In the current economy there are opportunities to sublease office space at favorable rates and terms.
When it comes to commercial leasing, the challenge for potential subtenants is to avoid the dangers of subleasing from a distressed tenant by asking specific questions, and also strengthening the language in subleases and related documentation to protect the subtenant’s interests.
Imagine a scenario in which there is a primary lease of office space between a landlord and a tenant. The tenant has been affected by the economic downturn and has undergone lay-offs, leaving approximately half of its office space vacant. The tenant decides to sublease the vacant office space. Before signing a sublease with the tenant, the potential subtenant should consider the following.
While it is a common requirement that a landlord must consent to a sublease, in this market, the consent document has even greater importance and should be carefully prepared. The landlord’s consent should be contained within a broader agreement between the landlord and the subtenant in which the landlord not only consents to the sublease but agrees with the subtenant as to certain issues which may arise if the primary lease were to terminate or the tenant were to be in default under the primary lease. Since today’s subleases commonly have below-market rent rates, the landlord will likely insist that the agreement provide for the rent to escalate or the term of the sublease to be shortened if the primary lease were to terminate and the sublease were to remain in effect. There will likely also be the opportunity, if not the requirement, that in such case the subtenant ultimately enter into a direct lease with the landlord at market rates. The terms of this agreement should factor heavily into the subtenant’s decision about whether to sublease a particular space.
What will happen to the sublease if the tenant fails to pay rent or ceases business operations and abandons the premises? These actions will likely be defaults under the primary lease for which the landlord will have the right to seek remedies against the tenant, including lease termination. Absent an agreement to the contrary, if the primary lease is terminated, the sublease automatically terminates. Even if the subtenant has been performing its obligations under the sublease, the primary lease between the landlord and the tenant will alone govern the landlord’s remedies when the tenant defaults under the primary lease. Therefore, the subtenant should insist its agreement with the landlord provides that if the primary lease is terminated as a result of the tenant’s default, the sublease will continue in effect as an agreement between the landlord and the subtenant, with the landlord stepping into the shoes of the tenant as sublandlord. As discussed above, this will likely result in the landlord requiring certain conditions such as increased rent or a shortened sublease term.
Right to Cure
If the tenant defaults under the primary lease, will the subtenant have the right to cure the default and avoid the landlord exercising its remedies under the primary lease? Whether the subtenant has such a right depends upon the terms of the primary lease, the sublease and any separate agreement between the subtenant and the landlord. The sublease should provide that the tenant will promptly give the subtenant copies of all default notices it receives from the landlord together with assurances that the default will be cured. If the tenant is unable to provide assurances that it will cure the default, the subtenant should be permitted to cure the default during the tenant’s cure period under the primary lease. The sublease should further provide for the subtenant to receive from the tenant reimbursement for its expenditures in curing the default, with interest. The subtenant should also seek to include in its agreement with the landlord, the right of the subtenant to cure a tenant default within a certain number of days after the expiration of the tenant’s cure period, though the landlord may resist such a provision. Without some agreement regarding curing defaults, the subtenant will not have the automatic right to cure the tenant’s defaults under the primary lease and will be forced to rely on the tenant to take remedial actions.
Representations and Warranties
The sublease should include adequate representations and warranties by the tenant, particularly that there is no default under the primary lease and that the primary lease remains in full force and effect.
If the tenant requires the subtenant to pay a security deposit, the subtenant should carefully consider the type (cash versus an alternative such as a letter of credit) and amount of the deposit and conditions for its return. If the tenant were to go out of business and abandon the premises, taking the subtenant’s cash security deposit with it, subtenant would likely lose the money. Typical sublease documents are silent regarding whether, in this situation, the landlord would require an additional deposit from the subtenant if the landlord assumed the sublease or entered into a new lease with the subtenant. A provision on this subject should be included in the separate agreement between the landlord and the subtenant, as well as in the sublease.
There may be outstanding documents such as default notices, settlement agreements or side letter agreements which change the terms of the primary lease. Before signing the sublease, the subtenant should request and thoroughly review all such documents in addition to reviewing a complete copy of the primary lease and its formal amendments.
The subtenant should evaluate whether any outstanding liens, such as mechanics liens, mortgages, purchase-money security interests and landlord’s liens established in the primary lease, may be detrimental to the subleased property.
While commercial leasing and subleasing in today’s market presents numerous challenges, careful preparation and documentation will help subtenants avoid many of the risks.