Assignment and Subletting: Part Two

March 2014

In part one of this article discussing the basics of assignment and subletting, we covered issues surrounding a landlord’s consent to (or denial of) an assignment or sublease and the types of factors a landlord may consider before deciding whether to consent to the transaction. In the second part of this article, we explore several additional issues that should be taken into consideration when negotiating the assignment and subletting provisions of a lease, including the landlord’s right to recapture the space, who gets to keep any profits that arise from the transaction, whether the original tenant will remain on the hook for the remainder of the term, and what remedies a tenant may have in the event a landlord unreasonably withholds its consent.

  • Recapture.  Many landlords include a recapture provision in their leases because, as we noted in part one, landlords like to maintain control over who leases their space and they like to reserve the right to take back space during a rising market so that they, and not the tenants, can keep any rent profits (landlords also cover this risk in other more direct ways as noted below).  A recapture provision gives the landlord the right to terminate the lease rather than allow a transfer to occur, and this decision can often be made in the landlord’s sole discretion. Tenants, on the other hand, resist recapture provisions in order to maintain their flexibility—assignment and subletting provisions allow a tenant to, among other things, transfer the lease when a tenant has outgrown the size of its premises, or conversely, when a tenant no longer has any use for the premises or needs to downsize, which they might do by subletting just a portion of the premises.  When a lease has a recapture right, it is more difficult for the tenant to market its space to potential transferees because the landlord may swoop in at the last moment and terminate the lease rather than consent to the transfer.  Knowing this risk, potential transferees may refuse to spend time to negotiate the deal.  Also, tenants lose the potential to recover rent profits during a rising market since the landlord will almost always recapture the premises if any profits are to be made.  In order to offset some of these problems, tenants may try to limit a landlord’s recapture right by, for example, restricting the period of time within which the landlord can exercise the recapture right (ideally, before the tenant hires a broker and spends time trying to find a new tenant) or else the right to recapture will be deemed waived.  Tenants will also want to ensure that the landlord does not have a right to recapture if the transfer is one that does not require the landlord’s consent (e.g., a transfer to a parent or subsidiary or in connection with a company sale or merger).

 

  • Transfer Premium.  As briefly discussed above, one of the big issues in an assignment or sublease can be whether the landlord or the tenant should benefit from any potential profit. Let’s assume that since the time the tenant originally signed the lease, rents in the surrounding area have skyrocketed.  From the landlord’s perspective, the landlord should get the benefit of those higher rents since, after all, it is the landlord who is in the real estate business and the one who invested in the real estate with all of the risks associated with ownership.  From the tenant’s point of view, however, the tenant leased the space for a certain period of time during which the tenant took on the “market” risk, and if the tenant can earn something above and beyond that amount, that should be for the tenant’s benefit.  Indeed, if the situation were reversed and rents had plummeted since lease execution, the tenant would have to make up the difference between any lower rent the transferee might be paying under the assignment or sublease and the rent due under the lease. In most cases, however, the parties will settle on a profit sharing agreement, whether it be 50/50 or some other agreed-upon ratio. It is also important to keep in mind that the tenant will likely incur some transaction costs in connection with the assignment or sublease, and tenants will want to recover those costs before determining what, if any, profit is due to the landlord. At the same time, however, landlords want to ensure that such deductions are limited to actual out-of-pocket costs reasonably and customarily incurred in these types of transactions.  Often, the parties will agree that the tenant can deduct brokerage commissions and tenant improvement allowances.  Landlords tend to resist deducting other expenses such as down-time and attorneys’ fees.

 

  • Release of Liability.  In some situations, a tenant may want to request a release from further liability after an assignment is complete. Such a release is generally conditioned upon the assignee having a net worth that exceeds a certain dollar amount.  In California, as in the majority of other states, the lease must expressly state that the tenant will be released from liability following an assignment of its leasehold interest; otherwise the tenant will remain liable.

 

  • Remedies. Because consent to an assignment or sublease transaction can be subjective and the landlord can often consider any number of factors in deciding whether to consent (as we discussed in part one), some leases will try to address what to do when there is a dispute over a landlord’s decision to deny consent to a transfer.  Landlords try to limit a tenant’s remedies to allowing the tenant to seek only declaratory relief or specific performance, and expressly state in the lease that the tenant will not have the right to pursue damages against the landlord or the right to terminate the lease.  Tenants argue that if the landlord has wrongly withheld its consent (i.e., the landlord has acted unreasonably despite having agreed in the lease to act reasonably), by the time a court orders specific performance, the tenant’s potential deal will be long gone, and the tenant will be left with a Pyrrhic victory—therefore, tenants are likely to resist this limit on their remedies.  Sometimes the parties will meet halfway and agree that if the landlord has withheld its consent in bad faith, then the tenant will be entitled to damages, but not otherwise.