Part 2! Exit Strategies for Commercial Tenants

When last we met we were discussing the need to plan ahead–exit strategies in commercial leasing–with a focus on retail. A number of scenarios were mentioned, such as the plight of a local eatery with what was once a novel concept that had become totally dated. We distilled the tenant goal on transfers down to one word: “flexibility.”

We then focused on assignment and sublet rights with the leasing goal to balance the owner’s need for stability and financial equilibrium and (in the case of the shopping center owner, maintaining the right tenant mix of uses) with the tenant’s focus on maximizing reasonably unfettered “transferability” of the lease–especially in the context of a potential sale of a retail location; or, especially pertinent nowadays, particularly in office leasing, in the context of a market-driven downsizing.

Also discussed was the need for the tenant’s advisers to look out for red-flag items: onerous restrictions (e.g., in a restaurant lease, use limited to one particular type of cuisine [“Nepalese burger bar ‘and for no other purpose'”]) that can make it all but impossible to sell the business. A number of questions came to mind, such as, is the landlord’s consent required? Criteria for consent? Must the landlord be “reasonable?” And, if so, what exactly does that mean?

General rule: Absent a statute or express restriction in a lease, a tenant has an absolute right to assign or sublet.

As to say the least: This did not sit too well with landlords (even landlords of biblical times); my legal brethren of long-ago dutifully took that old one-tablet, one-commandment lease (“Thou shall pay thy rent”) and chiseled in a second: “Thou shall not assign or sublease without landlord’s consent.” (As to how that now two-commandment ancient stone tablet turned into a 110-page “modern” lease form, I’ll have to save that for a future column.)

O.K., so we have landlords favoring restrictions and tenants seeking flexibility, their ability to assign/sublet essential to realizing the value of the business, but let’s drill down as to some details.

First, let’s look at the range of landlord clauses as to assignment and subletting:

• Total prohibition.
• Free consent.
• Assign with the consent of the landlord.
• Assign with consent but subject to certain enumerated conditions (e.g., consent not to be unreasonably withheld provided …).

e spoke above of the general rule regarding the tenant’s unfettered legal rights to assign or sublease under common law principles, but what of the landlord’s right to restrict? Is there a legal right to be unreasonable?

In New York the answer is “yes.”

In some jurisdictions (such as New York) consent can be arbitrarily refused if the lease does not provide for what I’ll call mandatory reasonableness. If the terms of the lease are clear and unambiguous, the provision will be enforced without a court inquiring as to the parties’ intent. One caveat: As this restriction constitutes a restraint on the free alienation of land, it is viewed with disfavor by the courts and will be strictly construed against the landlord. Also, restriction against assignment will not preclude subletting, pledging or mortgaging the lease, or granting a license. Likewise, a restriction against subletting does not prohibit an assignment.

So, let’s say you’ve done some good negotiating and obtained a somewhat favorable transfer clause. What does it mean when the lease provides that the landlord’s consent cannot be “unreasonably withheld?” Well, it’s far from a done deal.

• Landlord must act in an objectively reasonable commercial manner; and …
• … what is reasonable will differ depending upon the type of property. For example: commercial office building vs. multi-use complex vs. shopping center.

Proposed subtenant’s or assignee’s:

• Financial condition (most objective).
• Reputation and character (most subjective).
• Business experience.
• Identity (already a tenant in the shopping center or office building?).
• Use (whether the proposed new use conflicts with exclusive or restrictive use provisions in other leases).
• Nature of the occupancy-while no direct conflict, relevance to existing exclusives (shopping center)-suitability for tenant mix.

Also, as to tenant:

• Must not be in default.
• Must be in good financial standing.
• Tenant’s lender/franchisor may have to consent.

Landlord may also:

• Provide certain criteria deeming specific types of occupants or types of use as unacceptable.
• Disallow the tenant from increasing the number of occupants and/or regular visitors who frequent the premises.
• Disallow the tenant from subleasing to other tenants of the premises or a third party with whom landlord is then negotiating.
• Restrict the use of the leased space to the use that is specified in the lease agreement.
• Provide that any profit on the transfer must be paid to the landlord.
• Require the tenant to reimburse the landlord’s expenses in connection with the assignment or sublet.

The most objective test to determine the financial responsibility of the proposed assignee or subtenant: Net worth = to or greater than net worth of tenant as of the date of the original lease? Date of proposed transfer? (Note: possible interplay of this test with issue of transferor’s release from liability.) Courts have ruled that even seemingly highly subjective, vague and nebulous criteria such as “tone” and “image” may be considered by a landlord in withholding consent if there is evidence showing that the landlord’s subjective concerns are also objectively reasonable.

Proposed use: If same? If different?

• Tenant mix in a shopping center-interplay with exclusives (landlord’s counsel citing the Wrack case, holding it was reasonable to deny consent where the tenant mix is critical-the proposed tenant already leased mall space for the same proposed use).

Practice pointers:

Under the be-aware-of-silent-(not apparent from the face of the document)-lease-clauses category: You’re a tenant and you have reached some agreement concerning consent not to be unreasonably withheld, but weeks and then months drag by without any response. What if no time limit for the landlord’s consent is provided for in the lease? That’s why we always add language along the lines of “consent not to be unreasonably withheld, delayed or conditioned.”

One more: The typical lease assignment and sublet clause provides that prior to the landlord making a decision as to granting consent, the tenant must submit a fully executed assignment agreement or sublease, to streamline and simplify the approval process; agree that instead of providing a fully executed document, a simple term sheet will suffice. Otherwise the deal could wither on the proverbial vine, or, to paraphrase, a consent delayed often has the practical effect of consent denied.

Practice notes:

If a landlord has the right to consent, tenant should seek to have excluded, at the very least, assignments to affiliates; assignments in connection with mergers and consolidations; and assignments in connection with a sale of all or substantially all of the tenant’s assets. Also, any recapture rights and profit to landlord clauses should be waived in connection with transfer to certain permitted transferees-for example, a franchisor.

If the landlord participates in “profits” on the transfer, limit to net profits and give broad definition to the tenant’s expenses, allowing the tenant to recoup costs in connection with the transaction and also its TI work. Don’t just net out general expenses; be very specific:

• Brokerage.
• Legal.
• Marketing.
• Advertising.
• Alterations.
• Takeover.
• Free rent.
• Cost of carrying space.
• Transfer taxes.
• Unamortized balance of tenant’s original improvements to the space (TI work).

Make sure it’s only excess rent that is shared, not any other consideration received from transferee in the course of the sale; also look out for unlimited expense reimbursements for the landlord’s consent (legal, etc.)

“Silent” Lease Issue (last pointer for today):

Tenant’s profit participation payments to the landlord should be due only to the extent the tenant actually receives the anticipated “profit.” If there are installment payments, and the subtenant or assignee defaults, the tenant should be able to stop paying and perhaps insist on recalculating any payments already made.

We’re beyond permitted space here, so we’ll save for a future column a discussion of related lease clauses that the tenant’s counsel must consider in negotiating exit strategies/representing a prospective buyer: the not-so-silent lease provisions-for example, some rights as to changes in the use clause, and any assignment clauses that automatically cancel Options to Renew upon the sale of the business, and perhaps most important from the tenant’s POV, the tenant’s legal and equitable remedies if the landlord wrongfully withholds consent.

jamargolis@ newyorkleaselaw.com 

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.