Competing Interests – Equitable Sharing of Risks and Costs

Well it took more than two or three weeks, but I now post the fifth of five articles on commercial leasing issues. Though one of the articles previously posted concerns the insurance related issue of subrogation clauses in leases, another related area for you to consider is the topic of this post: that of the terms of the lease in the event of casualty, the requirements of insurance, and how the casualty and insurance provisions (which are often times separate clauses) relate to each other.

The casualty provision in the lease will generally include an “out” for either party, or both, in at least some cases where casualty has occurred. The terms will be different from lease to lease, and the party given the different types of rights will differ depending upon which party (landlord or tenant) is in what I call the “power position” in the lease. The interests and concerns of each of the two parties is very different when casualty occurs. A landlord will be concerned with maximization (or continuation)of income and protection (or restoration at the least cost to landlord) of its improved real property asset. The tenant will be concerned with the injury to, and replacement of, its business property, as well as the delays or stoppage of operations and revenue caused due to the casualty that has occurred. I have decided to give you a list of considerations this month. If you are in the position of making a preliminary review of a lease, either as landlord or tenant, here are some things to consider:

1. If you are a landlord dealing with a large national tenant , you may find that there is pressure by the tenant to allow tenant to self-insure. In the past this was primarily a concern due to the fact that even if the national tenant is financially stable as a self-insurer, many landlords reported that the process of claims adjustment is much more time consuming, contentious or cumbersome than with an independent provider of commercial insurance (which has a more limited interest in the specific leasehold estate). Additionally, however, due to our recent downturn in the economy, as we see some of the once mighty corporations crumble, it certainly would not be unreasonable for any landlord to require substantial proof of the financial condition of the tenant before agreeing to allow a tenant to self insure.

2. In any commercial lease, the casualty provision should be fair in light of the circumstances. You will want to carefully check the casualty provision with due consideration to your position as landlord or tenant. A full service lease for space within a building containing numerous commercial tenants, is to be viewed quite differently than a long term triple net lease of a standalone commercial building. Where a landlord has multiple tenants, and great control over common areas, repair, and selection of insurance, the commercial tenant will need to consider negotiating a shorter landlord repair timeframe, together with rent abatement during repair, and the right to terminate if the casualty is more than a certain extent of damage (often described as a percentage of damage to the premises). In the triple net scenario noted above, the Landlord might consider insisting upon proof of insurance, repair and no rent abatement in the event of casualty (leaving all burden and risk on the tenant).

3. Landlords should be aware that large national commercial tenants are going to be looking for lease provisions which assure that the proceeds of insurance are to be used for restoration of the leased premises, and that any deed of trust affecting the leased premises clearly permit this use of insurance proceeds without the ability of the lender to instead require payment against the loan balance.

4. Many commercial leases will leave it up to the tenant to determine whether or not they will insure personal or business property within the leased premises (which is not otherwise covered by the Landlord policy), and actually the extent to which this is obtained (giving wide discretion to tenant to simply decide to forgo the cost) . Landlords should seriously consider to not allow this to be left to the tenant’s own choosing. Tenants should be required to (and should in any event) have insurance to cover the full replacement of their business property contained within the leased premises. In addition, a prudent landlord will insist upon the lease containing a provision which clearly absolves the landlord from any liability for damage or loss to such tenant business property.

I hope that these articles on lease provisions are helpful to those of you who are involved in commercial leasing, either as landlord or tenant. McGuire, Wood & Bissette, P.A. has an extensive practice in the area of leasing and has provided lease drafting services for virtually every type of commercial setting imaginable in North Carolina. If we can be of assistance to you, either in your capacity as a landlord or tenant in drafting of a lease, or with respect to the review of a lease that you are considering entering into, please call or email at any time.

Thanks,

Tom Grella

Understanding vs. Misunderstanding

It has been several weeks since I made a post to this blog, due to the fact that I was vacationing in Europe (mainly Italy). In my travels, it was interesting that because of my heritage (all four of my grandparents were born in Italy), Italians looked at me and assumed that I speak Italian (which I do not, yet). They would come up to me and start into a question or statement, and I would stare at them with a blank look on my face. My wife , Elaine, obviously not of the same heritage would always get a “Hello”, “Good Morning” or some other attempt in English. I received the same polite greeting, but usually in Italian.

What we found is that even if an attempt was being made to communicate in the same language (such as my use of English and an Italian’s attempt to use English) there would often be a discontent as to the meaning and intent of terms, and this usually meant that the result was something not intended (such as receiving a completely different type of food on your plate than ordered).

The topic for this week’s blog post (and continuing along with my five part series on leases begun in June) is Assignment and Sublease. This is an area where the writing set forth in the lease document by both of the parties is often misunderstood or misinterpreted by one, or both, of the two parties to the agreement. The reason for this disconnect, I believe, is due to the fact that landlords and tenants come from different perspectives, and often assign different meanings to their inter-communication based on different expectations. In most cases, the parties come to the table believing the other to be well intentioned, and often times agree to basic principles without the aid of legal counsel. In the area of assignment and sublease provisions, this fact may result in an assignment provision that is only effective to give Tenant rights based upon absolute consent on the part of the Landlord (and if this is the case one can argue that the provision could have been limited to a single short sentence), or a Landlord who has basically lost control over the possession and nature of its property for the full term of the lease (this where the provision basically allows unfettered assignment or subletting).

It is in the Landlord’s best interest to create a lease which either does not allow assignment and subleasing at all, limits it, or penalizes its use. It is in the best interest of the Tenant to hedge its bet by having a right to transfer its lease obligation to a third party, with almost no right of the Landlord to reject or condition either an assignee, or a changed use.

Unfortunately, a detailed legal treatise on every issue involved in lease assignment and subletting is beyond the scope of this blog post. However, I thought I would give a short list of considerations to think about, both from the perspective of Tenant, and then from the perspective of Landlord, to conclude this post:

Tenant perspective:

1. Does the provision give the Landlord an absolute right to consent? Does it, at least, require the Landlord to be reasonable in its determination? Will the Landlord agree to some specific definition as to how consent will be determined (i.e. some objective standards)?

2. How does the lease define assignment and subletting? If I sell my business will the lease be deemed assigned by virtue of the fact that the stock or member interest of the company has changed hands? Does the lease freely allow assignment in the event that I sell all of the assets of my Company? What about in the event of merger by the Tenant entity into some other entity?

3. What are the costs going to be if I request an assignment or sublease? What time frame is allowed for the consent to be given by the Landlord, and are there any hidden definitions or requirements that might cause enough uncertainty such that the Landlord can get away with not granting its consent?

4. Does the provision allow for sublease of less than all of the leased space?

5. Does the provision provide the Tenant with a release from the burdens of the lease in the event of full assignment to a third party? If not, are there any set terms or conditions the satisfaction of which can earn the right to release?

Landlord Perspective:

1. Does the provision assure that the Landlord has ample basis upon which it can withhold consent: any change in use, or financial stability of the proposed assignees, etc.? Are there specific or peculiar reasons Landlord might want to withhold consent (even if the general provision allows consent)? If so these should be listed (i.e. If Landlord has specific objectionable uses for the property, but otherwise assignment is generally acceptable – this is particularly important for a Landlord with other neighboring leases where there may be exclusivity provisions?)

2. Who benefits from a difference in the rent to be paid by the assignees or subtenant? The Landlord should consider that any profit over and above the rent normally paid by Tenant should be paid to the Landlord?

3. Does the provision assure that Landlord does not bear any of the costs associates with the request for assignment, legal review and costs of documentation?

4. Does the assignment provision broadly define assignment and sublease such that the Tenant cannot do what is prohibited by other legal means (such as effecting assignment though a transfer of the Company instead of by actual assignment)?

5. Notwithstanding the ability of the Landlord to only withhold consent based upon being reasonable, does the lease make sure that the liability of the Landlord is limited if Landlord breaches the provision (by withholding consent)? It is in Landlord’s best interest in the lease to generally limit its liability to equitable remedies in any event, and in the case of this provision, consider being very specific as to remedy limitations.

The Failure to Document and Perfect – Tenant Beware

One of the most common mistakes that Tenant’s make in commercial leases is the failure to properly document and perfect a right they might have to purchase the leased space. Generally, these rights are either found in the form of an option to purchase, or a right of first refusal. Normally, an option to purchase will give a tenant the absolute right to purchase the leased premises, on or before a specified date, and at a certain price (or a price that can be ascertained with certainty). A right of first refusal, on the other hand, does not give the tenant an absolute right, but most often expresses that the tenant has the right to purchase the leased premises from the landlord prior to the landlord moving forward with a sale to a third party.

For the sake of cost and expediency, many commercial leases are created and executed without the aid of legal counsel. With the increase of free legal forms available from so many Internet sources, leases are often found and used without regard for the specifics of applicable state law. These facts, and the desire and need for the quick and cheap, often lead to less than what is commercially prudent as to formality. This has the potential of causing huge problems in the case of tenant options to purchase and rights of first refusal. In many instances, short term leases contain these options and rights with some expectation that the leased premises is on a short course for sale to the tenant. As a result, leases are in many instances executed without acknowledgement, and without thought of putting the purchase right on public record. Though many leases contain provisions that allow for the recording of a memorandum of lease to document the property rights of the parties, most leases are executed without any recording in the public records actually ever being made.

Unquestionably, a properly documented option to purchase or right of first refusal in a lease can create a legally binding contract between the landlord and tenant with respect to purchase rights described. However, when real property rights are concerned, the public records and the rights of third parties will always need to be considered. The failure to draft carefully worded legal documents that put all otehrs on notice of the rights under these types of options and rights may end with a trusting tenant losing its rights to an innocent third party purchaser.

Commercial tenants are well advised to understand that it is imperative that they both properly document (writing in proper recordable form) and perfect (by recording in the county register of deeds office) options to purchase and rights of first refusal. Without any intent to disparage commercial landlords (many of whom are my clients), I think it is important that the commercial tenant not rely upon the landlord to offer, or be responsible for, documentation and perfection of this right.

Thanks,

Tom Grella