A Tenant’s Options When Leased Space is No Longer Wanted
A tenant leasing retail, office, warehouse, or industrial space can sometimes find itself in a position where its lease expiration date is months or years away, but the tenant no longer wants that space. On the positive side, this may happen because the tenant has outgrown its space or found a more desirable location. On the negative side, a tenant may need to downsize or even close its businesses – perhaps as a consequence of the coronavirus quarantine. What are the tenant’s options when this happens?
I. Close the Doors and Walk Away?
Unfortunately, a tenant is legally obligated to pay rent and fulfill its other obligations under its lease regardless of whether the tenant still wants or needs its space, and regardless of whether the tenant may have closed its business. Thus, a tenant that simply abandons its space and fails to comply with its financial and other contractual obligations will cause a “default” under the lease. A default may then trigger the following consequences:
(a) The landlord may have the right to allow the lease to remain in effect and sue the tenant for the rent and any other amounts coming due under the lease, as well as for any other costs and expenses the landlord incurs because of the default, including the landlord’s attorneys’ fees.
(b) The landlord may have the right to terminate the lease and to sue the tenant for the total rent and other amounts payable to the landlord for the balance of the lease term, LESS the fair rental value of the space over that remaining period. A court would determine the “fair rental value” by making a hypothetical calculation as to how long it would likely take the landlord to find a substitute tenant, how much rent the landlord could reasonably expect to collect with respect to the period remaining under the original lease, and then deducting the expenses the landlord is anticipated to incur in order to obtain the new tenant (such as brokerage fees and any tenant improvement allowance given to the new tenant). Again, the landlord would also be entitled to recover any other costs and expenses the landlord incurs because of the default, including the landlord’s attorneys’ fees.
(c) If the landlord elects to allow the lease to remain in effect without terminating it, Indiana law generally obligates a landlord to minimize (or “mitigate”) its damages by trying to find a substitute tenant.[i] If the landlord is actually successful in doing so, the rent paid by the substitute tenant for the period remaining on the defaulting tenant’s lease, LESS the costs incurred by the landlord in obtaining the new tenant, would reduce the damages the landlord could collect from the defaulting tenant. However, many leases now include language that expressly releases the landlord from its obligation to mitigate. While it is not clear at this time whether the courts in Indiana would enforce such a release, the release of the landlord’s duty to mitigate its damages has been upheld by the courts in several states, including in Indiana’s neighboring states of Illinois and Ohio.[ii]
(d) It is extremely common in the case of a small business for the landlord to require one or more of the individuals who own the business to personally guaranty the obligations of the business under the lease. This means that if a default occurs, the landlord will have the legal right to collect its damages not only from the tenant, but also from each guarantor.
(e) In the context of retail leases, it is not unusual for the lease to contain a “continuous operation” clause, which actually prohibits the tenant from ceasing the operation of its business in the space – even if the tenant continues to pay rent. In addition, a continuous operation clause may actually allow the landlord to obtain a court order (an “injunction”) requiring the tenant to reopen its business. Although in practice it is uncommon for a landlord to actually exercise this right, it has happened.
II. Negotiate a Termination Agreement?
An alternative to walking away and defaulting on a lease (and unleashing the parade of horribles described in Section I) is to attempt to negotiate a “termination agreement” with the landlord. In a typical termination agreement, the tenant agrees to pay the landlord some amount in exchange for the landlord’s agreement to release the tenant (and any guarantors) from all further obligations under the lease. The amount of the payment a landlord is willing to accept will necessarily depend upon the duration of the unexpired term of the lease and the landlord’s determination as to the likelihood that it can find a suitable replacement tenant. In a prime location in a hot market, where the landlord has the prospect of quickly bringing in a replacement tenant at what might even be a higher rent, the required termination payment is likely to be much less than it would be for space in a poor location or in a down market where the landlord expects it to be difficult to find a replacement tenant. Of course, the landlord’s assessment of the tenant’s financial ability to pay will also be a factor – sophisticated landlords recognize that there is no point in suing a tenant with no significant financial resources who may simply file bankruptcy.
III. Sublease the Space or Assign the Lease?
Two final options available to a tenant with unwanted space are to either sublease the space or assign the lease for that space to a third party. Although most leases expressly give the tenant the right to sublease its space or assign the lease, that right is nearly always subject to certain restrictions. In the best-case scenario, the lease will simply say that the tenant has the right to sublease or assign “subject to the landlord’s consent, not to be unreasonably withheld.” Reasonable grounds for the landlord to withhold its consent would likely include the landlord’s good-faith determination that the substitute tenant does not have the ability to satisfy the financial obligations under the lease, or that the nature of the business of the substitute tenant is not appropriate for the particular location. Examples of the latter objection might include a landlord in a small retail center who does not want a marijuana dispensary as a substitute tenant, or who does not want to allow another shoe store in the center because it might harm the business of an existing shoe store already located in the center.
At the opposite end of the spectrum, a tenant may find that the assignment/subleasing clause of its lease contains a list of onerous limitations on the tenant’s right to assign or sublease. Typical examples would include language: (i) giving the landlord “sole and exclusive discretion” as to whether to approve a sublease or assignment; (ii) requiring the substitute tenant to have a net worth not less than a specific dollar amount; and (iii) in the case of a retail lease, requiring the substitute tenant to be engaged in exactly the same business as the original tenant.
It has also become increasingly common for leases to also require the tenant to pay the landlord a fee in connection with a request for the landlord’s approval of a sublease or assignment. The lease might either provide for a fixed fee (somewhere between $500 and $2,000 is common), or it could require the tenant to pay the landlord’s actual out-of-pocket expenses (including the landlord’s attorneys’ fees) incurred in reviewing the tenant’s request.
A “sublease” and an “assignment” are similar in that they both result in a substitute tenant taking over the leased space; however, they have a different legal structure and create different legal rights as among the original tenant, the substitute tenant, and the landlord. In the case of an assignment, the original tenant completely transfers all of its rights and obligations under the lease to the substitute tenant. The assignment then creates a relationship directly between the landlord and the substitute tenant to the same extent as if the substitute tenant were the original tenant. As a result, the substitute tenant will deal directly with the landlord with respect to the payment of rent and the fulfillment of all other obligations under the lease. While this might suggest that the original tenant is then released from further liability under the lease, that is generally not the case. In practice, most leases contain language stating that even if the landlord approves the assignment, the original tenant will continue to remain liable for the payment of rent and the performance of all other obligations under the lease – such that the original tenant effectively becomes the “guarantor” of the obligations the substitute tenant has assumed.
In contrast to an assignment, a sublease does not create a direct relationship between the substitute tenant and the landlord. Under a sublease, the original tenant remains directly responsible to the landlord for the payment of rent and the performance of all other obligations under the lease, and the sublease effectively creates a new lease for the same space between the original tenant and the substitute tenant (wherein the original tenant becomes the “sublandlord” and the substitute tenant becomes the “subtenant”). Under the sublease, the substitute tenant is then required to pay rent to the original tenant (which may be less, more, or the same as the rent payable by the original tenant to the landlord), and the substitute tenant is generally required to perform all other obligations of the original tenant under the original lease. Note that if the rent that the substitute tenant has agreed to pay to the original tenant is less than the rent the original tenant is required to pay to the landlord, the original tenant will be required to pay the difference to the landlord in order to prevent a default under the original lease.
The use of a sublease generally offers the original tenant several advantages over the use of an assignment (except in those very rare cases where a landlord agrees to release the original tenant from further liability in connection with the assignment). First, as mentioned above, the rent charged to the substitute tenant under a sublease need not be the same as the rent being charged to the original tenant under the lease. A tenant looking to unload its space and cut its losses may have greater luck finding a substitute tenant if the tenant can offer the space to the substitute tenant at a somewhat discounted rate. Second, since the original tenant will continue to be responsible for the payment of rent to the landlord in the case of a sublease, the failure of the substitute tenant to make its required rent payment to the original tenant will not cause a default under the original lease (although it may inflict some financial hardship on the original tenant). In contrast, with an assignment, the substitute tenant would be making rent payments directly to the landlord, such that the original tenant is unlikely to even be aware that a payment has been missed until the landlord has already declared a default. Lastly, since the sublease is an agreement directly between the original tenant and the substitute tenant, if the substitute tenant proves to be unable or unwilling to perform its obligations, the original tenant will have the right to evict the substitute tenant, retake possession and potentially re-lease the space to another substitute tenant, all without causing a default under the lease. However, under an assignment, since the substitute tenant becomes the direct tenant of the landlord, the tenant would have no ability to evict a noncompliant substitute tenant.
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It is important to remember that commercial leases are very different from residential leases. In the case of residential leases, there are various statutes and court-made rules that protect tenants from overzealous landlords and sometimes from tenants’ own poor judgment. However, few (if any) of these statutes and rules apply to commercial leases, where the courts will nearly always enforce the lease as written. As a result, the general discussion of a commercial tenant’s rights and obligations contained in this article may be superseded by the specific provisions of a particular lease. A tenant looking to vacate its space prior to the end of the lease term, and to minimize liability for its remaining obligations under its lease, will be well-advised to seek the advice of legal counsel experienced in leasing matters.
[i] See, e.g., Hirsch v. Merchants Nat’l Bank and Trust Co., 336 N.E.2d 833 (Ind. Ct. App. 1975).
[ii] See, e.g., New Towne LP v. Pier 1 Imports, Inc., 680 N.E.2d 644 (Ohio Ct. App. 1996) (Ohio); The Takiff Props. Grp. Ltd. #2 v. GTI Life, Inc., 124 N.E.3d 11 (Ill. Ct. App. 2018) (Illinois); Sylva Shops LP v. Hibbard, 623 S.E.2d 785 (N.C. Ct. App. 2006) (North Carolina); McGuire v. City of Jersey City, 125 N.J. 310, 321 (1991) (New Jersey).
Author John L. Egloff
John Egloff serves as trusted legal counsel for scores of local, regional and national businesses, providing a full range of legal services with respect to their operational and transactional needs. John’s more than 30 years of experience as a business attorney includes the formation, acquisition, sale and merger of business entities large and small, and the negotiation, drafting and/or review of virtually every type of business agreement and business-related documentation, including real estate and equipment leases and purchase agreements; financing documents (loan agreements, notes and mortgages); private placement memoranda; employment agreements (including non-competition agreements); licensing and franchise agreements; dealership and distributorship agreements; and routine customer and vendor documents (such as purchase order forms and warranty documentation).
John has served as the Firm’s managing partner and has continued to serve on the Firm’s Management Committee.
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Posted on June 26, 2019, by John L. Egloff