There is no substitute for due diligence.

A recent California Court of Appeal case affects the manner in which potential buyers of commercial property and lenders considering making a loan secured by commercial real property should analyze commercial leases that encumber such real property.

Typically, a prospective purchaser of commercial real property or a lender making a loan secured by commercial real property will condition the purchase or loan on obtaining satisfactory estoppel certificates from all or a majority of the tenants of the real property. An estoppel certificate informs prospective purchasers and lenders of a tenant's understanding of its lease agreement and therefore prevents unpleasant surprises that may otherwise adversely affect the income stream of the property. Theoretically, estoppel certificates prevent a tenant from claiming later (for instance, after the property has changed hands, either through a typical purchase and sale or by reason of a foreclosure sale) that the facts set forth in the estoppel certificate are not accurate.

Matters typically addressed by estoppel certificates include: (a) whether the lease is in full force and effect and whether the lease is modified (and if so, by what document or other agreement); (b) the commencement and expiration dates of the lease; (c) the amount of current rent, including estimated operating expenses and common area maintenance charges, and whether such rent has been paid in advance; (d) if there exist any options to extend the term of the lease, to acquire fee ownership of the property or to expand the existing premises; (e) whether the tenant is entitled to any credits, reductions, offsets, defenses, rent concessions or free rent; (f) whether there are any known or suspected defaults by either party under the lease; (g) whether the tenant has provided the landlord with a security deposit; (h) whether the tenant has availed itself of bankruptcy protection; and (i) clarification of any particularly troublesome terms, such as a termination right of the tenant. Many other matters may be addressed by an estoppel certificate as set forth below.

A recent California Court of Appeal case, Miner v. Tustin Ave. Investors, LLC, 116 Cal. App. 4th 264 (2004), limits the reliance that a prospective purchaser or lender should place upon an estoppel certificate. In 1997, plaintiff Miner entered into a commercial lease, including an addendum, with the predecessor of the defendant landlord. The lease expired in 2002 and the addendum contained an option to renew the lease; which option was exercisable no later than June 2002. In November 2001, the tenant executed an estoppel certificate stating that the lease was then in full force and effect. The estoppel certificate also contained a provision stating that the tenant had no options "except as follows." This statement was followed by blank lines which were not completed. A controversy arose concerning the option rent, and the tenant sued the landlord for, among other things, declaratory relief, claiming that the tenant had validly exercised its option rights. The landlord filed a cross-complaint in the unlawful detainer action and moved for summary adjudication, claiming that the estoppel certificate eliminated the option to renew contained in the lease. The trial court granted the motion.

The Court of Appeal reversed, holding that the landlord was not entitled to summary adjudication. The Court reasoned that determining whether the option existed was a matter of contract interpretation. Significantly, the Court found that the contract to be interpreted was both the estoppel certificate and the lease, including the addendum containing the option, the reason being that there was full integration between the estoppel certificate and the lease by virtue of the fact that the lease contained the option and the estoppel certificate declared the lease to be in full force and effect. The Court of Appeal found that there was an ambiguity in the contract to be interpreted, as the lease clearly contained an option but the estoppel certificate was unclear as to whether an option existed, for reasons that are discussed below.

The Court of Appeal based its further analysis upon two principles. First, because California Civil Code section 1654 provides that contracts should be interpreted most strongly against the party who caused an uncertainty to exist, the uncertainty in the lease and the estoppel certificate should be interpreted against the landlord, the primary drafter of the two documents. Second, the option right was clearly stated in the lease addendum, whereas the estoppel certificate was not clear with respect to the existence of the option. The Court of Appeal found that the provision of the estoppel certificate relating to the option could be read to "cut off option claims beyond those expressed in the four corners of the parties' contract" and not to address any option explicitly set forth in the lease and addendum.

What is the practical effect of this ruling? For prospective purchasers and lenders, the answer is that estoppel certificates are no substitute for actually reviewing and analyzing leases. Although the Court of Appeal raised the issue of a waiver of any option rights in the estoppel certificate or an acknowledgment that any option rights had been terminated, this would likely be strongly resisted by any tenant that had professional legal advice in completing an estoppel certificate. Even if the estoppel certificate had clearly indicated that no option rights existed (whether set forth in the lease or otherwise), it is likely that the landlord would not have prevailed due to the resulting ambiguity between the lease with addendum and the estoppel certificate. If the lease and the estoppel certificate are provided by the landlord (as they typically are), the ambiguity will still be construed against the landlord pursuant to California Civil Code section 1654. The prospective purchaser or lender presumably would be under the burden of discerning the conflict and inquiring further in order to clarify it. Thus, while estoppel certificates will continue to be important tools in determining whether a particular property is a good investment or adequate security for a loan, the lesson for purchasers and lenders is clear: there is no substitute for proper and complete due diligence.

While this ruling is, on its face, beneficial to tenants, it may result in the insertion of additional language into estoppel certificates to avoid the result of this case. For instance, it is likely that prospective purchasers and lenders will attempt to include express waivers or terminations of certain provisions, which in essence will modify the terms of the lease. In this way, estoppel certificates may become de facto lease amendments. Although tenants often fail to obtain legal advice in connection with the review of estoppel certificates, such failure is now far more likely to be at the tenants' peril.

Richard Cipra, Esq., is an associate in the Real Estate and Business and Corporate Law Departments at Ervin, Cohen & Jessup LLP. Mr. Cipra focuses on a broad range of commercial real estate and business matters including real property purchase and sale transactions, commercial leasing and mergers and acquisitions and can be reached at 310.281.6341 or [e-mail]