant.”
There is some indication in the case law that the implied covenant of good faith and fair dealing requires the acting party not to act arbitrarily or irrationally, but that does not stop the acting party from acting selfishly — even to the destruction of the counterparty. For example, several cases stand for the proposition that a lender does not have an “implied covenant problem” just because it conditions a consent to a loan assumption on raising the interest rate to a level consistent with the current market rate.
On the other hand, in Silver v. Rochester Savings Bank, a lender was obligated by its loan agreement not to unreasonably withhold its consent to a loan assumption, a New York court held that by conditioning its consent to a loan assumption on raising the interest rate to a level consistent with the current market rate, the lender did violate its reasonableness obligation.
In short, the courts are aligned with the marketplace understanding of the functional difference between “discretionary” prerogatives and those which must be exercised “reasonably” — the former are absolute, the latter are not.
Efforts
What about the best efforts versus reasonable efforts debate? In some jurisdictions, notably Delaware, best efforts means something more than reasonable efforts — but it may surprise some to learn that (broadly speaking) that is not the case under New York’s case law.
Essentially, New York seems to compress all the variants of this theme into one, so that best, reasonable, and good faith are more or less synonymous — and on a least common denominator basis, i.e., in the face of a naked efforts clause, New York courts will not bestir themselves to make best mean anything more than reasonable, or to make reasonable mean anything more than good faith, regardless of plain language and market usage arguments to the contrary. (And New York is far from alone in taking this seemingly quirky posture.)
Why this result? In a word, the concept of efforts seems to be too situation-specific for courts to develop a one-size-fits-all definition or means of applying it, absent context in the documents or in the specific industry, market, asset, or parties. In fact, the New York (and other) courts have historically been inclined to find the concept void for vagueness, only to relent as the volume of transacting parties using them has continuously grown.
In addition to its vagueness (lack of operational meaning without context), efforts has an element of ambiguity to it, in that by its dictionary definition it has two very different senses — an objective sense reflected in visible activity and a subjective sense reflected by invisible states of mind. This seemingly academic distinction is actually a practical one, for two reasons: (i) some courts actually recognize the distinction between an objective version and a subjective version of efforts, in which reasonable efforts are subjective and commercially reasonable efforts are objective; (ii) second, parol evidence is admissible in some courts in case of ambiguous provisions, but not necessarily vague provisions under New York law.
SETTING THE CONTEXT
In the present environment, more pressure is certainly coming to bear on any number of transaction-based relationships in commercial real estate, so more litigants will likely test the shorthand in courts. But we see no reason for the courts to change their approach as a result of the added volume.
It’s probably smart to pause now, in a time of ongoing uncertainty in politics, the economy, and public health, to be on guard and recognize that many contracting parties may feel heightened pressure these days to leave things unsaid, uncharacterized, or unspecified about relevant contingencies and their respective responses to it.
Picture the broad range of commercial real estate transactions and ongoing contractual relationships — from purchase/sales, to debt and/or equity financing arrangements, ground and space leases, and construction, management, and/or operational/franchising agreements. One thing they all have in common is that no one expects the documentation to cover every eventuality, much less to articulate the party’s detailed understandings about how each eventuality (should it actually occur) would be addressed.
In order to avoid costly and time-consuming negotiation, based on assumptions and calculations that might not be well-founded, parties often use shorthand language — sometimes even mere buzzwords — rather than spelling things out in detail. In law as in life, it’s bound to happen when we try to govern complex relationships in uncertain environments with limited transaction budgets and limited time to focus beyond today’s problems.
All of this means there are gaps, gray areas, and vagueness in every contract. Some of this is mitigated by generic yet detailed further assurance clauses, cooperation covenants, and certain other boilerplate provisions. These are not shorthand. They are fully articulated sets of interlocking covenants that address post-closing cleanup and other similar concerns, and do it generically.
And some of the vaguest, grayest gaps are never filled, clarified, or specified at all. In that case, one party might not have given the matter any consideration — or might have simply reckoned that (for whatever reason) any time, effort, or money spent to address it would be wasted. The other party, perhaps, thought it best to remain silent on the subject. Cost-benefit analysis is easy to do if you don’t sweat the long term too much, or, on the other hand, if you think you know better than your counterparty what the long term will really bring.
But real estate transactions are also, and frequently, characterized by much more specific (yet still extremely flexible) bits of technology for providing some form of guidance on a given concept or topic, while avoiding a detailed road map.
And prerogatives provisions and efforts clauses? They are probably among the most popular of these technologies. For principals and their lawyers alike, there are times when it’s worth a closer look at these two ubiquitous yet tricky standbys of the contracting toolkit.
In non-lending contexts, efforts provisions are particularly common in purchase and sale agreements, where the seller or buyer each may have one or more efforts obligations to perform in support of clearing specified conditions precedent to the closing. In this case, the entire deal hinges on the efforts clause.
Outside of real estate, efforts provisions are staples of certain kinds of contracts such as merger/acquisition agreements and exclusive marketing and distribution agreements. Here again, efforts clauses are fundamental, in this case because they relate to one party’s obligation to generate contingent proceeds using the other party’s good will, intellectual property, or merchandise, the amount of which then determines the amount of the principal’s net profits or the selling party’s deferred purchase price.
One thing that is pretty obvious when thinking about efforts clauses is that — especially in the high-stakes sale/purchase and merger/marketing contexts — they tend to be accompanied by a specific kind of moral hazard: the risk that during the contract period, one of the two contracting parties might get cold feet or become distracted for whatever reason. If the party that regrets entering into the contract or allocating resources to it is also an “efforts obligor,” then there is a conflict of interest.
What’s more, the efforts party often has some level of plausible deniability about its motivations. The very fact that the condition precedent in question is partly or potentially out of its hands provides cover and camouflage for it to argue that any failure of the condition to be satisfied is due not to the insufficiency of its efforts but to other causes outside its control.
As a result, it should not be too surprising that many of the leading cases (in New York at least) on efforts clauses do involve parties who have effectively torpedoed the very same transaction in which they have committed themselves to make best efforts or commercially reasonable efforts to consummate.
And some of the New York courts do sometimes get mired in the complications that this moral hazard problem can cause. You often see efforts parties engaged in flagrant, even flamboyant, sabotage of the very goal of the contract that they are supposed to be expending efforts to help achieve. And that has been a distraction for the courts.
Equally clearly, prerogatives provisions are also inherently prone to moral hazard. When no one can call a person’s decision into question, you are essentially saying that nothing is out of bounds, nothing is wrong, the person can do no wrong — and that can’t be right, or so it would intuitively seem.
There is a particularly strong feedback loop between the front-end contracting process and the back-end enforcement process built into these tools, because they are both in essence mechanisms for deferring much of the process (and thus the cost) of specifying contract obligations to the future (including by the courts) but only to an unpredictable future in which a dispute has arisen. That cost deferral (and hopefully cost elimination) function is what makes them as popular as they are.
WHAT DOES IT ALL MEAN?
To get to the bottom of all this, it helps to recognize that prerogatives and efforts are very different creatures.
When contracting parties delegate a discretionary prerogative exclusively to one of the parties, they enact a governance rule between them covering a specified situation. It’s a low-cost bright line everyone can understand. If nuance is needed, one can add conditions, exceptions, or other qualifications — or replace discretion with reasonableness and then qualify that. But if we want no gray areas, we have a simple effective tool to avoid them.
The story’s different with efforts clauses, which serve a different function. They speak not to the task of setting up simple binary decision-making algorithms, but that of defining performance where uncertainty of one form or another precludes precise characterization of the performance. It’s all very complicated and subjective.
In that context, the word ‘best’ (or any qualifier) has impossibly too much work to do and one could say that New York courts have put us all on notice of that reality. As such, wise borrowers and lenders (and their counsel) will want to think twice about using the efforts concept at all. It helps that the nature of mortgage lending allows for a limited level of reliance on the concept. There are industries much more susceptible to the concern — for example, New York’s leading efforts case related to the acquisition of a beer distributorship business’s goodwill and distribution network and the buyer’s obligation to use efforts to monetize those assets.
So maintain awareness of how the courts treat these terms. Whether a loan application is being negotiated or a set of master loan documents is being created, it may be worth screening for them and confirming that principal and counsel are on the same page about what happens if it should come to litigation. And of course, since litigation is rare, and the market believes what it believes, one might conclude that no change is needed because the incentives are, ultimately, what the parties think they are.
CONCLUSION
This discussion of prerogatives and efforts provisions should reinforce two truisms. First, in commercial real estate, there are always tactical approaches to negotiation and drafting. Second, if the parties don’t take the time and effort to articulate their intentions clearly, courts won’t be particularly eager to allocate their time and resources to filling in the gaps. You can always prevent this situation by being very careful in commercial real estate drafting — not just with prerogatives and efforts provisions, but with all provisions of your documents.
Notes
Transit Funding, LLC v Capital One Equipment Finance Corp., 48 N.Y.S. 3d 110 (N.Y. App. Div. 2017).
Id. at 114.
Silver v. Rochester Savings Bank, 4 N.Y.S.2d 945 (N.Y. App. Div. 1980).
See, e.g., Holland Loader Company LLC v. FL Smidth A/S, 313 F. Supp. 3d 440 (S.D.N.Y 2018) (“When interpreting the meaning of a reasonable efforts clause, “New York courts use the term ‘reasonable efforts’ interchangeably with ‘best efforts'”).
Bloor v. Falstaff Brewing Corp., 454 F. Supp. 258 (S.D.N.Y. 1978).
Prerogatives Provisions and Efforts Covenants in Commercial Real Estate Finance, The Practical Real Estate Lawyer
MICHAEL J. HURLEY, JR., managing partner of Cassin & Cassin LLP, represents institutional lenders in all aspects of commercial real estate finance including loans intended for sale, syndication, or securitization.
In addition, Mr. Hurley handles commercial transactions encompassing the sale and disposition of real property and equity interests, mortgage and mezzanine loan originations, and formation of entities for acquisition, ownership, development, operation, and/or management of real property.
He is admitted to practice in the State of New York and is a member of the American Bar Association, Community Bankers Association of New York State, Mortgage and Real Estate Finance Committee, CRE Finance Council, Mortgage Bankers Association of New York, where he served as President from June 2008-2010, National Multifamily Housing Council, and New York State Bar Association, Real Property Law Section.
BRET R. SALZER, a partner at Cassin & Cassin LLP, has more than 20 years of experience in executing complex real estate acquisitions, financings, joint ventures, and other development and operating agreements, preferred equity transactions, fund investments, buyouts, and dispositions.
Mr. Salzer represents investment banks, asset-based lenders, private equity funds, and developers as outside counsel. In addition, he has also acted as in-house counsel to leading real estate developers and operators.
In both capacities, Mr. Salzer has conducted numerous mortgage and mezzanine loan originations, acquisitions, dispositions, participations, restructurings, and workouts covering term, bridge, construction, and other financings of every real estate asset class, as well as other corporate, fund, and asset-level loan facilities.
RYAN M. VINES is an associate at Cassin & Cassin LLP. In this role, he focuses his practice on representing institutional lenders in closing commercial real estate loans intended for securitization or other sale on the secondary market.
He received his Juris Doctor from the Benjamin N. Cardozo School of Law and his Bachelor of Science, cum laude, from the University of South Carolina, Darla Moore School of Business.
During law school, Mr. Vines was Editor in Chief of the Cardozo Journal for Conflict Resolution, in which he published his Note, Developing Improved Tactics for Advance Pricing Agreements to Decrease Negotiation Lead Time, 19 Cardozo J. Conflict Resol. 191 (2017).
He is admitted to practice in the State of New York.
This article addresses prerogatives provisions and efforts covenants in commercial real estate transactions, primarily under New York law. Two of the more ubiquitous and interesting widgets of contracting technology, they play roles throughout the commercial world.
Since our practice focuses on commercial real estate, and especially commercial mortgage finance, we’ll tend to use examples from that arena (with a few useful detours). It so happens that prerogatives provisions are extremely common in mortgage loan documents, but efforts covenants much less so. By comparison, efforts covenants are a lot more common in commercial leases, sale/purchase agreements, joint ventures, and certain other transaction categories, both in the real estate world and beyond, as we’ll touch on below.
WHAT ARE PREROGATIVES PROVISIONS?
So — what are prerogatives provisions? A prerogative is simply any right, power, or privilege, and in real estate deal-making, typical examples of prerogatives provisions are those pursuant to which:
As the list suggests, one of the remarkable things about prerogatives provisions is how many of them there are and what a wide range of circumstances they touch on and concern in a commercial (and particularly a real estate finance) context.
Another is how much they vary in impact. Some concern routine, immaterial procedural determinations, while many others — if exercised to their fullest — can confer on lenders life-or-death powers over borrowers. People tend to think of consent provisions as a placeholder for this category of concepts, but prerogatives provisions cover a lot more ground.
Prerogatives are commonly expressed either as being exercised “in good faith,” “reasonably” or “in the holder’s discretion,” or some variant or combination of the three. (Commercial custom, plain language definitions, and the New York courts all seem to generally agree on the meanings and therefore the functions of these seemingly vague terms, as we will discuss below.)
What are efforts covenants?
Efforts covenants are those pursuant to which one party has an obligation to use a certain level of effort in furtherance of satisfying or achieving a condition, state of facts, other result that is vague, uncertain, and/or partially or potentially out of that party’s hands. In the real estate finance context, one sees obligations on the borrower’s part to use “reasonable,” “commercially reasonable,” or “best” efforts (or some variant thereof) toward a wide range of uncertain and contingent outcomes including:
One also occasionally sees efforts obligations binding on lenders. For example, a loan application might obligate the lender to use reasonable efforts to close the loan by a specified target date, or a loan agreement might obligate the lender to use good faith efforts to fund a draw request on the requested date. Finally, a borrower’s ability to receive a refund of a good faith deposit might hinge on its having exercised commercially reasonable efforts to perform its obligations under the application.
How are prerogatives provisions built?
Having described and illustrated our terms with a few examples, let’s next articulate how they’re typically constituted and formulated, sticking with our commercial mortgage lending context.
Focusing first on prerogatives provisions, the fundamental topic for debate — whether the context relates to a lender’s right to grant or withhold a consent, make a determination, approve a deliverable, enforce or waive a right, and perform or withhold an action — is almost universally the standards that will apply to the lender’s exercise of its right. What are they? And are there any?
And lenders, in their standard form lending documentation, typically make use of shorthand language — up to and including “in lender’s sole, absolute, and unfettered discretion” — to describe the standard; whereas in the course of transactions, borrowers sometimes successfully negotiate for some form of reasonableness standard instead.
How are efforts covenants built?
Next, let’s consider how efforts covenants are typically constructed.
Whenever loan documents obligate a borrower to act in furtherance of an outcome that it can’t fully control, the basic question implied is always, “What standards will apply to the borrower’s performance of its obligation?” By way of opening bid, lenders’ standard form loan documents typically use phrasing up to and including, “Borrower shall use its best efforts” to describe the standard in shorthand, whereas, again, borrowers sometimes successfully (just how successfully, we will return to consider) negotiate for some form of reasonableness standard instead.
WHAT DO THE PARTIES THINK THESE CONSTRUCTS MEAN OPERATIONALLY?
Of course, all of this is just the start. These widgets fit into many different niches and play many different roles within our world of complex contracting technology. Sometimes they stand alone, and may by themselves constitute major deal points, and other times they play silent or supporting roles.
With all their versatility, it’s not surprising that both of these constructs are renowned for the degree of negotiation that goes on around them — to such an extent that one not infrequently hears expressions of weariness about it all.
In fact, given all the vagueness of the terms and the complexity and variability of their roles, what is surprising is that people seem to have such strongly held ideas about what’s at stake with the negotiations.
In other words, there seem to be well-established expectations and a broad degree of agreement in the marketplace as to how the terms, once settled by negotiation, actually function to govern borrowers’ operational conduct.
WHAT HAPPENS IN COURT?
How does all of this play out if a dispute over someone’s exercise of a prerogative, or failure to exercise sufficient efforts, puts these concepts to the test in litigation?
New York’s case law supports the conventional wisdom among parties and counsel regarding the application of prerogatives provisions but confounds the conventional wisdom as to the application of efforts clauses.
Prerogatives
Whenever Party A makes a choice that it has the right to make in its sole discretion, and Party B is aggrieved by that choice, one of Party B’s most typical arguments is that state law implies a covenant of good faith and fair dealing on Party A’s part, and that Party A’s choice violates that covenant. In some states and under certain conditions, this argument has prevailed, but in New York it doesn’t seem to be viable, at least within the limited scope of situations described in the opinions.
New York’s courts have consistently shielded sole discretion-based prerogatives provisions from implied covenant attack to such an extent that such provisions lend certainty and therefore stability to real estate transactions: People know what they mean and act accordingly. Certainly, some of those who subject themselves by contract to discretionary prerogatives end up aggrieved when the prerogative holder succumbs to moral hazard and abuses the leverage built into the prerogative. In those cases, the line is bright — there is no implied consent-based relief to be expected from New York courts.
Exceptions are made perhaps for certain cases of unfair asymmetry in bargaining power or some other equitable reason, but generally speaking, people able to fend for themselves in the commercial marketplace know where they stand with “sole discretion” and know what they have to do in order to avoid it — either successfully bargain for a reasonableness standard (such as “consent will not be unreasonably withheld”) or do not proceed with the transaction.
For example, in Transit Funding, LLC v Capital One Equipment Finance Corp., a commercial line-of-credit loan case, the loan agreement gave the lender the right to decline any request for a loan advance in its “sole and absolute discretion,” the court held that the implied covenant of good faith and fair dealing was no basis to force the lender to make an advance, and also not a basis for a damage claim by the borrower. In the court’s words, “motivation…is irrelevant.”
There is some indication in the case law that the implied covenant of good faith and fair dealing requires the acting party not to act arbitrarily or irrationally, but that does not stop the acting party from acting selfishly — even to the destruction of the counterparty. For example, several cases stand for the proposition that a lender does not have an “implied covenant problem” just because it conditions a consent to a loan assumption on raising the interest rate to a level consistent with the current market rate.
On the other hand, in Silver v. Rochester Savings Bank, a lender was obligated by its loan agreement not to unreasonably withhold its consent to a loan assumption, a New York court held that by conditioning its consent to a loan assumption on raising the interest rate to a level consistent with the current market rate, the lender did violate its reasonableness obligation.
In short, the courts are aligned with the marketplace understanding of the functional difference between “discretionary” prerogatives and those which must be exercised “reasonably” — the former are absolute, the latter are not.
Efforts
What about the best efforts versus reasonable efforts debate? In some jurisdictions, notably Delaware, best efforts means something more than reasonable efforts — but it may surprise some to learn that (broadly speaking) that is not the case under New York’s case law.
Essentially, New York seems to compress all the variants of this theme into one, so that best, reasonable, and good faith are more or less synonymous — and on a least common denominator basis, i.e., in the face of a naked efforts clause, New York courts will not bestir themselves to make best mean anything more than reasonable, or to make reasonable mean anything more than good faith, regardless of plain language and market usage arguments to the contrary. (And New York is far from alone in taking this seemingly quirky posture.)
Why this result? In a word, the concept of efforts seems to be too situation-specific for courts to develop a one-size-fits-all definition or means of applying it, absent context in the documents or in the specific industry, market, asset, or parties. In fact, the New York (and other) courts have historically been inclined to find the concept void for vagueness, only to relent as the volume of transacting parties using them has continuously grown.
In addition to its vagueness (lack of operational meaning without context), efforts has an element of ambiguity to it, in that by its dictionary definition it has two very different senses — an objective sense reflected in visible activity and a subjective sense reflected by invisible states of mind. This seemingly academic distinction is actually a practical one, for two reasons: (i) some courts actually recognize the distinction between an objective version and a subjective version of efforts, in which reasonable efforts are subjective and commercially reasonable efforts are objective; (ii) second, parol evidence is admissible in some courts in case of ambiguous provisions, but not necessarily vague provisions under New York law.
SETTING THE CONTEXT
In the present environment, more pressure is certainly coming to bear on any number of transaction-based relationships in commercial real estate, so more litigants will likely test the shorthand in courts. But we see no reason for the courts to change their approach as a result of the added volume.
It’s probably smart to pause now, in a time of ongoing uncertainty in politics, the economy, and public health, to be on guard and recognize that many contracting parties may feel heightened pressure these days to leave things unsaid, uncharacterized, or unspecified about relevant contingencies and their respective responses to it.
Picture the broad range of commercial real estate transactions and ongoing contractual relationships — from purchase/sales, to debt and/or equity financing arrangements, ground and space leases, and construction, management, and/or operational/franchising agreements. One thing they all have in common is that no one expects the documentation to cover every eventuality, much less to articulate the party’s detailed understandings about how each eventuality (should it actually occur) would be addressed.
In order to avoid costly and time-consuming negotiation, based on assumptions and calculations that might not be well-founded, parties often use shorthand language — sometimes even mere buzzwords — rather than spelling things out in detail. In law as in life, it’s bound to happen when we try to govern complex relationships in uncertain environments with limited transaction budgets and limited time to focus beyond today’s problems.
All of this means there are gaps, gray areas, and vagueness in every contract. Some of this is mitigated by generic yet detailed further assurance clauses, cooperation covenants, and certain other boilerplate provisions. These are not shorthand. They are fully articulated sets of interlocking covenants that address post-closing cleanup and other similar concerns, and do it generically.
And some of the vaguest, grayest gaps are never filled, clarified, or specified at all. In that case, one party might not have given the matter any consideration — or might have simply reckoned that (for whatever reason) any time, effort, or money spent to address it would be wasted. The other party, perhaps, thought it best to remain silent on the subject. Cost-benefit analysis is easy to do if you don’t sweat the long term too much, or, on the other hand, if you think you know better than your counterparty what the long term will really bring.
But real estate transactions are also, and frequently, characterized by much more specific (yet still extremely flexible) bits of technology for providing some form of guidance on a given concept or topic, while avoiding a detailed road map.
And prerogatives provisions and efforts clauses? They are probably among the most popular of these technologies. For principals and their lawyers alike, there are times when it’s worth a closer look at these two ubiquitous yet tricky standbys of the contracting toolkit.
In non-lending contexts, efforts provisions are particularly common in purchase and sale agreements, where the seller or buyer each may have one or more efforts obligations to perform in support of clearing specified conditions precedent to the closing. In this case, the entire deal hinges on the efforts clause.
Outside of real estate, efforts provisions are staples of certain kinds of contracts such as merger/acquisition agreements and exclusive marketing and distribution agreements. Here again, efforts clauses are fundamental, in this case because they relate to one party’s obligation to generate contingent proceeds using the other party’s good will, intellectual property, or merchandise, the amount of which then determines the amount of the principal’s net profits or the selling party’s deferred purchase price.
One thing that is pretty obvious when thinking about efforts clauses is that — especially in the high-stakes sale/purchase and merger/marketing contexts — they tend to be accompanied by a specific kind of moral hazard: the risk that during the contract period, one of the two contracting parties might get cold feet or become distracted for whatever reason. If the party that regrets entering into the contract or allocating resources to it is also an “efforts obligor,” then there is a conflict of interest.
What’s more, the efforts party often has some level of plausible deniability about its motivations. The very fact that the condition precedent in question is partly or potentially out of its hands provides cover and camouflage for it to argue that any failure of the condition to be satisfied is due not to the insufficiency of its efforts but to other causes outside its control.
As a result, it should not be too surprising that many of the leading cases (in New York at least) on efforts clauses do involve parties who have effectively torpedoed the very same transaction in which they have committed themselves to make best efforts or commercially reasonable efforts to consummate.
And some of the New York courts do sometimes get mired in the complications that this moral hazard problem can cause. You often see efforts parties engaged in flagrant, even flamboyant, sabotage of the very goal of the contract that they are supposed to be expending efforts to help achieve. And that has been a distraction for the courts.
Equally clearly, prerogatives provisions are also inherently prone to moral hazard. When no one can call a person’s decision into question, you are essentially saying that nothing is out of bounds, nothing is wrong, the person can do no wrong — and that can’t be right, or so it would intuitively seem.
There is a particularly strong feedback loop between the front-end contracting process and the back-end enforcement process built into these tools, because they are both in essence mechanisms for deferring much of the process (and thus the cost) of specifying contract obligations to the future (including by the courts) but only to an unpredictable future in which a dispute has arisen. That cost deferral (and hopefully cost elimination) function is what makes them as popular as they are.
WHAT DOES IT ALL MEAN?
To get to the bottom of all this, it helps to recognize that prerogatives and efforts are very different creatures.
When contracting parties delegate a discretionary prerogative exclusively to one of the parties, they enact a governance rule between them covering a specified situation. It’s a low-cost bright line everyone can understand. If nuance is needed, one can add conditions, exceptions, or other qualifications — or replace discretion with reasonableness and then qualify that. But if we want no gray areas, we have a simple effective tool to avoid them.
The story’s different with efforts clauses, which serve a different function. They speak not to the task of setting up simple binary decision-making algorithms, but that of defining performance where uncertainty of one form or another precludes precise characterization of the performance. It’s all very complicated and subjective.
In that context, the word ‘best’ (or any qualifier) has impossibly too much work to do and one could say that New York courts have put us all on notice of that reality. As such, wise borrowers and lenders (and their counsel) will want to think twice about using the efforts concept at all. It helps that the nature of mortgage lending allows for a limited level of reliance on the concept. There are industries much more susceptible to the concern — for example, New York’s leading efforts case related to the acquisition of a beer distributorship business’s goodwill and distribution network and the buyer’s obligation to use efforts to monetize those assets.
So maintain awareness of how the courts treat these terms. Whether a loan application is being negotiated or a set of master loan documents is being created, it may be worth screening for them and confirming that principal and counsel are on the same page about what happens if it should come to litigation. And of course, since litigation is rare, and the market believes what it believes, one might conclude that no change is needed because the incentives are, ultimately, what the parties think they are.
CONCLUSION
This discussion of prerogatives and efforts provisions should reinforce two truisms. First, in commercial real estate, there are always tactical approaches to negotiation and drafting. Second, if the parties don’t take the time and effort to articulate their intentions clearly, courts won’t be particularly eager to allocate their time and resources to filling in the gaps. You can always prevent this situation by being very careful in commercial real estate drafting — not just with prerogatives and efforts provisions, but with all provisions of your documents.
Notes
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CONTACT
Michael J. Hurley, Jr.
Managing Partner
212.798.0124
mhurley@cassinllp.com