Feature

Service Contracts: Often Overlooked, but Deserving of Respect

When buying commercial real estate, due diligence requires careful analysis not only with respect to the asset itself, but also of the service contracts that ensure the smooth and efficient operation of the asset.

By Kevin L. Shepherd
Service Contracts

Service Contracts

The seller and the buyer have just closed on the purchase and sale of a multi-tenanted office tower. The diligence period was truncated, and the closing occurred on an accelerated timeline. At closing, the seller assigned the space leases and security deposits to the buyer. The seller also assigned to the buyer the various service contracts relating to the day-to-day operation of the office tower. The buyer plans to terminate most, if not all, of the service contracts shortly after closing so that it can bring on its preferred service providers.

Within a couple of weeks of the closing, the buyer sends termination notices to the service providers, indicating that the service contracts will terminate in 30 days. But to the buyer’s surprise and chagrin, several service providers reject the termination notice and assert that their contracts remain in full force and effect and that, in some cases, the assignments were ineffective. One service provider asserts that if the buyer desires to terminate the service contract in question, the buyer will need to pay the stipulated (and exorbitant) termination fee. The buyer regrets that it did not devote sufficient attention to the service contracts during the diligence period and in the purchase and sale agreement (PSA) negotiations.

Service Contracts: What Are They?

Service contracts, and their providers, are integral to the smooth and efficient operation of a commercial real estate asset. Service contracts cover a wide range of operations and services, such as janitorial, HVAC systems, elevators and escalators (i.e., vertical transportation), security alarm and fire panel systems and security, access control systems, building energy (e.g., electricity, natural gas, and steam), entrance floor mats and carpets, landscaping and interior plant maintenance, chilled water, snow and ice removal from sidewalks and parking areas, indoor air quality management and mold prevention, roof maintenance (including green roof maintenance), parking lot sweeping, property management, parking garage and fitness center operations, tax appeal agreements, water treatment, fire extinguisher maintenance, concierge services, internet, cable, and other telecommunications, pest control, window washing, waste hauling and recycling services, postage and copier machine rentals in the management office, holiday decorating, food services and vending machines, and uniform rental. Some service contracts may be somewhat exotic, such as a service that installs and manages honeybee hives atop commercial properties. Some asset types may involve a wide variety of service contracts, such as uniform rental and health club and pool maintenance service contracts in hotel transactions.

Of interest to any buyer of commercial real estate are those service contracts associated with maintenance and other building operations. Most service contracts are not of record, but some may be, and those would typically be treated separately as title documents. An example would be maintenance obligations contained in a recorded easement. By contrast, some service contracts may deal with one-time capital projects (as distinguished from ongoing operations), which may or may not be completed before the closing. Yet another category of service contracts relating to a project is the type that the seller may have no intention of sharing with a buyer, such as engagements of counsel, accountants, and certain consultants. These contracts will thus be excluded from the universe of contracts subject to the sale transaction. A final category of service contracts relating to operations, a category not typically assigned to a buyer, includes the property management agreement and listing agreement (but, as discussed below, the seller may want the buyer to assume the tail leasing obligation of the seller). Given the various categories of service contracts, it may be difficult to separate out a simple category that includes only the contracts relevant to a buyer. For example, focusing on service contracts that provide services in connection with the operation of a building (or identified capital projects) would fail to cover the honeybee hive contracts noted above.

In evaluating the service contracts from a business perspective, buyers should focus on the scope of services and the cost. From a legal perspective, two issues loom large: (a) the term of the contract and the termination rights; and (b) the assignment rights and restrictions. The contract should be terminable by the seller on not more than 30 days’ notice without a termination fee and terminable by the seller automatically on the sale of the asset (or the ownership interests of the seller in the title-holding entity). With respect to assignment, the contract should be assignable by the seller to a buyer without the approval or consent of the service provider. Two additional but often overlooked legal points are sometimes important to a buyer. Ideally, the contract does not limit the service provider’s liability to the fees it receives. The absence of such an exculpation clause, however, may not be that helpful if the service provider has little or no credit or insurance coverage. The second point deals with insurance, and the contract should obligate the service provider to carry general liability insurance and errors and omissions coverage.

Although the focus of this article is on the seller’s service contracts, it is worth noting that a buyer will likely enter into its own service contracts as part of its due diligence activities well before the buyer has access to the seller’s service contracts. A buyer will order a title search and survey, engage an environmental consultant, commission a zoning and land use evaluation, and hire someone to inspect the physical condition of the asset. All of these engagements invariably will be the subject of service contracts. A buyer and its counsel will need to be mindful of a number of the points discussed below in reviewing these contracts.

PSA Provisions

Service contracts implicate six main areas of a typical PSA, and the parties need to ensure that these provisions are coordinated and do not conflict. These areas are (1) the process for obtaining, reviewing, and rejecting the service contracts during the due diligence period; (2) the seller representations and warranties; (3) the seller’s operational covenants pending closing; (4) estoppels (which are the exception rather than the rule); (5) termination at closing of those service contracts not assigned at closing; and (6) the mechanics of assigning the service contracts to the buyer at closing.

Due Diligence of Service Contracts

During the due diligence period, buyers understandably spend much time and effort reviewing the space leases for an asset because they will serve as the cash flow for the project. Diligent buyers prepare lease abstracts that summarize the key provisions of the leases and identify issues of concern, such as rental amounts, commencement and expiration dates, and renewal options.

Sellers typically either make the space leases and related documentation available to a buyer on a password-protected website or otherwise make copies available for the buyer’s review. The same processes should govern the delivery or availability of service contracts, including all amendments. The seller should make a schedule of the service contracts available along with copies of the service contracts themselves.

Buyers should exercise diligence in reviewing service contracts. Some service contracts may be on a month-to-month or “as needed” basis (e.g., painting and carpentry) while others may be for a term of years (typically one year, with automatic renewal options). The fees under certain service contracts may be payable in arrears while in others they must be payable in advance. A buyer needs to understand the expenses associated with the operation of the asset so that it can develop its financial models.

Many service contracts typically contain provisions allowing their termination on 30 days’ notice without cause or automatically terminating on the sale of the asset. Other service contracts may not contain these types of termination provisions or may allow termination only on the payment of a termination fee or after an extended notice period. Service contracts may allow the seller to assign them freely to a buyer without the service provider’s consent, but others may prohibit or impose conditions on an assignment. The contracting party on the ownership side may be the ownership entity itself or a management company as agent for the owner. On the latter point, make sure the contract clearly states that the management company is signing the contract as agent of the seller (but an interesting question arises if the property management agreement disclaims in the first instance any agency relationship between the seller and the property manager). Because major property owners have national or regional master service contracts that apply to a portfolio of assets, these contracts obviously cannot be assigned with a single asset sale.

A buyer may want to pick and choose which service contracts will be assigned to it at closing. Thus, a buyer may want the ability to identify those service contracts that it wants the seller to terminate. In that case, the buyer should be required to identify those service contracts by no later than the expiration of the due diligence period. Note that a buyer will want to make sure that the termination is effective as of the closing, not that the seller will send the termination notice as of the closing. The parties will need to negotiate which party will pay any applicable termination penalties or fees.

The seller will need to send the appropriate termination notice to the vendor within the applicable term under the service contract, stating that the service contract will terminate as of a specified closing date. A seller may want to add language to the termination notice indicating that the termination is conditioned on closing occurring as scheduled and, if closing is delayed, the seller will notify the vendor and the termination will be effective as of the delayed closing date. Set forth below is an example of a provision governing the buyer’s right to designate which service contracts it desires the seller to terminate effective as of the closing:

Not later than the expiration of the Due Diligence Period, Buyer may deliver a written notice to Seller setting forth which, if any, of the Contracts Buyer has elected to have Seller terminate. In connection with the foregoing, Buyer confirms that it has elected to have Seller terminate that certain Contract known as the “____________ Contract” bearing a date of _________ (“XYZ Contract”). Seller will deliver a notice of termination terminating the XYZ Contract effective as of the Closing, provided that (i) such Contract is terminable on or before the Closing in accordance with its terms, and (ii) Buyer shall be responsible for, and shall indemnify Seller for, any termination penalties, fees, or other costs arising from such termination.

Some service contract vendors may insist on receiving the full benefit of the notice period set forth in the termination provision of the service contract. Thus a conditional termination notice may not be appropriate. If so, the seller may be required to send the termination notice on the closing date, thereby creating a “stub” period between the closing date and the termination date. The PSA will need to allocate the responsibility for the charges associated with the stub period.

Portfolio Transactions: Unique Considerations

Portfolio transactions present challenging issues for a comprehensive review of service contracts. Time pressures and the sheer volume of service contracts conspire against a buyer’s inclination to methodically scrutinize each service contract. What is a buyer to do?

A buyer could seek a more expansive and comprehensive set of representations and warranties from a seller covering all service contracts. If a buyer is simply unable to review all the service contracts during the due diligence period, a buyer could review the form service contract used by the seller and extract a representation and warranty that seller has not entered into any service contracts that deviate from the form in any material respect. A buyer could also review a representative sample of the universe of service contracts, focusing on those types of service contracts that may have provisions of concern to a buyer (e.g., atypical termination or assignment provisions). A buyer could also seek a representation and warranty that no material defaults exist under the service contracts on a portfolio-wide basis. This language may read as follows:

No material default exists under any Contract on the part of Seller or, to Seller’s knowledge, on the part of any other party thereto, and no event exists that, with the passage of time or the giving of notice or both, will become a material default thereunder on the part of Seller or, to Seller’s knowledge, on the part of any other party thereto.

Seller’s Representations and Warranties

A buyer should seek representations from a seller in the PSA addressing key points about the service contracts. A seller, though, may reject that request by stating that it has provided copies of the service contracts to the buyer during the due diligence period, and thus the buyer had ample opportunity to review the service contracts.

A middle ground between the two positions would be to make a few basic representations and warranties about the service contracts. For example, the seller should represent that (1) it has provided or made available to the buyer complete copies of all service contracts applicable to the asset, (2) the service contracts are in effect (some sellers may insist that this representation be to seller’s knowledge), and (3) the seller has not received or provided any default notices to the service provider. These representations and warranties would appear reasonable because a buyer’s due diligence would not necessarily confirm (or question) any of these points. The PSA typically contains a schedule of the service contracts, which should list the vendor, the type of service involved, and the date of both the contract and any amendments. A sample representation that addresses these fundamental points is set forth below. Note that the use of the defined term “contracts” presupposes the exclusion of those service contracts not included in that term, such as engagements of counsel, accountants, and certain consultants:

Except for the Contracts referenced on Schedule X, there are no contracts or agreements to which Seller is a party or by which it is bound relating to construction, architectural services, parking, maintenance, or other supplies or services, management, leasing, or brokerage services, or any equipment leases that are currently in effect [and will be in effect after Closing]. [Sellers may prefer to include the bracketed language, but buyers should insist that it not be included on the basis that the buyers need to understand the full scope of the contracts.] Seller has delivered to Buyer true, correct, and complete copies of the Contracts referenced on Schedule X. To Seller’s knowledge, the Contracts referenced on Schedule X are in full force and effect. Seller has not received or provided written notice of a default thereunder on the part of Seller or the vendor, respectively.

A buyer may seek a representation and warranty that no default (or potential default) under a service contract would have a material adverse effect on the asset or on the seller’s ability to consummate the sale transaction. Given its subjectivity, a buyer should not expect a seller to warmly embrace this type of provision. An example of this provision is set forth below:

No default exists under any Contract on the part of Seller or, to Seller’s knowledge, on the part of any other party thereto, and no event exists that, with the passage of time or the giving of notice or both, will become a default thereunder on the part of Seller or, to Seller’s knowledge, on the part of any other party thereto, except for any defaults, individually or in the aggregate, that would not, and could not reasonably be expected to, have a Material Adverse Effect. For the purposes of this Agreement, a “Material Adverse Effect” means any result, occurrence, fact, event, change, or effect that, individually or in the aggregate with other such results, occurrences, facts, events, changes, or effects, has had and/or would have a materially adverse effect on (a) the business, affairs, assets, results of operations or financial condition of the Property, or (b) the ability of Seller to consummate the transactions contemplated by this Agreement.

Construction contracts are often overlooked in preparing the PSA’s schedule of service contracts. Yet in many transactions, there are ongoing capital projects, especially tenant improvement work. A buyer will thus request a representation and warranty that discloses any ongoing capital projects, and a seller will need to make sure the schedule of service contracts lists all construction contracts.

Service Contract Estoppels

Although a seller is generally required to deliver estoppel certificates from all or a certain number or percentage of tenants leasing space at the asset, it is not common for a seller to have any obligation to deliver estoppel certificates from vendors whose service contracts are being assigned and assumed at the closing. Why is that?

As discussed above, the PSA will usually contain a representation and warranty that the service contract is in full force and effect, no defaults exist under the service contract, and the seller has delivered or made available to the buyer a true and correct copy of the service contract. Most service contracts likely do not contain a provision obligating the vendor to provide an estoppel certificate in any event. Equally important, even if the service contract contained an estoppel delivery requirement, it could be burdensome to extract estoppels from the vendors. The one situation in which an estoppel may be warranted is when a long-term service contract is not terminable for a considerable time period and involves a critical service for the asset (e.g., energy service contract).

Seller’s Operational Covenants

A buyer will want assurances that, during the period between PSA execution and closing, a seller will continue to operate the asset in the same manner as it has historically operated the asset. As part of these assurances, a seller will need to keep the service contracts in place and, if a replacement provider is needed, a buyer may need the right to approve that provider. A seller may seek to limit the approval right only after the due diligence period has expired. A buyer may request that it has reasonable approval rights during the due diligence period and, if a buyer elects to move forward to closing at the end of the due diligence period, a buyer may insist that it has the right in its sole and absolute discretion to approve—or disapprove—changes in the service contracts or their providers. An example of this provision is set forth below:

Between the Effective Date until the Closing Date, (a) Seller shall continue to operate, maintain, and repair the Property in the ordinary course of business and to the standard that Seller has operated the Property to date, and (b) Seller shall not take any of the following actions without the prior written consent of Buyer: (i) enter into any contracts for the provision of services or supplies, or both, to the Property that are not terminable without premium or penalty by Buyer upon no more than thirty (30) days’ prior written notice, or (ii) terminate or modify any of the Contracts in any material respect, unless such Contract, as amended, may be terminated without premium or penalty by Buyer upon no more than thirty (30) days’ prior written notice. Between the Effective Date and the expiration of the Due Diligence Period, Buyer’s consent shall not be unreasonably withheld, delayed or conditioned. Between the day after the expiration of the Due Diligence Period and the Closing Date, Buyer may grant or withhold its consent in its sole and absolute discretion. Buyer shall be deemed to have consented to such new or amended Contracts or the termination of Contracts if Buyer fails to respond to a written request for its consent within “x” days after written notice requesting consent. Seller shall promptly provide Buyer with a copy of any Contract entered into by Seller, regardless of whether Buyer’s consent is required pursuant to this paragraph. In the case of emergency or other exigent circumstances, Seller shall have the right to enter into Contracts to perform repairs or replacements without Buyer’s consent but with notice to Buyer as soon as practicable.

If the seller enters into a new service contract while the PSA is pending, at closing the seller will need to revise the service contract schedule attached to the PSA as an exhibit to make sure the schedule is accurate as of the closing. The PSA should thus contain a provision allowing the seller to revise the service contract schedule, especially since the seller may be reaffirming at closing the accuracy of the schedule of service contracts pursuant to a down-date certificate.

Mechanics of Assigning Service Contracts

If both the seller and the buyer have agreed that certain service contracts will be assigned to and assumed by the buyer at the closing, the parties will typically enter into a separate assignment and assumption agreement for the service contracts. The PSA may include the form of the assignment and assumption agreement to avoid last-minute negotiations of that document. The operative provisions of the assignment and assumption agreement should include the following: an assignment of the seller’s right, title, and interest in the service contracts; the buyer’s assumption of the seller’s obligations under the service contract first arising or accruing from and after the closing; and a clear identification of the service contracts being assigned and assumed. In some cases, the parties may agree to mutual indemnification provisions requiring the seller to indemnify, defend, and hold the buyer harmless from any breaches under the service contracts before the closing, and requiring the buyer to indemnify, defend, and hold the seller harmless from any breaches under the service contracts on and after the closing. The assignment and assumption agreement typically does not include or repeat the representations and warranties relating to the service contracts that may have been included in the PSA. From a buyer’s perspective, there should be some credit standing behind the seller’s indemnification obligations (otherwise it may not be worth having reciprocal indemnification provisions at all). From a seller’s perspective, the agreement should be subject to the same survival period and damage and threshold caps, if any, contained in the PSA. The PSA may include a provision along these lines:

At Closing, Seller shall assign to Buyer, [to the extent assignable], [to avoid the bracketed language, the parties should determine whether a contract is assignable and at what cost and reach agreement on the allocation of that cost] and Buyer shall assume, all Contracts pursuant to the Assignment and Assumption Agreement in the form attached hereto as Exhibit X.

At closing, the parties will need to prorate the costs under the service contracts that are being assigned and assumed. The settlement statement, or an accompanying schedule, should detail the proration for each service contract.

In case of a sale of the interests in the ownership entity in lieu of a direct conveyance of the asset, it may not be necessary to assign and assume the service contract because the ownership entity is not changing. In these circumstances, there is in effect an absolute assumption—both prospective and retroactive. Most PSAs in these circumstances generally dictate the obligations for past and undisclosed liabilities. The buyer will need to review the service contracts to determine whether such a transfer of ownership interests will trigger the assignment, notice, or termination provisions.

Property Management and Brokerage Agreements

A buyer almost always requires that two types of service contracts be terminated at the closing: property management agreements and brokerage agreements for the leasing of space in the asset. A new owner generally prefers to engage its own property manager and leasing agent on economic terms acceptable to the new owner. A PSA typically contains an explicit provision directing the seller to terminate the property management agreement and brokerage agreement at the closing.

Brokerage agreements present a secondary issue for buyers to consider. A brokerage agreement typically contains a provision entitling the broker to a “tail” commission for any leases entered into by the new owner within a certain period of time after the closing if that tenant’s name appeared on the so-called “prospect list” generated by the broker. It is important to determine whether a prospect list provision exists in the brokerage agreement and, if so, ensure the list has been generated per the terms of the underlying brokerage agreement. An example of this type of provision is set forth below:

Seller shall cause the existing Management Agreement dated ________, between Seller and _______________ (“Manager”), and the existing Leasing Services Agreement (“Exclusive Leasing Agreement”) dated ____________ between Seller and __________ (“Broker”) to be terminated effective as of the Closing Date. However, Seller and Buyer recognize that the provisions of Section “X” (“Tail Provisions”) of the Exclusive Leasing Agreement survive Closing. Within five (5) days before Closing, Seller shall furnish Buyer with a list of any potential tenants registered by Broker pursuant to the Tail Provisions. If Buyer enters into a Lease at the Property after Closing and a brokerage commission is due under the Tail Provisions as a result of such Lease, Buyer shall, as covenants that shall survive the Closing, pay any such commission(s), and shall indemnify, defend and hold harmless Seller for, from and against any claims, penalties, fees, costs, expenses, liabilities, and damages (including without limitation reasonable attorneys’ fees) resulting from Buyer’s failure to pay such commission(s).

Master Service Contracts

Major businesses may have master service contracts with regional or national service providers. A prime example of a master service contract is an agreement owners enter into with utilities and others to supply electrical service to their assets. These agreements, through a master agreement, may sometimes cover several properties owned by the same group. What distinguishes these agreements from most other service contracts are limitations on assignability of the agreements and the potential triggering of termination fees if the agreements are terminated before their expiration date.

Buyers should scrutinize any energy agreements affecting the asset and determine the assignment and termination rights, notice requirements, and documentation requirements. Energy agreements may contain lengthy notice requirements for a proposed assignment as well as information about the proposed assignee/buyer so that the energy vendor can perform any necessary underwriting. The energy vendor typically requires the use of its custom assignment documentation, and experience shows that the energy vendors are not inclined to modify this documentation. If a buyer does not want to take an assignment of the energy agreement, the seller will need to terminate the agreement as of the closing. This termination may trigger a termination penalty or fee, and the seller and the buyer will need to negotiate the payment responsibility for these amounts. Some buyers may engage a consultant specializing in the transfer of energy agreements to navigate these nettlesome issues. Waiting to address these issues until late in the process may run the risk of the asset not having an energy supply agreement in place at closing.

Construction Contracts

A seller, as landlord, may be obligated to perform tenant improvements under a space lease or may be in the midst of performing certain capital repairs or replacements to the asset. The seller will have entered into one or more construction contracts for this work. If the contractor does not complete the work and is paid in full by closing, the seller and the buyer will need to anticipate the possible assignment of the construction contract at closing so that the work in process can be completed post-closing. The seller and the buyer will need to negotiate the assignment of the construction contract and the mechanics of ensuring that the work proceeds unimpeded through completion. The seller and the buyer may negotiate a clause along these lines:

Before Closing, subject to the receipt of the applicable building permits, Seller shall cause all work under the Construction Contracts, if any, to be performed in a diligent manner. Seller will keep Buyer generally advised of the status of construction under the Construction Contracts. With respect to any Construction Contract for which the work is completed prior to the Closing Date, Seller shall pay all sums due to the contractor, obtain releases of lien (from contractor, subcontractors at all levels, and parties that provided notice to owner), obtain contractor’s final affidavits, and cause all permits with respect to the work to be closed out. With respect to any Construction Contract for which the work has not been completed as of the Closing Date, Seller shall provide Buyer with copies of material correspondence between Seller (or Seller’s property manager) and contractor, copies of all notices to owner received by Seller, copies of all lien releases and lien waivers received, if any, and an accounting of all payments made to contractor or otherwise with respect to the work under such Construction Contracts. Seller shall cooperate with Buyer in all reasonable respects in connection with the turnover of the construction job to Buyer and shall arrange meetings between Buyer and the applicable contractor(s) prior to Closing.

If a construction contract is assigned at closing, the PSA will need to address the economics of that assignment. As between the seller and the buyer, the costs for any tenant improvement work may be payable by the buyer since it will enjoy the benefits of the tenancy post-closing. In the case of building repairs that are not tenant improvements made under a space lease, it may be appropriate for the seller to absorb the cost of those repairs if they are completed post-closing. The following provision seeks to address these points:

With respect to Construction Contracts for building repairs (that are not for tenant improvements or alterations made pursuant to a Lease), Seller shall be responsible for the payment of all amounts payable under such Construction Contracts as of the Closing Date. If as of the Closing Date Seller has not paid all such amounts owed under the Construction Contracts pursuant to the foregoing provision, then (a) Buyer shall receive a credit against the Purchase Price in an amount equal to such unpaid amounts, (b) Seller shall deliver to Buyer executed lien waivers from those performing any such repairs, (c) Buyer shall assume the obligations of Seller to pay such amounts pursuant to the Assignment and Assumption Agreement, (d) Seller shall no longer be responsible for payment of any amounts owed under the Construction Contracts, and (e) Buyer will hold Seller harmless from payment of such amounts owed under Construction Contracts.

One area that merits special attention is the potential for cost overruns for construction work that will be completed post-closing. A buyer that receives a credit at closing for the remaining balance of the unpaid costs may come up short if the project costs more to complete than originally agreed. For example, suppose that by closing a seller has completed only 25 percent of the work for a tenant improvement project but has paid 50 percent of the cost. Crediting a buyer for the remaining unpaid costs (50 percent) will fall short of the funds actually necessary to complete the remaining 75 percent of the work. It may be prudent to obtain an estoppel or other form of assurance from the contractor indicating the status of the project and the costs needed to complete it. That information will allow the seller and the buyer to determine the appropriate credit at closing. Another option is to escrow funds in excess of the projected completion costs (e.g., 125 percent of those costs) to take into account possible cost overruns. Any remaining funds will be returned to the seller when the project is completed.

Conclusion

Service contracts are easy to overlook in a commercial real estate transaction since most of a buyer’s focus is on the physical asset, financing, and space lease review. But it would be a mistake to neglect or marginalize a review and analysis of the service contracts that ensure the smooth and efficient operation of the asset. Service contracts deserve the respect—and attention—of a prospective buyer. 

Entity:
Topic:

By Kevin L. Shepherd

Kevin L. Shepherd is a partner with Venable LLP in Baltimore, Maryland, and is the Section’s representative to the ABA Board of Governors.