Circumventing Lease Transfer (Assignment – Subletting) Restrictions And Other Ploys (Part 3)

Today’s blog posting may not make sense to those who haven’t read our previous two postings. In the first part of this three part series, we presented some basic assignment and subletting concepts, legal and practical. That can be seen by clicking: HERE. Last week we continued that presentation, but moved into what we titled: “The Troubles I Have Seen – General Assignment / Subletting Issues.” That posting ended with a list of shortcomings commonly plaguing many assignment/subletting lease provisions. It can be seen by clicking: HERE.

Today, we continue by listing more practical issues faced by all of us when trying to restrict lease transfers (what most landlords seek to do) or when trying to facilitate lease transfers (what most tenants seek to achieve). Even if you’ve chosen not to look at the prior postings, we guaranty that today’s posting will make you want to do so. So, to that end, we begin with:

Creative Use of Entity-Tenant Structuring

• In most cases and most jurisdictions, the transfer of an ownership interest in a tenant does not constitute an assignment and won’t violate a bare-boned “no assignment” provision in a lease. According to the case law, “the landlord should have anticipated such transfers.”

• Allowing assignment to an affiliate of the tenant and not dealing with changes in ownership interests will allow the assignee-affiliate to change its ownership and defeat any restrictions dealing with assignments to non-affiliates. Freely allowing a tenant to sublet to an affiliate without barring or restricting an assignment of the sublease or a further subletting can result in an otherwise prohibited subtenancy. Mischief indeed. Merely saying that a transfer of ownership interests is deemed to be an assignment won’t avoid all circumventions. What if a corporate tenant or an LLC restructures itself by bringing in entirely new owners by issuing new ownership interests and making the old owner a non-economic owner or only an economic participant once the tenant has a net worth of more than, say, 900 trillion dollars?

• Under the doctrine of independent covenants, a tenant may be able to accomplish indirectly what it couldn’t effectuate directly. A merger or other corporate or entity restructuring can be seen as resulting in a transfer of the entity’s assets by operation of law, and if the restructuring doesn’t trigger a no-transfer lease provision, the lease transfer by operation of law can bring about what would otherwise have been a prohibited assignment. This allows a tenant with the right to assign its leasehold interest to an affiliate to drop the lease into the affiliate and merge the affiliate into a stranger.

• On the other hand, some jurisdictions treat transfers from a parent to a subsidiary as an assignment, but don’t see a transfer from a subsidiary to its parent the same way. Perhaps those decisions were influenced by the facts, stated or not. With that in mind, tenants may not want to face the issue at the time they need to make such transfers.

• Entity reorganizations pose additional issues. Suppose a tenant wants to reorganize in a different jurisdiction? At one time, to do so, effectively resulted in the creation of a brand new entity, albeit with all of the assets and liabilities of the old entity. Traditional lease provisions may have relied upon the technical creation of a new entity. To the extent that made a difference and gave a landlord comfort or a tenant grief, today, in an increasing number of jurisdictions, an entity can be “domesticated.” The purpose of domestication is to keep the same legal entity intact, thus making what previously may have been prohibited – permitted.

• Including restrictions in a lease to deal solely with assignees and subtenants does not address the entire range of possible occupants or capture all those who, holding under the tenant, effectively control the leased space. For example, a tenant may allow another to manage its business, and in effect step-in for the tenant. The tenant may effectively turn its business over to someone else through use of an operating or profit sharing agreement. It might or might not retain some management control over the resulting business, but never exercise those rights. This isn’t to say that every such and similar arrangement will pass muster. To the extent one can summarize the “test,” it is whether the tenant still holds some effective, economic interest in the real estate. If it does – no assignment; no subletting. This is a fact-sensitive, “feel and taste” area, where it is difficult to predict what a court would do. As a result of such uncertainty, settlements are common. If the matter can be settled when it happens, the lease could have covered it in the first place.

• A concessionaire looks like a subtenant for some purposes and not for others. So, does a restriction against subletting bar such arrangements?

The Devil is in the Details

• Using terms loosely often creates problems, issues, and uncertainty. Conditioning an otherwise permissible transfer on an assignee’s or subtenant’s net worth overlooks that a tenant can meet the test and yet be worth nothing. The concept of net worth, standing alone, is one used by accountants and can include items of no comfort to a landlord. It includes certain intangibles, such as good will, and as a result many an insolvent company had a solid net worth at the same time. That’s why some draftspeople talk of “tangible” net worth.

• Just stating that a tenant will pay its landlord a portion (say, half) of the “consideration” received upon a lease assignment or a subletting leaves the parties to guess (fight?) about what constitutes “consideration.” Is the value of the tenant’s business wrapped up in the amount to be shared? What if a tenant assigns a package of leases at the same time? What is the consideration if parties swap one or more leases? How does one handle a tenant’s transaction costs? Is it deducted from what it receives? If it is deducted, when? Over the remaining lease term; all at once, up front? What are those transactions costs anyway? Do broker’s commissions and legal fees qualify? What about the cost of refitting the leased premises for use by the assignee or subtenant? Can a tenant take credit for the time its space was vacant (a/k/a – “during the “down time”)?

• How long does a tenant need to wait for an answer from its landlord about a proposed lease assignment or subletting?

• What happens if a lease states merely that a tenant may not assign it or sublet the leased premises or if, using a variant approach, says it may do so, but only with the landlord’s consent? It appears that a majority, perhaps even a substantial majority, of jurisdictions do not require the landlord to be reasonable. But, by saying “a majority,” room has been left for the minority view. So, the lease needs to adapt to the place where the leased premises are located. Even at that, the winds they are a shifting, and they are away from the day when, left unsaid, a landlord didn’t have to be reasonable. Little by little, the implied covenant of good faith and fair dealing is on the minds of the courts. And, by the way, in those jurisdictions that have been enforcing this covenant, it is likely that even when a landlord reserves the right to deny consent for any reason or no reason at all, it can’t do so with the purpose of taking away a tenant’s reasonably expected benefit of the bargain. Basically, the covenant, as is increasingly being interpreted, prevents a party from using a given contract right as a sword when it was intended to be a shield.

• Even if a lease or a jurisdiction’s particular case or statutory law requires a landlord to be reasonable, there is a lot of room, perhaps even a hi-rise building’s worth of rooms, to argue: reasonable over what? The character of the new occupant’s use? The character of the new occupant’s ownership or management? Its financial strength? The landlord’s business prejudices? The availability of other empty space at the property? A deleterious effect on the expected percentage rent? Jurisdictions are all over the place on this and the law is far less than clear even where there is law. Further, the law changes over time. What is more predictable, however, is that, absent some serious public policy problem, courts respect the agreement struck by the parties to a lease, and if the lease is silent, the courts will fill the gap.

Inadvertent Waivers of Consent

• Then, there is the inadvertent granting of consent to a lease assignment by the acceptance of rent from an otherwise ineligible assignee with knowledge of the assignment. A broad “no waiver” provision in a lease may not cover this; a specific waiver in the lease might be a wiser approach.

Remedies of the Parties

• So, the tenant assigns or sublets anyway. Is the assignment or subletting void or voidable as between tenant and landlord? Is it merely a default, giving rise to a right on the landlord’s part to terminate? If the landlord terminates the lease as a result of the unauthorized assignment or subletting in a jurisdiction where a landlord has a duty to mitigate a tenant’s damages, has the landlord breached its mitigation obligation by throwing the assignee or subtenant out?

• Suppose, by its terms, the lease terminates automatically upon a prohibited assignment or subletting. Can a tenant use this to avoid future liability? Probably not because this would bring about an illogical result, but it could put bargaining power in the tenant’s hands where none previously existed based on the uncertainty of result.

• Perhaps the worst that can happen to the landlord who wrongfully denies its consent to a lease assignment or a subletting is that it loses the tenant and can’t collect damages or the balance of the rent under the lease. Or, perhaps the landlord isn’t that lucky and its tenant earns an award from the landlord as compensation for the tenant’s losses when its assignee or subtenant walked away from a fight. A lease can limit a tenant’s remedies, and if a landlord wants to be protected, it can negotiate for such limitations.

• Even where a landlord is not permitted to act unreasonably, local law may place the burden of proving unreasonableness on the party who didn’t expect that it would have to do so.

• Some leases allow a landlord to “recapture” the lease or part of the leased premises upon an actual or proposed assignment or subletting. Let’s say a tenant only requests its landlord’s consent to a transfer and the landlord exercises its right to recapture. Is that the result the tenant expects?

• Let’s say the tenant purportedly assigns its interest in the lease when the lease says it can’t. So, is that a breach of the lease that permits the tenant to attempt a cure and avoid a lease termination and consequent eviction? Or, is the purported transfer ineffective and therefore not even a breach of the lease because “it didn’t take place in the first place.” Perhaps it is easiest to ask forgiveness instead of permission. Perhaps the new tenant or subtenant will be there long enough so as to undercut any argument that it doesn’t “fit” at the property. Or, that it is there long enough that injunctive relief may not be available because it becomes clear that there is no irreparable harm.

Back Door Issues

• Even a lease that lets a tenant freely assign to another person or entity can have hidden restrictions. Care may not have been taken to allow for any lawful use. There may be no continuous operation provision. There may be no trade name restrictions and no signage problems. But, what about the otherwise innocuous lease terms? By way of example, a lease might require the tenant to submit copies of its public filings, but the assignee, otherwise qualified, is not a reporting company? What if the lease contains a net worth or shareholder equity threshold that would permit consent-less assignment and the proposed assignee, while owned by a qualifying parent company, doesn’t meet that test? That’s easy to overlook, but the consequences could be distasteful. Certainly the assignee’s parent company could take the lease directly, but what if, for legitimate business or taxation reasons, it didn’t want to do business in the jurisdiction where the leased premises are situated? Planning ahead when a lease is drawn can avoid this dilemma.

• Speaking of continuous operation provisions in a lease, it might be noted that in a lot of situations it is difficult to change tenants without closing down the business operation at the leased premises. Left uncovered, that could be a show stopper.

• Almost everywhere, a landlord is under no obligation to give its tenant an estoppel certificate unless the lease requires such. So, an incoming assignee or subtenant may be stepping into a hornet’s nest without first being able to see inside.

• Suppose, after the underlying lease is terminated, a landlord wants to force a subtenant to remain as a direct tenant? A properly crafted lease provision could make this happen or even give the landlord the choice of doing so at the time in question, but if the lease (or sublease consent) is silent, the subtenant can pack up and leave.

• A lease can be mortgaged by the tenant absent a restriction in the lease to the contrary. But, what good would a leasehold mortgage be if an unexpected lease termination, such as by reason of the tenant-borrower’s default, leaves the lender with a terminated, valueless lease as collateral? A well-crafted lease will make it financeable in the hands of a tenant. Otherwise, maybe not.

• Absent a restriction to the contrary, when a tenant assigns its interest in a lease, it assigns all rights it has under that lease. What if a landlord later regrets that the right to renew the lease follows the assignment?

The Trouble With Subtenants

• How frustrating would it be for a landlord to see that a subtenant, with whom it has no privity, is paying rent on time, each and every month, but the subletting tenant isn’t. A lease provision allowing for a landlord to insist upon direct payments by the subtenant under such circumstances might have avoided such a situation.

• When a subtenant signs on, it takes the risk that a lease termination, even one having nothing to do with the subtenant’s behavior, will terminate its possession. While it has a monetary claim against its sublandlord, the original tenant under the lease, how good will that claim be when the reason the lease was terminated in the first place is that its sublandlord went out of business? A lease can be crafted to obligate the landlord to recognize the subtenant as its direct tenant under those circumstances, but if the issue isn’t addressed in the lease or in a later sublease consent, the subtenant will be out on the street.

• A landlord’s dealing with an assignee may prejudice the original tenant’s ability to protect itself from future liability when the assignee defaults under the lease. In a lot of cases, this prejudice will relieve the assignor-tenant from its liability as surety for its assignee.

• A landlord may not be doing itself a favor if the lease prohibits assignments, but it gives its consent anyway. If the lease (or the consent document) doesn’t provide otherwise, the assigning tenant may be immediately off the hook for future lease obligations.

It’s Now The Readers’ Turn

Oh, how much easier life would be if one could buy (or lease) a perfect, clear crystal ball. Until the time that fortune telling is perfected, landlords and tenants may need to continue their reliance on their own experience, acumen, and talent and that of their own qualified real estate leasing lawyer. The lists presented over this and our prior postings are long, but only the limitations of the author’s mind, his sense of “enough is enough,” his (limited) talents, and his belief that the reader will be exhausted by this time, have brought it to an end. So, consider them as only suggestive in nature because the scope of this three-part presentation precludes anything more than laying out an abbreviated list of the consequences of leaving myriad assignment and subletting issues unaddressed in a lease. There is no shortage of literature suggesting lease clauses to deal with, plan for, or avoid these and other common and uncommon problems. Find them; use them.