Subleases & Assignments

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1.              General Business Concerns.

When a tenant executes a lease, the tenant is liable for the tenant’s obligations under the lease for the term of the lease. The tenant’s obligations will continue even though the tenant’s circumstances change, such as the death of an individual, a downturn in tenant’s business, a change in the retail tenant’s concept or a merger or consolidation of a corporate tenant resulting in the space becoming unnecessary. When circumstances change, the tenant wants the flexibility to find other users to occupy all or a portion of the space and assume some or all of the tenant’s remaining obligations under the lease. In order to have this flexibility, the lease must allow the tenant to assign the lease or sublet all or a portion of the tenant’s interest in the premises. In addition, the other provisions of the lease (such as the lease’s use clause and its restrictions on alterations) must be flexible.

A landlord, on the other hand, wants to be able to control who occupies the landlord’s building or project and for what uses. The occupants must be credit worthy, not adversely affect the reputation of the building, not increase the landlord’s ownership risks or adversely affect other tenants of the building or project. To the extent a landlord allows a tenant to assign the tenant’s interest in the lease or sublet the premises, a landlord will require the assignee or subtenant, as the case may be, to be responsible for all of the tenant’s obligations under the lease in order to ensure that the landlord has a remedy directly against the assignee or subtenant.

2.              Distinction Between Assignment and Sublease.

An assignment is a transfer of a tenant’s entire interest in a lease to the assignee. The assignee will deal directly with the landlord and will be directly liable to the landlord for the payment of rent. Unless specifically released from liability under the lease by the landlord, the assignor will remain liable for the lessee’s obligations under the lease. If the landlord makes a claim on the assignor, the assignor will then have a claim against the assignee, but only the landlord (and not the assignor) will be able to evict the non-paying or non-performing assignee. Thus, because the landlord can wield the eviction stick, the landlord is in a better position to compel the assignee’s performance than the assignor.

In a sublease, the tenant retains its interest in the lease and merely transfers a right to occupy all or a portion of the premises subject to the tenant’s rights under the lease. In this instance, the tenant retains the direct contractual relationship with the landlord. The subtenant will pay rent to, and deal directly with, the tenant. Typically, a tenant will seek to sublease a premises where the tenant wants to continue to retain a portion of the premises for the tenant’s own use or where the tenant desires to re-enter the sublet premises prior to the termination of the lease.

3.              Restrictions on Assignments and Subleases.

A landlord can restrict the ability of the tenant to assign the tenant’s interest in the lease or sublease the premises. The limitation in the lease on the tenant’s ability to assign the lease or sublet the premises may be: (i) absolute (in other words, the landlord may approve or disapprove of a proposed sublease or assignment in the landlord’s sole and absolute discretion), (ii) conditional (in other words, the landlord only has the right to withhold the landlord’s consent to a proposed sublease or assignment if the landlord has a reasonable basis for withholding such consent), or (iii) unqualified (in other words, the lease simply provides that “the tenant may not assign the lease or sublet the premises” and does not specify any standard governing the landlord’s determination of whether or not to withhold the landlord’s consent to such proposed assignment or sublease).

Many states allow a landlord to absolutely prohibit assignments and subleases. In some states such as California, the basis is statutory. See California Civil Code Section 1995.230. In Oregon, the Oregon Supreme Court in Pacific First Bank v. New Morgan Park Corp. upheld the ability of a landlord to absolutely withhold the landlord’s consent to a proposed assignment or sublease.

If the lease is silent as to whether the landlord’s right to withhold the landlord’s consent to a proposed assignment or sublease is absolute or conditional, the landlord’s implied covenant of good faith will prohibit the landlord from unreasonably withholding the landlord’s consent in most states. See Pacific First Bank v. New Morgan Park Corp. (Oregon Supreme Court). California reaches the same result by way of California Civil Code Section 1995.260. However, under a recent Court of Appeals case in Washington, a landlord has no implied duty to act in good faith in deciding whether to approve an assignment of a lease when the lease simply provides that an assignment requires the landlord’s consent. See Johnson v. Yousoofian.

Where a landlord agrees not to unreasonably withhold the landlord’s consent to a proposed assignment or sublease, the landlord will often include in the lease a number of circumstances in which it is reasonable for the landlord to withhold the landlord’s consent. These circumstances include:

(i)             the transferee’s financial condition is inadequate;

(ii)           the transferee’s proposed use is different than the tenant’s use;

(iii)          the nature of the proposed use may result in: (a) an increase in insurance premiums, (b) an increased risk with respect to the use or release of hazardous materials in the building or project, (c) increased likelihood of damage or destruction, (d) increased density or pedestrian traffic through the building or project, or (e) the installation of new tenant improvements which are incompatible with existing building system components;

(iv)          the transferee has a bad reputation;

(v)           the transferee has inadequate managerial skills;

(vi)          the expected percentage rent for the transferee’s business is less than that of the tenant;

(vii)        the transferee’s proposed use may violate or create a potential violation of an applicable law;

(viii)       the transferee’s proposed use may create traffic congestion or burden existing parking;

(ix)          the transferee is a labor union, foreign or domestic governmental entity, public utility or tax-exempt organization;

(x)            the transferee is an existing occupant of the building or project, or a person or entity the landlord has dealt with previously with respect to leasing space in the building or project;

(xi)          in the case of a sublease, the monthly rental and other economic concessions result in the effective rent being less than the monthly rental landlord is asking for similar space in the building or project (the landlord sometimes prohibits tenants from advertising sublease space);

(xii)         any ground lessor or lender whose consent is required fails to consent;

(xiii)       the tenant is in default at the time of the sublease or assignment request;

(xiv)       in the case of a sublease, the proposed subletting would result in more than a specified number of subleases of portions of the premises being in effect at any one time or more than a specified number of subleases during the term of the lease.

4.              Tenant’s Remedies for Withholding Consent.

Since a landlord’s decision to withhold consent is a subjective one, many landlords prohibit a tenant from obtaining damages based upon any assertion that the landlord unreasonably withheld or delayed its consent to a proposed assignment or sublease, thus limiting the tenant’s remedy to injunctive relief.

Unless injunctive relief can be obtained immediately, the tenant may be in an unfortunate position even if it prevails in court. This is because the proposed assignee or subtenant will not put its relocation on hold while waiting to see how the controversy between the landlord and tenant is resolved. Therefore, some tenants seek to include a clause requiring an expedited arbitration where a dispute arises as to the reasonableness of a landlord’s decision to withhold consent to an assignment or sublease.

5.              Landlord Recapture Rights.

Because the control of one’s building or project is very important to a landlord, a landlord will often include a “recapture” clause in the lease. If a tenant seeks the landlord’s consent to an assignment or sublease under a recapture clause, the landlord has the option to “recapture” the space, terminating the lease. By recapturing the space, the landlord will release the tenant from any further liability under the lease. A landlord will presumably exercise this option (and forego having the tenant remain liable on the lease) if the landlord wants control of the space or if the landlord can relet the space at a higher rent.

The “standard” recapture option allows the landlord to recapture the space after the tenant has found a perspective subtenant or assignee and has reached agreement as to the business terms of the sublease or assignment. This puts the tenant in a difficult position of having to market the space subject to the landlord’s ability to kill the deal at the last minute. The tenant can minimize this problem by requiring the landlord to decide whether to exercise the landlord’s recapture option earlier in the process.

When drafting a recapture provision, landlords and tenants should consider including the following types of clauses in the lease:

(i)             The landlord will want to make it clear that the landlord may choose, in its sole discretion, either: (a) to recapture the space, or (b) not recapture the space (in which event landlord retains the right to decide whether or not to accept the proposed sublease or assignment);

(ii)           The tenant will want the lease to have a clear (and short) time period within which the landlord must exercise its recapture option;

(iii)          The tenant will want the ability to withdraw its request to assign or sublet if the landlord notifies the tenant that the landlord intends to terminate the lease;

(iv)          The tenant will want to recover the costs of its unamortized tenant improvements if the landlord terminates the lease;

(v)           The tenant will want the lease to specify that in the case of a proposed sublease, the landlord’s recapture right only applies to the sublet space and the lease will be amended to reflect the reduced size of the leased premises, with the rental rate and tenant’s share of taxes and insurance adjusted accordingly;

(vi)          The landlord will want to make it clear that if the landlord recaptures the space, the landlord may lease the space to tenant’s proposed transferee or any other party.

6.              Exceptions from Restrictions on Assignment or Subletting.

Restrictions on assignments and subleases are usually so broadly drafted as to cover any direct or indirect transfer of the tenant’s interest in the lease. However, there are certain types of transfers which should be allowed to occur without the tenant first obtaining the landlord’s consent. These include:

(i)             Transfers by an individual tenant to an entity controlled by the tenant;

(ii)           Transfers by a tenant to an affiliated entity;

(iii)          Transfers by way of merger, consolidation or the acquisition of assets or capital stock (however, if the lease is a retail lease, the landlord will want to condition the approval of such transfer on, among other things, the proposed transferee having sufficient retail experience and no change in the use of the premises).

7.              Bonus Rent.

A landlord will often require a tenant to share the profits the tenant receives from subletting space or assigning the lease. A “bonus” rent clause is one which entitles the landlord to receive some or all of the rent or other consideration payable by a transferee as a result of the lease transfer to the extent the new rent exceeds the existing rent. This additional rent may be in the form of a lump sum payment in the case of a lease assignment or higher subrent in the case of a sublease. Landlords justify their “right” to bonus rent on the theory that they, not the tenant, are in the real estate business, and only the landlord is entitled to increases in rents due to increases in the value of the real estate.

8.              Continuing Liability of Tenant.

Where a tenant assigns its interest in the lease, the tenant will remain liable for all of the obligations of the lessee under the lease unless the landlord specifically releases the tenant from the tenant’s obligations under the lease. Landlords are reluctant to agree to release the tenant and typically only do so, if at all, where the assignee has a sufficiently large net worth. Tenants sometimes ask for the right to retain a “security assignment” back of the lease if an assignee defaults to the tenant has a mechanism to retake the leasehold interest. Landlords can respond to such a request by saying that the landlord can achieve such a result by executing a sublease instead of any assignment.

9.              Subtenant Concerns.

A subtenant will have a number of concerns which need to be addressed when negotiating a sublease. First, the subtenant must determine if the landlord’s consent is required under the prime lease. If so, the effectiveness of the sublease should be conditioned upon the tenant obtaining the prime landlord’s consent to the sublease (and the landlord’s consent to all other relevant matters such as the subtenant’s proposed alterations and any changes in the use of the premises) within a specified period. If such consent is not granted within such specified period, the sublease will automatically terminate.

Second, if the majority of the terms of the sublease are “incorporated by reference” from the prime lease, the subtenant must carefully study the prime lease to be sure that there are no unanticipated pass throughs. In addition, there may be some provisions which should not be incorporated by reference (such as the initial construction provisions (especially any improvement allowances the landlord agreed to pay the tenant), further option rights of the tenant, and the rights of the parties upon condemnation or casualty). In addition, the tenant will want the subtenant’s default and cure periods under the sublease to be shorter than the tenant’s default and cure periods under the prime lease to ensure that the tenant will have an opportunity to cure defaults under the prime lease if the subtenant fails to cure such defaults under the sublease.

Third, the subtenant must be sure that it gets copies of all notices under the prime lease, whether sent by tenant or landlord. The subtenant should consider copying the landlord on notices sent under the sublease.

Fourth, if the prime lease terminates, the sublease terminates as a matter of law unless the landlord specifically agrees not to disturb the subtenant’s possession of the space upon a termination of the prime lease. This is often difficult to negotiate, especially if the subrent is less than the rent under the prime lease or if the subtenant is leasing only a portion of the premises leased under the prime lease.

Fifth, while the landlord will, as a practical matter, provide basic building services and be responsible for maintenance and repairs of structural elements and building systems, the subtenant is not privity with the landlord and cannot directly enforce such obligations against landlord. To address this problem, the subtenant will want the ability to: (i) terminate the sublease if a breach is material, and (ii) have the ability to require the tenant to enforce its remedies against the landlord, or if the tenant fails to do so within a specified time period, enforce the tenant’s remedies against the landlord directly as the tenant’s agent.

Sixth, the subtenant may be able to obtain the benefit under the sublease of any special rights the tenant received under the prime lease. An example of this would be the ability to make any repairs the landlord fails to timely perform and deduct the cost of such repairs from subrent.

10.           Landlord Consent.

The landlord will condition the landlord’s consent to an assignment or sublease upon the execution of the landlord’s form of consent. The form will, among other things: (i) require the tenant and the assignee or subtenant to acknowledge that the landlord is not in default of the lease, (ii) require the assignee to assume the lessee’s obligations under the lease, in the case of an assignment, or, in the case of a sublease, require the subtenant to abide by the terms of the prime lease, (iii) make clear that the landlord’s consent to the sublease or assignment in no way modifies the terms and provisions of the lease or in any way expands or enlarges the landlord’s obligations under the lease, (iv) reaffirm the ongoing liability of the tenant under the lease (unless an assignment in which the tenant is specifically released of liability), and (v) reserve the landlord’s right to approve all future assignments or subleases. If the tenant’s obligations under the lease were guaranteed, the landlord will also require a reaffirmation of that guaranty as condition to consenting to such assignment or sublease.