Important Considerations for Retail Landlords
When Negotiating Transfer Provisions
At the time a landlord and tenant enter into a retail lease, it is typically the expectation that the tenant will remain in the premises for the duration of the lease term. However, things change and a tenant may find itself in a situation where it needs to assign its interest in the lease or sublease the premises. It is, therefore, important that the lease addresses certain issues relating to transfer provisions. What follows is a summary of five of those key issues that a landlord should consider when negotiating and drafting a retail lease.
1. When is Landlord’s Consent Required?
As a general rule, retail leases prohibit tenants from assigning the lease to an assignee or subleasing the premises to a subtenant (each referred to herein as a “Transfer”) unless the landlord consents in writing to such Transfer. You may ask yourself, why is it fair for retail landlords to have the right to approve or deny a Transfer? Landlords invest substantial time and resources into analyzing and negotiating leases with tenants and they may also invest substantial amounts of money into the construction and buildout of a tenant’s premises. In addition, retail landlords often attempt to create an environment in the shopping center that maximizes tenant sales and opportunities for success (including generating the necessary foot traffic to assist the success of other tenants in the shopping center) and this requires that retail landlords have the right to select the types of businesses that operate from their shopping center. Accordingly, landlords need the ability to control the use of their centers and require flexibility to select credit-worthy tenants.
Despite this necessary level of control, it is common for a lease to allow a tenant to assign the lease or sublease the premises (without the obligation to obtain the landlord’s consent) in a limited number of circ*mstances (generally referred to as “Permitted Transfers”). Allowing a tenant to perform a Permitted Transfer without the landlord’s consent gives the tenant the flexibility it needs to operate its business without compromising the landlord’s investment in the tenant and shopping center. Examples of Permitted Transfers include a Transfer in connection with a merger, corporate reorganization, or a sale of the business (i.e., a sale of all or substantially all of the tenant’s stock or assets), provided the premises continues to be operated under the same trade name for the same permitted use.
2. Criteria for a Landlord to Withhold Consent
Because the landlord has the right to withhold its consent to a Transfer, it is a good and common practice to specify in the lease agreement the circ*mstances when it will be deemed reasonable for the landlord to withhold its consent. This should be a non-exhaustive list and often includes the following: (i) the transferee’s business is not consistent with the quality of the shopping center; (ii) the transferee’s business reputation or character is not reasonably acceptable to the landlord; (iii) the transferee is a governmental entity or agency; (iv) the transferee does not have the financial ability to fully and timely perform the tenant’s obligations under the lease; or (v) the proposed Transfer would cause the landlord to be in violation of another lease in the same shopping center. If the proposed Transfer violates any of these examples, then it would automatically be deemed reasonable for the landlord to withhold its consent to the Transfer.
3. Landlord’s Right to Recapture the Premises
When a tenant seeks a landlord’s consent for a Transfer, the landlord will have the right to grant its consent or withhold its consent. However, to the extent a landlord has the negotiating leverage, the landlord should also negotiate for a third option: the right to recapture the premises and terminate the lease. There are two main reasons why a landlord would want to recapture the premises and terminate the lease.
The first reason is that a landlord wants the absolute ability to control the types of businesses operating in the shopping center and to ensure that each tenant is of a caliber that can satisfy its lease obligations and contribute to the success of the shopping center. For example, a tenant whose business is failing is financially motivated to assign the lease or sublease the premises to any third party that will take over the tenant’s lease obligations, regardless of whether that third party is appropriate for the landlord and/or the shopping center. Accordingly, the proposed assignee or subtenant may not be the landlord’s first choice for a tenant. If the landlord reserves the right to recapture, then the landlord will not be stuck with the replacement assignee or subtenant and, instead, will have the option of terminating the existing tenant’s lease and installing a replacement tenant of the landlord’s sole choice.
The second reason is economic. If the existing tenant is paying a rent amount that is below fair market rent, then a recapture right would allow the landlord to take the premises back and enter into a new lease with a new tenant at fair market rent. Rather than the tenant earning a profit (sometimes even a higher profit than the tenant’s business earned) from subleasing the premises, this recapture right allows the landlord to capture all of the increased rent during a rising rental market. Landlords prefer this situation over the alterative so-called “transfer premium” clause which may require the landlord to share the “transfer premium” with the tenant (or, depending on the lease, may result in the tenant keeping the entire “transfer premium”).
A tenant’s typical response to a recapture right is to negotiate for the right to withdraw its request for a Transfer in the event the landlord exercises its right to terminate the lease following a tenant’s request for a Transfer. This allows a tenant to change its mind and nullify the landlord’s right to recapture and, as a result, the lease will continue in full force and effect as if the tenant never requested the Transfer in the first place. However, this right to rescind a Transfer request eliminates the certainty that landlords value. For example, the landlord may have spent time and money to identify a replacement tenant and change the course of its business, only for the tenant to abruptly withdraw its request and attempt to resume the lease as if the tenant never requested a Transfer. Understandably, landlords do not like this start and stop approach, so landlords can avoid it by not agreeing to a right to withdraw a request for a Transfer. Another common compromise is to limit the tenant’s right to rescind its recapture to one time during the term of the lease and only within strict time parameters.
4. Criteria for Releasing a Tenant of Liability
Generally, a retail lease will provide that the tenant will remain liable for all lease obligations following an assignment of the lease unless the tenant is affirmatively released from its lease obligations. That is, the original tenant is not off the hook simply because it found a third party to take over its lease obligations. This favors the landlord because there will be two parties (the new assignee and the original tenant) who are each contractually obligated to perform the lease obligations rather than just the original tenant. In contrast, tenants will ask that the tenant (and the guarantor, if any) be released from the lease obligations accruing after the date of the assignment.
Landlords will generally resist agreeing to release the tenant unless the tenant has the requisite negotiating power to require it. In that case, landlords should condition the release of the tenant upon the assignee having a tangible net worth that exceeds a certain dollar amount. For example, the lease may provide that the tenant will be released from its lease obligations following an assignment of the lease only if the assignee has a tangible net worth equal to the greater of (i) tenant’s tangible net worth as of the date the lease was signed or (ii) tenant’s tangible net worth as of the date the lease was assigned. Landlords should require that the assignee’s net worth can only be satisfied by “tangible” assets so that the value of assignee’s “good will” (which has book value but is not supported by assets that are particularly fungible) is not included in the calculation of assignee’s net worth. Notwithstanding the tangible net worth argument, landlords should try to resist releasing original tenants and guarantors, as an assignee with a high tangible net worth may still be a greater credit risk. Maybe the assignee has fewer liquid assets or maybe the assignee had the requisite net worth for a shorter period of time. At the end of the day, the original tenant contracted and obligated itself for the entirety of the term of the lease and the landlord relied upon that.
5. Limitation of Remedies and Waiver of Rights
In California, if a landlord unreasonably withholds its consent to an assignment or sublease, Section 1995.310 of the California Civil Code provides that a landlord may be liable to pay the tenant for damages caused by the landlord’s breach and the tenant may be able to terminate the lease (in addition to any other remedies provided by law for breach of the lease). To combat this, landlords can, as a condition of entering into the lease, require the tenant to waive these statutory rights and, in lieu thereof, grant the tenant (as tenant’s sole remedy) the right to sue the landlord and have the proposed Transfer declared valid as if the landlord’s consent had been duly and timely given. Most retail leases contain such waivers and provisions. Due to the extreme remedies set forth in the Code and potential ambiguities that parties may dispute in connection with a failed Transfer attempt, it is important that landlords insist upon this type of provision.
Conclusion
It is common for both landlords and tenants to be optimistic about their new relationship at the time of entering into a lease. Despite this optimism and both parties’ best intentions, landlords should keep in mind the foregoing considerations when negotiating assignment and subletting provisions in order to put themselves in the best position with the maximum amount of rights in order to protect themselves in the event of a dispute. This article is a brief overview of certain issues a landlord should consider when negotiating and drafting a lease and is by no means an exhaustive analysis of assignment and subletting issues in the retail leasing context.
