December 2009

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News

Leasing Space—A “Capital” Idea?
By C. Leslie Banas, Banas and Associates PLLC

Retail lessors and lessees are closely examining a Financial Accounting Standards Board (FASB) proposal to change the accounting treatment of leasehold assets.

FASB’s current standard, SFAS 13, currently classifies leases as either “operating” or “capital”. A lease is only “capital” if it meets one of four SFAS 13 criteria. A “capital” lease assumes the tenant purchased the real estate with 100% financing. The tenant does not record a rent expense but depreciates the real estate value plus interest over the lease term.  An operating lease, on the other hand, is not included on a lessee’s balance sheet but is an “off balance sheet transaction.” The rent is treated as a straight line expense on the lessee’s income statement. The higher depreciation and interest results in a higher charge against the tenant’s income under the early years of a capital lease than what would occur under an operating lease.

A March 2009 FASB discussion paper (Leases: Preliminary Views) proposes that all leases be treated as capital leases. If FASB adopts this standard, it may significantly impact the economics of a lease transaction for both landlords and tenants. For example, the new standard may nudge a retail center lessee to opt for a shorter lease term due to the depressing effect of depreciation and interest on income. Alternatively, a prospective retailer may opt to purchase space rather than lease. Either of these circumstances could have a significant economic effect on both landlords and their tenants.

Reaction to the FASB’s proposal has been strong. Tenants and landlords should watch this closely. If it looks like the proposal “has legs,” plan accordingly.

“New Hazard ” = New Liability
By Randall B. Kleiman, Oade, Stroud & Kleiman, P.C., and Elan S. Nichols, MSU Law Rental Housing Clinic

Builders could face new liability by creating a “new hazard” on a job site, according to the U.S. Sixth Circuit Court of Appeals (Davis v Venture One Const, 568 F3d 570 (CA 6, 2009)).

In Davis, a subcontractor stored an unused door in a room just outside the remodeling site, not in the dumpster area. Employees of the business under renovation regularly entered the room. The door fell on an employee causing injury, and the employee sued the subcontractor for negligence.

The Davis court first discussed the threshold question: does the defendant owe a duty of care to a third party that is “separate and distinct” from the duties between the contractor and the premises owner? Ordinarily, an injured third party has no theory of recovery against the contractor for breach of duty. The Davis opinion, however, held that if a contractor creates a “new hazard” to a third party, a “separate and distinct” duty arises. Negligent storage of the door in an employee area “increased the risk” of injury and created a “new hazard” outside of the regular construction zone. The contractor had a duty of care to third parties to remedy the hazard or be liable for negligence.

Even though Michigan courts are not bound by Sixth Circuit decisions, some judges may find the Davis opinion persuasive. Builders should play it safe and keep the construction in the construction zone.

Court Increases Lender Due Diligence
By Howard A. Lax, Lipson Neilson Cole Seltzer & Garin PC

A recent unpublished Michigan Court of Appeals decision increases the amount of due diligence mortgage lenders should undertake before closing a loan (Washington Mutual Bank v JP Morgan Bank, 2009 WL 3365865, Mich.App. October 20, 2009). In Washington Mutual, the borrower obtained loans from two lenders. One mortgage was assigned to JP Morgan; the other to Washington Mutual. The JP Morgan mortgage was executed first, but Washington Mutual recorded their mortgage first. In some states, equitable subrogation permits a lender to assume the priority of a mortgage that is being refinanced. But prior Michigan decisions hold that equitable subrogation is not available absent fraud or other extenuating circumstances such as involuntary extension of the mortgage debt. See Ameriquest Mortgage Co v Alton, 273 Mich App 84, 731 NW2d 99 (2006). The Ameriquest Mortgage decision would dictate that JP Morgan Bank may not claim the priority of the refinanced loan, and the Washington Mutual Bank mortgage is the senior mortgage. However, the Washington Mutual panel found that information in the loan application and the borrower’s credit report gave clues to the existence of a prior unrecorded mortgage. The report put the second lender on notice that it must inquire about an unrecorded loan. Since the second lender did not exercise due diligence and make this inquiry, the mortgage executed later but recorded first was not entitled to priority under Michigan’s race-notice statute.

Credit reports list all of the lenders that obtained a borrower’s credit report in prior months. This list provides notice to a lender that a borrower is seeking a loan from other lenders, whether or not the credit report lists the unrecorded mortgage. Each lender should exercise due diligence to determine whether the borrower obtained other financing before closing its loan.

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