In most lease forms the assignment/sublease clause is buried near the back, somewhere between estoppel certificates and “miscellaneous provisions”. Many letters of intent contain no mention of restrictions on assignment/subleasing, and this provision often receives little or no attention during the initial negotiation of the lease.
In many ways, leases are like purchases of real estate – tenants receive a right to use the premises together with other property rights. Like most real estate ownership rights, the rights owned by a tenant are freely alienable unless there is a contract that restricts alienation. That is, absent contractual restriction, the tenant is free to buy, sell, (sub)lease, hypothecate, or otherwise convey or transfer its rights under the lease.
Most leases contain some restrictions on the tenant’s transfer of these rights. There are good reasons for this. Landlords have a legitimate interest in knowing who is occupying their property and the nature of the use of the property, and Landlords also want the opportunity to underwrite the credit of the tenant who will be paying the rent and operating in the space, regardless of who might be obligated to pay the rent.
For all of these reasons, most lease forms contain restrictions on assignment/subleasing by tenants. This article will explore some of the basic concepts of these clauses and hopefully provide food for thought in terms of your review of your current lease form.
Distinction Between Assigning and Subleasing
An assignment is a transfer of all or substantially all of the tenant’s remaining rights under the lease; that is, a transfer of occupancy of all of the premises for all of the remaining term of the lease. A sublease is a transfer of less than all of the tenant’s remaining rights under that lease; that is, a transfer of occupancy of a portion of the tenant’s premises, or a transfer of occupancy for a portion of the remaining term. Under the law of most states, absent an agreement to the contrary, the tenant remains primarily liable to the landlord under the lease (though most leases contain language affirming this point). The difference is that under an assignment, the assignee must do everything the tenant is obligated to do, including paying rent, CAM, etc., and maintaining/cleaning the premises, etc. In contrast, under a sublease, the tenant must act as a pseudo-landlord for the subleased premises, making sure that these items are completed.
The simplest lease provision on assigning/subleasing states that tenant “shall not assign, sublease, transfer, hypothecate or otherwise convey all or any portion of tenant’s interest under this lease.” This type of outright prohibition of assigning/subleasing is rare but may be warranted for special use buildings occupied by a tenant uniquely suited to such special use. In general, restrictions against alienation are disfavored in the law, and thus if you are considering an outright prohibition of this nature, there ought to be a good business reason justifying it. For generic office space, such a restriction is likely not enforceable, which could render the clause meaningless and give the tenant an unfettered right to assign/sublease. However, for highly specialized properties with a unique user/tenant, such a restriction might be appropriate.
To add a level of discretion to the provision above, the drafter could add, “without prior written consent from Landlord, which may be granted or withheld in Landlord’s commercially reasonable discretion.” Court generally like “commercially reasonable” standards. There are clearly articulable reasons underlying decisions made in a commercially reasonable fashion. Perhaps a proposed assignee is not as creditworthy as the original tenant, or intends a use that is not consistent with the character of the property, or the assignee is a current tenant in the property and the assignment would leave a vacancy for the landlord in the building – these would be circumstances under which it might be commercially reasonable for the Landlord to deny its consent.
Mergers and Acquisitions
We often think of assignments or subleases in the context where the tenant wants to place another occupant in the premises. However, what happens when a tenant is purchased by a competitor, or where the tenant merges with another business? This is perhaps the most commonly negotiated portion of a typical assignment/sublease clause. It is often critical to tenants and for this reason we suggest that modern LOIs contain a provision discussing this so that the parties know up front what they are agreeing to on this point. Is it a transfer if the tenant conveys 49% (or 50% or 51%) of its ownership to a new equity member? Does the percentage depend solely on the tenant bylaws and/or articles concerning transfer of control? Does it make a difference if the company ownership is such that control of 34% of the equity results in effective control of the company? Tenant should look closely at these provisions, as they affect the long-term strategy and viability of their business operations. Tenants should think about what their longer-term business plans are when negotiating this position, as Landlords who have strong prohibitions against assignments can hold up sales or mergers.
Profits from Subleasing
If a tenant leases space at $10/psf, but later manages to sublease at $12/psf, the tenant could sit around and make a tidy profit with no investment or risk. The landlord obviously does not lease out space so that tenants can profiteer from arbitrage in market values. Thus, a well drafted assignment/sublease clause should require the tenant to pay this profit (net of leasing costs) over to the landlord, and can be negotiated by tenants to state that a landlord is entitled to some percentage of the profits, less costs tenant incurs related to such subleasing or assignment (leasing commissions, improvements, etc.).
Recapture and Similar Provisions
The concept of recapture is that if a tenant wishes to assign or sublease all or virtually all of its space, the landlord should be able to “recapture” the space and seek to lease it out at market rent in a direct relationship with a new tenant. Like all contractual provisions, recapture provisions can be a double-edged sword. A landlord who elects to recapture is essentially releasing the tenant from future responsibility. What if the new assignee/subtenant ends up being a bad tenant, or going out of business? Worse, what if the landlord recaptures and the proposed assignee/subtenant backs completely out of the deal at the last minute. For all of these reasons at the very least, a good recapture provision allows the landlord to gather some level of information about the proposed new assignee or subtenant for the purpose of conducting due diligence on the question whether to recapture.
Third Party Relationships
There are some third party contractual relationships that often affect assignability. The most common are where the tenant is a franchisee of a national franchise, or where the tenant is obtaining a significant amount of financing to construct extensive leasehold improvements within the premises. In both cases, the tenant’s franchisor and/or lender will ordinarily expect the landlord to enter into a three-party agreement that gives the franchisor/lender broad rights to take over the premises in the event the tenant defaults, and to then assign the leasehold to a successor selected by the franchisor and/or lender.
It is of course up to the landlord’s business judgment to determine whether and/or when to grant these rights to a franchisor/lender. However, in many instances it is impossible to sign with the tenant unless these rights are granted.