The sudden and dramatic reversal in the financial condition of many high-tech companies, and the ensuing softening of the local commercial real estate market, has led to a flood of sublease space on the commercial real estate market. Although this flood represents a potential economic windfall for those seeking to occupy commercial space, there are a number of potential legal pitfalls and practical problems commonly overlooked by potential subtenants, who often merely rely on boilerplate sublease forms when entering into subleases.
The most basic pitfall involves the legal status of the subtenant of a sublet space. A subtenant’s rights pursuant to a sublease are entirely dependent upon the existence of the master lease for the space. A subtenant, however, is not a party to the master lease—the master lease is the document between the landlord and the tenant; the sublease is the document between the tenant (which is the sublandlord in the sublease) and the subtenant. If the master lease terminates, so does the subtenant’s rights to the sublet space. Therefore, the subtenant must protect itself against the potential loss of its sublet space and the associated costs invested in the sublet space.
Another basic pitfall involves the problems inherent in a subtenant inheriting the terms of a master lease which has been negotiated by its sublandlord. Most of the terms of a sublease are incorporated by reference from the master lease. However, the terms of the master lease may be entirely inappropriate for the use contemplated by the subtenant, or they may reflect the balance of negotiating power of the white-hot real estate markets of 1998, 1999 and 2000, as opposed to the softening market of today.
This article describes these issues in greater detail, and attempts to provide practical solutions designed to allow all of the parties to a sublease to successfully complete the transaction.
When deciding whether to sublease space, a subtenant should first analyze the master lease. It is important for the subtenant to understand all of the agreements that collectively make up the master lease. Although most subtenants review the master lease itself, many neglect to review any amendments to the master lease, estoppel certificates, non-disturbance agreements, work letter agreements, or relevant conditions, covenants and restrictions which may augment or amend the terms of the master lease. A full review of those documents is necessary.
First, it is important for the subtenant to determine whether or not the master lease allows the sublease to occur. The landlord’s consent is almost always required for an assignment or a sublease. In California, most leases state that the landlord’s consent to a sublease is not to be unreasonably withheld. For a lease in California entered into after September of 1983 which does not state the standard for a landlord’s consent to a sublease (i.e., whether the landlord may withhold its consent to a sublease in its sole discretion, or the landlord cannot unreasonably withhold its consent to a sublease), California law implies that the landlord’s consent may not be unreasonably withheld. Factors generally recognized by the courts as reasonable concerns of the landlord include the net worth and business reputation of the subtenant and the proposed use of the sublease premises by the subtenant.
It is important to review the master lease, however, because less obvious requirements may be stated therein which the landlord may apply in order to withhold its consent to a sublease. For instance, many leases specify that a tenant may not sublease space to an existing tenant in the building or project in which the leased premises are located, or to any entity with which the landlord has negotiated a potential lease within the last six months. Some leases also specify that the tenant may not enter into a sublease at less than the fair market value rent for the space or the rent otherwise being offered by the landlord in the building at the time of the request for consent to the sublease.
Given that sublease rents are often less than those of direct lease transactions, such a requirement may be difficult to surmount. The subtenant should also review the master lease in order to review the restrictions on use of the premises in order to ensure that the subtenant’s proposed use of the sublet space is not in conflict with the master lease.
Many leases also provide a so-called recapture right of the landlord, allowing the landlord to respond to a request for a sublease by instead terminating the lease with respect to the space proposed to be subleased. If such a recapture right exists, it is important to determine the time period in which the landlord may exercise the right, and to refrain from spending any significant amounts with respect to the sublease until it is certain that the recapture right will not be exercised.
Please note that many leases are quite vague as to when the landlord must exercise the recapture right and also when the recapture right terminates. Under a particular lease, is the recapture right triggered by merely showing the landlord a letter of intent, financial information regarding the subtenant, or the actual executed sublease? It is important to check.
If possible, the potential subtenant should require the sublandlord to expedite the landlord’s decision-making process in order to determine the extent to which the potential subtenant should pursue alternative subleasing arrangements.
Also, the subtenant should determine what financial and other information regarding the subtenant is required by the landlord in the landlord’s review of a potential sublease. Are there confidentiality concerns or other issues of the subtenant which may make it inappropriate for the subtenant to pursue the transaction? It is also important to determine if the subtenant is able to comply with any other conditions which must be fulfilled in order to obtain the consent of the landlord to the sublease.
Next, it is important for the subtenant to review the terms of the master lease in order to determine whether or not it would be fair to the subtenant to incorporate the terms by reference into the sublease. To a large extent, the subtenant will be stuck with what the sublandlord bargained for in the master lease because the sublandlord cannot give the subtenant any more rights to the sublet space than the sublandlord has pursuant to the master lease.
However, as between sublandlord and subtenant, there is room for negotiation on certain issues. On other issues, it might be appropriate to consider approaching the landlord for modifications to the terms of the master lease by way of an amendment to the master lease or a landlord’s consent.
Given the dramatic swing in the commercial real estate leasing market in the past twelve months, it may make sense for a subtenant to try to renegotiate some terms of a master lease rather than living with the terms that its sublandlord was forced to accept in the pro-landlord market of the past few years. Although these subjects will be discussed in greater detail below, areas of particular concern to a subtenant often concern late fees, default rates of interest, the ability to make alterations to the sublease premises, the allocation of responsibility for capital expenditures and holdover rent provisions of the master lease passed-through to the subtenant.
Terms of the Subleases
Once the subtenant has determined that the terms of the master lease will allow the sublease to occur, and that incorporation of the terms of the master lease will be acceptable to the subtenant, the terms of the sublease itself must be negotiated. The following is a list of some of the issues requiring the attention of the subtenant:
Definition of the Sublet Space
Although the portion of the premises subject to the master lease which is to be subleased as sublet space is often shown on a floor plan attached to the sublease, it is not uncommon for the parties to fail to understand fully whether the sublet space includes, or whether the subtenant at least has non-exclusive use rights to, lobbies, common areas, plazas, patios and lunchrooms servicing both the premises retained by the sublandlord and the sublet space.
The subtenant should determine whether it needs the right to place satellite dishes on the roof of the building, to the extent that right was given to the sublandlord pursuant to the master lease. Subtenants will generally want the right to measure the sublet space after the demising improvements are completed in order to verify that basic rent and other pro-rata obligations stated in the sublease are correct.
Also, it is currently a common practice for sublandlords to either lease or sell their furniture and/or other equipment to their subtenants. In any particular sublease, the parties should determine whether the sublandlord desires to sell or lease such furniture and/or other equipment at the time of the sublease. If the sublandlord sells such furniture and/or other equipment to the subtenant, the sublandlord should deliver a bill of sale which should state that the sublandlord is the owner of such items, and that the items are not currently encumbered by any liens. The subtenant should have the free right to remove such furniture and/or other equipment from the sublet space at any time.
Condition of the Sublet Space
Is the sublet space to be delivered on an “as-is” basis, or is it to be built-out by the sublandlord or the landlord? There are special issues associated with the landlord’s control of the build-out and/or use of tenant improvement allowance for the sublet space. If the subtenant is subleasing space which has not been substantially completed by the landlord, or is given a portion of the tenant improvement allowance that is provided to the sublandlord by the landlord under the master lease for completion of the subtenant’s improvements, it is important for the subtenant to obtain estoppel certificates or other statements affirming the current status of construction and describing the conditions that will be imposed on the subtenant’s use of the tenant improvement allowance for completion of the subtenant’s tenant improvements.
The subtenant should make sure that it has the right to monitor the construction process, audit costs and make change orders, if necessary. If the subtenant does not control the build-out process, the subtenant should make sure that the rent commencement date is not a fixed commencement date (thereby assuming the construction risk), but instead is based on the date the sublet space is substantially completed. The subtenant might also consider negotiating the right to terminate the sublease if the sublet space is not substantially completed by a certain date.
Sharing Functions of the Leased Premises
It is important for the sublandlord and the subtenant to allocate responsibility with respect to services and utilities that are provided jointly to both the sublandlord’s premises and the sublet space. Are the utilities that are provided to the sublet space separately metered? If not, the parties should determine whether a sub-meter should be installed and, if so, at whose expense. In the alternative, the parties may determine a manner for the equitable allocation of the cost of the utilities. To the extent that the sublandlord has the right as the tenant under the master lease to choose certain utility providers, the subtenant might consider requiring a say in that choice.
The sublandlord and the subtenant should also consider how to approach issues related to the cost of after-hours HVAC or electrical systems. Typically, the master lease will allow the landlord to charge the tenant an additional hourly charge for after-hours HVAC or electrical use. In some modern buildings, such HVAC use may be provided separately to zones within the buildings in order to limit costs by providing the HVAC to only small portions of a floor (zones) for which the HVAC is needed. In older buildings, often many floors or the entire building must be cooled on such an after-hours basis. If the sublandlord and the subtenant are to share portions of a building in which one or more zones services both the space to be occupied by sublandlord and the space to be occupied by subtenant, then the sublandlord and the subtenant should discuss procedures by which each party may request such services and allocate the cost between themselves to the extent that they jointly benefit from the services.
Other building systems that may deserve additional consideration involve the joint use of telephone systems, UPS systems, T-1 or other internet providing lines and interbuilding cables.
Possible Problems Under the Master Lease
As mentioned above, the subtenant’s right to its sublet space is dependent upon the continued existence of the master lease. In addition, the subtenant agrees to assume many of the obligations of the master lease to the extent that the obligations relate to the sublet space. Therefore, it is important for the subtenant to establish that it is not entering into a sublease that is subject to a problematic master lease. It is important to consider whether the subtenant should obtain representations and/or indemnities from the sublandlord protecting the subtenant from such problems.
Common representations and/or indemnities from the sublandlord are that: a) the master lease is the entire agreement between the parties, and there are no other agreements between the landlord and the sublandlord; b) there are no existing defaults or set of circumstances which would lead to a default under the master lease; c) the premises and the improvements therein are in compliance with all applicable laws; and d) the premises, improvements and building systems are in good working order and condition.
Landlord’s Obligation to Provide Services for a Sublet Space
Typically, a master lease specifies that the landlord is to provide building services and utilities to the tenant. These services include plumbing, electricity, water, janitorial service and maintenance, and repair of common areas. However, because a subtenant does not have a direct contractual relationship with the landlord, it has no redress against the landlord for the landlord’s failure to provide such services or utilities to the subtenant or other occupants of the building.
Obviously, the sublandlord does not have physical access to those services or utilities, and therefore cannot ensure that the services or utilities are actually received by the subtenant. (However, please note that this rationale may not apply to single-tenant, triple-net leases under which the tenants arrange for and provides all such utilities.) Therefore, the question becomes what level of effort the sublandlord must make in order to require the landlord to provide the services and utilities required under the master lease.
Attorneys will often negotiate over whether the sublandlord must use “diligent,” “reasonable” or “best” efforts. In any event, it is important for the subtenant to attempt to provide in the sublease that the subtenant has the right to sue the landlord in the name of the sublandlord in order to ensure that such services and utilities are provided to the sublet space.
In addition, if the tenant has self-help rights in the master lease to cure such an interruption in services and utilities and to charge the costs back against the rent due under the master lease, the subtenant should request the right to require that the sublandlord exercise those rights on the subtenant’s behalf. If the tenant is entitled to a reduction in rent under the master lease due to the failure of such services or utilities, then the subtenant should receive a similar reduction under the sublease to the extent that the sublet space is affected by such an interruption. Also, the failure of the services or utilities to be provided due to a default by the sublandlord under the master lease should be a default under the sublease and the sublandlord should be liable for such failure.
The subtenant should require that the sublandlord preserve the sublandlord’s rights as the tenant under the master lease to dispute pass-through expenses (i.e., triple-net charges and other additional rent), and that the sublandlord exercise the right to dispute on the subtenant’s behalf. If the sublandlord is successful in a dispute regarding pass-through expenses, the subtenant should receive the proportionate share of any credit received by the sublandlord.
Protecting Subtenant from a Sublandlord’s Default
A subtenant should obtain a good understanding of the financial strength of any proposed sublandlord. Does the sublandlord have sufficient financial strength to perform its obligations under the master lease? Will the sublandlord be paying more rent under the master lease than the subtenant will pay under the sublease? If so, what, if anything, should be done to assure the subtenant that the sublandlord is in a financial position to pay the difference in rent?
Furthermore, what is the sublandlord’s strategy with respect to the remaining premises if the subtenant is subleasing less than the entire premises which are the subject of the master lease? Will the sublandlord remain in the remaining portion of the premises, or will the sublandlord sublet the remaining portion to other subtenants? If so, who, and how many? A subtenant’s strategies will vary depending on the answers to these questions.
The following are strategies commonly used by subtenants to protect themselves against defaults by sublandlords under master leases:
First, the subtenant might request a recognition agreement from the landlord pursuant to which the landlord agrees to recognize the sublease as a direct lease between the landlord and the subtenant in the event that the tenant defaults under the terms of the master lease. Landlords are historically reluctant to provide recognition agreements, because recognition agreements interfere with landlords’ ability to play the market in the hope of an increase in fair market rental values.
If the subtenant is unsuccessful in obtaining a recognition agreement, it should at least attempt to obtain an agreement from the landlord that the landlord will simultaneously deliver to the subtenant a copy of any default notices that the landlord provides to the tenant under the master lease and that the subtenant will have the right to cure such defaults.
In addition, or in lieu of a recognition agreement, a subtenant might also bargain for the ability to pay the sublease rent directly to the landlord in order to defeat the potential diversion of the subtenant’s rent. The subtenant should obtain an indemnity from the sublandlord for damages resulting from the sublandlord’s defaults under the master lease.
Also, the sublandlord should covenant to promptly provide the subtenant with any notices of defaults and other matters received by the sublandlord. The sublandlord should also agree not to amend the master lease in any manner that would adversely affect the subtenant.
Protecting Subtenant Against a Landlord’s Default
Because the subtenant’s rights to the sublet space are dependent upon the existence of the master lease, the subtenant also has an interest in making sure that the master lease is not terminated due to a failure of the landlord (i.e., the owner of the building) to pay when due any debt encumbering the sublet space. If the landlord fails to pay such debt, and the lender forecloses as a result, any lease of the property which was executed after the loan was made may be terminated by law, unless the tenant in question has received a non-disturbance agreement from that lender promising that the lease will survive the foreclosure so long as the tenant is not in default under the lease.
Subsequent to a foreclosure, a subtenant’s interest in its sublease will rise or fall with the status of the master lease. Therefore, a subtenant should make sure that such a non-disturbance agreement has been granted to the sublandlord. This protection is especially important as the commercial real estate market continues to soften.
Protection from Termination of the Master Lease
Again, because the existence of the sublease is dependent upon the existence of the master lease, the subtenant will want to prevent the master lease from terminating for any reason. The sublease should contain a covenant of the sublandlord not to terminate the master lease pursuant to a separate agreement between the sublandlord and the landlord. The master lease may also provide that the sublandlord, as the tenant under the master lease, has the right to terminate the master lease under certain circumstances if the premises are affected by casualty or condemnation, or if there is an interruption of services to the premises. The subtenant should try to control that decision to terminate, if at all possible.
Preserving Flexibility: Assignment and Subletting Provisions
It may be appropriate to modify the assignment and subletting provisions of the master lease which are incorporated by reference into the sublease. Any recapture right of the landlord pursuant to the master lease should not be extended to the sublandlord under the sublease, unless the recapture right is exercised by the landlord itself. It also may be appropriate to review the bonus rent provisions of the master lease.
If the landlord is entitled to more than 50% of such bonus rent, that allocation of bonus rent as between the sublandlord and the subtenant in the event of a sub-sublease should be renegotiated given the changing market conditions. A sublandlord simply has less rationale than a landlord for such a provision regarding any “bonus subrent,” given that the sublandlord does not take on the risks of a real estate owner.
In any event, the sublease should provide that, if the landlord consents to the subtenant’s assignment or subletting to a sub-subtenant, the sublandlord should not be able to withhold its consent. The sublandlord also should agree to process promptly the subtenant’s assignment or sub-subletting request with the landlord.
A subtenant may also wish to take advantage of various options to extend the term of the master lease or expand the size of the premises that are provided to the sublandlord pursuant to the master lease. However, such options are typically made “personal” to the original tenant (and any affiliate thereof), and are not exercisable by subtenants.
Nonetheless, the subtenant may wish to negotiate directly with the landlord and the sublandlord for the right to exercise such options. If the subtenant is unsuccessful in obtaining the right to exercise such right, the sublease should at least require that the sublandlord will not itself exercise any option to extend the master lease if the subtenant is then negotiating a direct lease with the landlord at the end of the term of the sublease.
Insurance and Liability Issues
The subtenant should review the insurance requirements of the master lease to make sure that the subtenant is able to comply with the requirements to the extent that the requirements are incorporated by reference into the sublease. It is common for issues to arise with respect to the type of insurers and endorsements required of the tenant under the master lease.
If the subtenant is taking significantly less space than is set forth in the master lease, the amount of liability insurance required under the master lease may be excessive for the purposes of the sublease. In addition, subtenants may want to self-insure, notwithstanding the fact that the sublandlord was prohibited under the master lease from self-insuring because of the sublandlord’s lower net worth.
A landlord’s waiver of subrogation (i.e., an agreement from the landlord’s insurance company not to sue the party causing damage to the insured) and release of liability, if any, pursuant to the master lease should also apply to the subtenant.
A master lease typically includes a provision in which the landlord limits its liability under the master lease to its equity interest in the property, and further states that the landlord is not liable for injury to the persons or property of the tenant. The landlord also seeks to exclude its liability for the tenant’s consequential damages. Subtenants should try to exclude all of these provisions from a sublease, so that the sublandlord would not enjoy such exclusions, on the basis that they are inapplicable to a sublandlord/subtenant relationship.
If the subtenant will perform an initial build-out of the sublet space, the subtenant should consider incorporating an agreement into the sublease regarding whether or not such build-out must be removed at the end of the term of the sublease. The sublease should also include a provision stating that the subtenant is not required at the end of the term of the sublease (and the lease) to remove any alterations made by the sublandlord, or which were already in the sublet space at the time the sublease term began.
If the subtenant already has plans for the alterations and intends to build out the sublet space, the subtenant should obtain approval of those plans from the landlord and the sublandlord at the time the subtenant enters into the sublease in order to eliminate the risk of later disapproval by the landlord and/or the sublandlord. If the master lease provides that the landlord is entitled to construction management fees in connection with any alterations to the premises, such fees should not be incorporated by reference into the sublease (construction management fees should not be paid by the subtenant to the sublandlord).
If the master lease requires that the sublandlord make any and all alterations required by law to the premises, the subtenant should try to negotiate either an exclusion from the alteration obligation, or an allocation and coordination and responsibility for the cost and performance of such alterations between the sublandlord and the subtenant. If an amended certificate of occupancy is required for the subtenant’s occupancy, the parties should determine who is responsible for obtaining the certificate.
Obtaining Landlord’s Consent
The effectiveness of the sublease should be conditioned upon receipt of a written consent to the sublease by the landlord within a certain period of time. The provision regarding a landlord’s consent should state that if the landlord fails to consent prior to that deadline, then the subtenant has the right to terminate the sublease. The sublease should also specify that the sublandlord pays the cost of obtaining the landlord’s consent.
The sublease should discuss the subtenant’s rights to use the parking spaces that are provided by the master lease (or by a separate parking agreement). The sublandlord and the subtenant should consider how they will police the parking areas to ensure that neither party is exceeding its share of parking rights.
The sublease should discuss what rights, if any, the subtenant has to the sublandlord’s signage on the building directory, on the door to the sublet space, and, if applicable, to the premises. Subtenant might also consider having both landlord and the sublandlord pre-approve any sign actually contemplated by the subtenant.
Current market conditions provide users of space a rare opportunity to sublease space at reduced rental rates. However, the same market conditions have created an unprecedented number of potential legal and practical pitfalls for the unwary. Reliance on a boilerplate form sublease in order to sublet a meaningful amount of space is a common way to suffer such pitfalls. We recommend consulting with legal counsel before entering into any sublease transaction.
About the Author
For additional information on this topic, please contact Doug Van Gessel:
Douglas G. Van Gessel, Esq.
Sheppard Mullin Richter & Hampton LLP
E: [email protected]
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