Part 2! Dealing with a Financially Challenged Landlord (or Sublandlord)
Dan Duray Nov. 4, 2010, 1 p.m.
In Part 1 of this column in September, we highlighted tenant protections against a landlord in distress, in particular use of the Subordination, Non-Disturbance and Attornment Agreement, or SNDA. Essentially, in return for subordinating the lien of the lease to the lien of the mortgage, the lender agrees not to “disturb” the tenant in the event of a landlord default and a subsequent foreclosure. We also highlighted that the typical SNDA represents a sharp trade-off for many important tenant concessions and protections as were obtained during hard-fought negotiations.
Now, we discuss protecting subtenants and brokers from sublandlords and landlords in distress. Where we last covered tenant protections, now we look at some peculiar issues to be dealt with in the sublease context, and then revert to the issue of how brokers can protect their commissions, whether in a direct lease or a sublease scenario.
The scene: midtown office of a midsize ad agency.
The dramatis personae: the agency COO, its lawyer and its broker.
The discussions to this point: On the table is a draft term sheet for a seven-year 18,000-rsf sublease from a fairly well-known communications company in a Class A building at a substantially below-market rent. The space is pretty much in move-in condition. Broker will be getting its standard commission rates, but payable in two installments, half at signing and half six months later.
(We now listen in on the conversation. …)
Tenant: That rent is so appealing, but I have to be concerned about the finances of Telcomm. The street says they may not be around through the end of the year, let alone until 2017, when our sublease term ends. You know I’m a bit gun shy here. Back in the ’60s, when we first opened Cooper Sterling, we had taken a few rooms from one of our marginal clients–of course, that’s the only kinda client we had back then [chuckles]— and the guy left town owing mucho rent and we got booted by the landlord. It was not a pretty scene. [Tenant pauses to light a cigarette, his ninth of the day, and reaches for the bottle of Jack Daniels he keeps on his desk. It’s 10 a.m.]
Lawyer [declining the proffered bottle]: Well, a Recognition Agreement from the building owner should go a long way in terms of making sure you don’t have to live through that again, but the big bargain rent may be in jeopardy; that rent concession in years two and four will also take a bullet.
Broker [to himself, while debating the pros and cons of the proffered bottle]: Hmmm. I better figure out how I’m gonna make sure my commission gets paid … especially as half is due six months after signing. Gotta find that memo to all brokers on this from the company’s new international HQ office in Saigon. Try for an escrow? Commission in lieu of rent? Nah, that will never fly. Broker’s Entitlement Affidavit? (Does that apply to commercial leases?) Well there’s always a lien action … but who’s gonna pay for the litigation?
Oh, before we move off tenant protections, I wanted to share with you a letter I received after Part 1 of this column appeared:
You have said that SNDA equals bargaining power. I represent a space-challenged small tenant. I was laughed at when I requested that SNDA. What should I do?
If unable to get an SNDA, at least get a representation from landlord that it has not received notice of default from lender. While not protecting tenant from future default, at least tenant will know it is not signing on with a landlord in trouble.
Hope this helps.
O.K., NOW ON to protecting the subtenant.
We emphasized the importance of the SNDA in terms of protecting the tenant from a foreclosing landlord’s lender in the direct lease context; well, a document called the Recognition Agreement (“RA”) is its counterpart in the sublease context.
Simply put, under a Recognition Agreement, if the prime tenant-sublandlord defaults and the prime lease is terminated, the landlord will recognize the subtenant as its new, direct tenant. For the sake of completeness, we’ll add: provided the subtenant did not precipitate the tenant’s default and provided, too, that the subtenant is not then in default of its sublease obligations.
Like the SNDA, a tenant with clout will try to negotiate for this agreement up front, so it can be offered to suitable prospective subtenants. It is far more important than a mere subleasing checklist item.
With a sublease, potential pitfalls are magnified. Sure, a tenant may seek to sublease in connection with a consolidation of its operations or simply to lay off excess space for future expansion, but often the context is more dire: The space is on the market because the sublandlord is weak.
Again, major tenants are able to extract some agreement from the landlord to provide the RA when the initial lease is executed, usually with parameters as to the financial qualifications of the subtenant. More frequently, the request for the recognition agreement comes at the time the sublease consent is requested. The issue for the subtenant negotiating team is how to make the sublease equal a viable, market-worthy lease (and the subtenant an attractive direct tenant) in the landlord’s eyes.
As with the SNDA, if there is to be a “takeover,” the landlord does not want unwelcome baggage to go along with the deal. More on this later.
Leaving aside glamorous legal concepts as to privity of land and contract (stifle that disappointment) the landlord-lender-tenant relationship is different than that of landlord-tenant-subtenant.
All relations between landlord and subtenant flow through–are subordinate to–the main or prime lease. When we discussed the SNDA, it was in the context of protection from a foreclosing lender–that “S” was for subordination, getting the lien of the lease subordinate to the lien of the mortgage.
Not so in the sublease context. In fact, by definition, there is no such thing as a nonsubordinate sublease. If the prime tenant is forced out of the picture, the sublease ipso facto (O.K., you got some Latin) disappears and the subtenant must surrender and vacate or, if fortunate to have a Recognition Agreement, then a new legal relationship is formed, a direct relationship (tenancy) between the prime landlord and (former) subtenant.
WHO IS LIKELY to get a Recognition Agreement and what does this new relationship look like? As in the case of the lender who has granted an SNDA, the landlord in its Recognition Agreement declares it is not bound by prior defaults of the sublandlord, or rights of offset the subtenant may have, nor essentially much of any term or condition in the sublease that varies in the subtenant’s favor from the terms and conditions of the prime lease: yes, most significantly, any difference in the rent.
Other provisions not adopted would include: acts or omissions of the sublandlord (thus, no obligation to cure sublandlord defaults), the old security deposit (a new security deposit would be required), prepayments of rent, rent concessions and special services, if any; nor will the landlord be obligated to recognize certain affirmative rights and obligations it had bestowed on the prime tenant-sublandlord such as options to renew or rights of first offer.
As to who will qualify for an RA, first, second and third, it will be an entity with an appropriate net worth so that the landlord can be reasonably assured that this go-round his tenant will have the ability to pay and perform (also known to Who fans as the “won’t get fooled again” initiative). Note, too, that it is not uncommon (in fact quite understandable) for the landlord to request additional security at this juncture.
Lastly, to anticipate the next letter from a clout-challenged reader, if your landlord will not give a Recognition Agreement, then here’s a stop-gap to negotiate: the subtenant to receive notice of any prime tenant default and the opportunity to cure on behalf of the prime tenant. At least that way the sublease will not be at risk. (And if trying this gambit, don’t forget to include a concomitant right of rent setoff in the sublease.)
FOR BROKERS: COLLECTING your commission.
First, the good news: Most of our local landlords are decent, honorable businesspeople who pay brokers the commissions earned. O.K. Got that out of the way. Now, at least for the purposes of completing the promised essay, let’s turn to the landlord who makes a business decision to not pay because the brokers’ remedies of arbitration or litigation are costly and months will pass before the landlord actually must make the payment.
What’s in the brokers’ quiver to deal with this mal-“ownerous” (audible groan) recreant? Here are a few:
- Escrow or letter of credit to secure future payments.
- Rent in lieu of commission clause in lease.
- NYS Lien Law Sec. 2(4) re improvements, and for residential brokers in connection with sales contracts.
- RPL 294-b (a.k.a. the Commission Escrow Act).
Certainly, getting a landlord to agree to an attorney escrow or LC to secure payment of future commission is a wonderful achievement. The basic problem is the landlords you’re most concerned about are the ones least likely to be in a position to show you the money. I also like the inclusion in the lease of a so-called “rent in lieu of commissions” clause, where if the landlord stiffs the broker, the tenant will pay and have the right of setoff against rent.
It’s a very powerful tool, and the fact that it’s still a rarity has a lot to do with a tenant’s (fairly sensible) reticence to put himself in the middle of a dispute between the landlord and the broker, with a rent default notice being dangled in front of him as a not-too-subtle message to stay out of the fray. (Some have suggested that it’s better to include this in a separate tri-party agreement–landlord, tenant, broker–than in the lease, but I don’t see much practical difference.)
Filing liens can also help brokers collect commissions.
The broker’s lien, while infrequently invoked, is a very potent addition to the broker’s arsenal. Once docketed, it is akin to a mortgage and can be foreclosed à la the typical contractor’s lien. A title search will highlight the lien, and any prospective purchaser or lender will demand that it be cleared of record prior to a sale or refinancing. The filing will also trigger other unwelcome results, including a notice from the landlord’s mortgagee demanding that the lien promptly be paid or bonded upon penalty of the mortgage being declared in default. Good stuff.
As with all statutory benefits of this type, the requirements are strictly construed. The NYS Lien Law (Sec. 2 ) applies to commercial leases with a term in excess of three years, and there must be a written brokerage agreement.
What the statute did for the leasing brokerage community was to equate brokerage services on longer-term commercial leases to an “improvement” (like a contractor doing foundation work), which can then be the subject of a foreclosing lien. Yes, indeed, serving a Notice of Lien will get an owner’s attention. Then the owner will have to either bond or pay. (Note that any requested waiver of the right to lien can be ignored. It is void as against public policy.)
Among other suggestions we heard for brokers is the future commission agreement being exhibited with the lease, so the “world” knows of the arrangement; also, that the commission agreement provide for acceleration of the payment schedule if there is a default; lastly, if that commission in escrow or commission in lieu of rent or the like is simply not on the table, at least get the landlord to make a representation in the lease that he has put aside funds for the commission.
Yes, better than nothing. Would that the community only had to deal with the good guys.
Jeff Margolis is founding principal of the Margolis Law Firm in New York City, where he specializes in “dirt law”: buying, selling and leasing. He writes regularly for The Commercial Observer on legal issues. Part 1 of this column can be found at: http://tinyurl.com/3432j42.