September 15, 2008

The Ties That May Still Bind: Subleases and the Paradox of Lease Assignment

For small and large businesses alike, the commercial real estate lease is often an important and necessary tool. Whether you are opening your first retail store or expanding a successful business in a new market, leased space can provide an essential building block to success without the headaches and expense of property ownership. Leases can also provide the flexibility to contract or expand your real property as your company's needs change.

Should it come time to find a new home for your business, however, your existing commitment to a landlord might seem like an afterthought—something trivial, to be handled easily when you move. But for businesses looking to sublet or assign their rights under a lease, careful consideration must be given to the ties that may still bind you to your ex-landlord.

Among other dilemmas, you must confront the basic paradox of lease assignment: Despite appearances to the contrary, even a strict assignment of a lease is not tantamount to a release of a former tenant's liability to a former landlord. Instead, a former tenant may be and frequently is held accountable for the shortcomings of the new tenant. Put simply, you are not free of obligations to the landlord unless the landlord agrees that you are free of obligations.

To Sublease or to Assign?

No matter what your circumstance—whether you want to give up all or part of your space, and whether you have two years or ten remaining on your lease—your first step is to have someone dig up a copy of your lease from the remote filing cabinet in which it has been stored, unread, since you signed it. Next, have a real estate attorney do a thorough review—you need to know your options.

If both subleasing and an assignment of space are available options, the process of choosing between the two is often an amalgamation of legal interests and business-world practicalities. Should you find the perfect replacement tenant—someone who conducts a type of business permitted under the lease and who has the financial wherewithal to step into your shoes—an assignment is likely your best choice. In other situations, though, a sublease may be the best—or only—option. The most viable replacement tenant may, for example, be a startup business willing to commit to only a portion of the remaining term.

Though the terms are often used interchangeably, there is an important distinction between a lease assignment and a lease sublet.

The grant of a sublease conveys only a portion of the tenant's rights in the property. In a sublease scenario, the new tenant frequently leases only a portion of the original tenant's space, or the sublease covers only a portion of the remaining lease term. For this reason, a sublease is often viewed as a lease within a lease. The analogy of landlord and tenant arises and is applied to the original and new tenant, respectively.

A lease assignment can occur in two forms: a strict assignment or an assignment pro tanto (only to the extent). A strict assignment constitutes a complete disposition of all your rights and interests to the entire premises for the remaining duration of the lease. By the terms of a strict assignment, a tenant has no latent interest in the property. In contrast, an assignment pro tanto results in the disposition of the tenant's entire right to only a portion of the premises.

Due to their similarities, an assignment pro tanto and a sublease are frequently mistaken for one another. Technically, the distinction is often drawn by the presence, or absence, of a "reversionary interest" to the property. A true sublease will result in the premises being returned to the original tenant before the end of the term, if only for a day. By contrast, an assignment pro tanto carries no reversionary interest for the original tenant, and once the original tenant assigns its rights to that portion of the premises, it should never be theirs again. Though the distinction may seem amorphous, the legal ramifications can be significant.

In crafting an assignment, careful consideration must likewise be given to ancillary issues, such as whether a suitable replacement guarantor exists, if needed, and whether options for additional space or lease renewal can be assigned to the replacement tenant.

The Paradox of Lease Assignment: Why All Doesn't Necessarily Mean All

It is a common misperception that the strict assignment of a lease relieves the original tenant of its obligations to the landlord. The first substantive clause of an assignment document typically reads, "XYZ hereby assigns and ABC hereby assumes all rights, interests and obligations under the terms of the lease." The plain language—all obligations—implies that your commitments under the lease end when you turn over the keys.

Often, that is not so.

The technical basis underlying the persistence of that obligation is the legal doctrine of privity, or the connection between the original parties. A lease revolves around two essential privities, those of contract and estate. The privity of contract is created when the landlord and tenant sign the original lease, each agreeing to certain duties and obligations with respect to the other. Privity of estate represents the mutual interest of both parties in the property itself. With the assignment of the lease, the new tenant will fall into privity of estate with the landlord, since both share an interest in the premises. By law, however, privity of contract (in this case, between landlord and original tenant) is not defeated by assignment to another party. Legally, the covenants undertaken by the landlord and tenant still exist for the benefit of each other.

As a result, should a replacement tenant fail to pay rent, the landlord can look to the original tenant to be made whole. Similarly, a new tenant's failure to uphold covenants in the lease, such as those regarding proper use of common areas or restrictions against hazardous materials, could result in termination of the lease (though not the rent obligations), and with it charges for legal fees associated with the termination, or an assessment of damages incurred by the landlord as a result of the new tenant's actions. In some cases, the extent to which a landlord may recover against a former tenant will be governed explicitly by the terms of the lease. In others, the parties—and in bad cases, courts—will primarily be guided by the presumption of the original tenant's liability.

Another common cause for confusion lies in the typical lease provision governing the landlord's consent to an assignment: "Tenant shall not sublet any part of the premises or assign this lease or any interest therein without the written consent of Landlord, which consent shall not to be unreasonably withheld or delayed." But even where a landlord consents to the assignment, such consent should not be interpreted as a release of responsibility. Nor does the acceptance of rent by the landlord relieve the former tenant of its liabilities.

Avoiding Pitfalls

In order to avoid the pitfalls of the lease assignment/privity paradox, exiting tenants can take several steps to more fully sever their liability to the landlord. One approach is for the withdrawing tenant to seek indemnification from the new tenant for liabilities to the landlord as a result of the new tenant's failure under the lease. Indemnification provisions can relieve much of the financial liability you may face as a former tenant. However, recouping costs pursuant to an indemnification provision often requires further legal intervention, a process that becomes even more difficult in cases where the new tenant's default results from insolvency, bankruptcy or similar restructuring proceedings.

Another alternative—termination of the existing lease—sidesteps the assignment issues altogether. In this scenario, the landlord and original tenant terminate their lease agreement, leaving the new tenant and landlord to negotiate a lease. This option, however, often encounters resistance from the landlord, and not unjustly so. Lease negotiations are often time-consuming and costly, and landlords typically believe they have the right to gain the benefits of their original negotiations with the withdrawing tenant. Convincing a landlord to terminate an existing lease may thus require some creative thinking. Perhaps the new tenant is willing to agree to a longer lease term, or to a different rent structure that would mean greater cash flow for the landlord. The new tenant may be more creditworthy or may be willing to lease additional space. A real estate attorney may be able to provide innovative arguments for persuading your former landlord that lease termination is the best option.

If termination of the lease is not an option, seeking a full release from the landlord is the most effective method of dissolving the obligations and privity of the lease. Release language can be drafted into the lease assignment, provided that the landlord is a signatory. Or, if only the withdrawing and new tenants are parties to the assignment, the release can be drafted as a separate document that makes reference to the assignment. But unless the original lease contains language obligating the landlord to release the original tenant upon assignment of the lease, the landlord has no obligation to release a withdrawing tenant from its obligations. Still, because of the certainty a release can provide, it may be worth broaching the subject with your landlord.

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