Legal N Illinois

Guest post: Protecting yourself in a sublease or assignment

  
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James Moorhead

Tech companies have been growing and hiring at a very quick pace for several years now. These companies have been growing at such a speed that they have become a significant percentage of the new office leases in markets such as downtown Chicago.

by James Moorhead, Moorhead Law Group

Tech companies have been growing and hiring at a very quick pace for several years now.  These companies have been growing at such a speed that they have become a significant percentage of the new office leases in markets such as downtown Chicago.

Tech firms now are taking a more cautious approach to growth and hiring.  With this slowdown in growth, the high demand for office space is similarly slowing.  Available sublease space has increased markedly as a result of the tech companies attempting to decrease their office footprints and expenses.

It might be too late for landlords and tenants to review and improve the sublease and assignment provisions in existing signed leases.  However, for brokers, investors, developers and tenants, a transitional moment in the market like the one we are now experiencing with the tech companies is a good reminder to make sure that sublease and assignment sections in leases are as tightly written as possible.

An assignment and sublease provision rarely has an immediate impact on the parties at the time the lease is signed.  Consequently, the parties have been known to review it quickly during the negotiation and to not think through this section as carefully as they should.  The assignment and sublease language will become very important if the tenant needs to quickly transition out of the space, so all parties to a lease should negotiate this section with an eye toward future concerns.

For owners, developers and landlord brokers

Landlords and tenants sign leases with the expectation that the tenant will do well at the location.  Property owners and their brokers will have done the necessary due diligence and security deposits and guarantees will have been put in place to protect the owner.  Excitement is high, and the desire generally is to get the lease signed and the business opened as soon as possible.  The reality, however, is that the statistics for businesses are daunting.  Roughly 80 percent of new businesses fail within the first two years.  The 2009 recession showed that even seasoned businesses can face severe challenges.

A landlord needs to protect itself in several important ways in a sublease or assignment situation.  The main concern for the owner is to maintain control of the property, including the tenant use, the intensity of the use, such as parking and HVAC demands, and any environmental impact.  For retail landlords, the quality and mix of the tenants also are critical considerations.

The owner’s lease negotiation checklist should include the following for the sublease and assignment section:

  1. All subleases and assignments should require the prior written consent of the landlord, with tenant requesting the consent and providing a copy of the transferring document at least 30 days – but ideally 60 days - in advance of the planned transfer date.
  2. Detailed information regarding the identity and financial status of the proposed assignee or subtenant should be provided with the tenant’s request for consent.
  3. Landlord should have the right to terminate the lease in lieu of the sublease or assignment.
  4. Tenant should remain liable under the lease and not be released.
  5. Landlord’s consent should be limited to the immediate transfer, and consent should remain required for any subsequent assignment or sublease.
  6. A change in voting control of the tenant should be deemed an assignment.
  7. Tenant should reimburse the landlord for landlord’s cost to review and consent to the assignment or sublease. The landlord likely will incur legal expenses for the transfer.  It also might incur engineering and architectural expenses.  The landlord also probably will spend internal administrative time to accommodate the transfer.  The cost for tenant to transfer the lease should not be the landlord’s obligation, so the reimbursement requirement is reasonable and standard.
  8. If the rent or consideration under the sublease or assignment is greater than the rent under the lease, then the landlord should have the right to the excess rent. The reason is that the landlord, as the owner of the property, should have the right to avail itself of the opportunity to earn the highest market rent possible.  The tenant should not be allowed to become a de facto landlord by leasing the space at one rent and easily subleasing it at a higher rent.
When reviewing a tenant’s request to sublease or assign the lease, the landlord should use certain criteria to evaluate the request.  If the prospective tenant’s character or business is not on par with the standards of the building or would violate the terms of the lease or another lease in the building, the landlord should have the right to deny the transfer.  If the new transferee would impose an unreasonable burden on the building’s facilities, including the parking, building systems, or elevators, landlord should be able to deny the transfer or demand some sort of accommodation from the transferee.  If the net worth and business experience of the transferee are not equal or better than the tenant, then the landlord should have the right to deny the transfer or receive additional security or guarantees from the transferee.

Additionally, if a tenant sells its company, this likely will be done by a stock or an asset sale.  In a stock sale, the buyer steps into the shoes of the existing tenant, and the lease remains intact because the tenant does not change, but most landlords deem this a ‘change of control’.  In an asset sale, the existing tenant will assign its lease along with the other assets to the purchasing entity.  The tenant will want to sell its company without any landlord right to approve the new tenant or new management, but the landlord still should insist on, at a minimum, advance notice and satisfaction of certain criteria, including a suitable net worth for the new tenant entity or management.

For tenants and tenant brokers

Tenants need to realistically view their future business.  A sublease and assignment provision should be written to accommodate the needs of a tenant when its business does not do as well as expected or if there is a shift in its business plan.  If a business fails or a site underperforms, a tenant may want to wind down operations and quickly unload the lease obligation.  The typical way to do this is to sublease the site to a subtenant.  Therefore, the sublease provision in the tenant’s lease should provide maximum flexibility in the event quick action becomes necessary.  Things to try to negotiate into the document include minimal restrictions on the type of acceptable subtenant, limited landlord approval rights with a ‘not to be unreasonably withheld, conditioned, or delayed’ standard, a capped or reasonable landlord review fee, and a short time period for any landlord review.  In conjunction with this, a tenant also should review the permitted use section of the lease to make sure it is as broad in scope as possible, so that the audience of prospective subtenants is not unnecessarily narrowed by being prohibited from operating at the site.

If the landlord demands that any excess rental or consideration being paid by the transferee that is above the rent in the current lease, the tenant usually can reduce that payment to only 50% of the excess rent, less the tenant’s expenses incurred from the transfer.  In addition, the tenant’s reimbursement of landlord’s expenses incurred from the transfer usually can be capped or otherwise limited.  One way to do this is to limit the reimbursement to landlord’s actual, reasonable out-of-pocket expenses, without internal administrative fees.  The tenant also can agree to use landlord’s preferred consent form, which could help persuade the landlord to limit its fee.

For asset or stock sales of tenants, the tenant should limit the landlord’s right to review and approve the lease transfer.  If the company stock sale triggers a ‘change of control’ provision in the lease, the tenant should try to exclude a company-wide stock sale from the landlord’s right to consent to the change of control.  If a tenant wants to have a public stock offering in the future, it should make sure that going public is permitted without landlord’s prior approval.  The reason for this protection during a company sale or a public stock issuance is that one landlord should not have the ability to hold up the much larger corporate matter affecting the entire company.  These protections will help streamline the entire process.

A lease is a multi-year commitment, and it is very important to think through the terms not only with respect to the current tenant but also for any future subtenants.  There are other considerations beyond the scope of this article, but focusing on issues as raised above will help when, and if, the sublease and assignment section is invoked.

James Moorhead is an attorney with Chicago’s Moorhead Law Group. You can reach him at 312-445-6262.