To Recognize Or Not To Recognize? That Is The Question (Part 1)

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One important exit strategy for a large space tenant seeking to shed itself of leased space is to have the option of assigning its lease or of subletting all or part of its premises. Generally, a tenant who no longer needs its space will prefer assignment if it can be simultaneously relieved of its lease obligations or if the prospective assignee is adjudged to be rock solid. Otherwise, subletting is preferred because the departing tenant, stuck with continuing contingent liability, can retain control of its space. However, to get rid of the old tenant as an intermediary between it and the landlord, an incoming tenant would prefer to take an assignment of the existing tenant’s leasehold interest. Sometimes, such as when the incoming tenant’s rent is substantially lower than the rent payable under the lease, a lease assignment just won’t work. Thus, where assignment of the lease is not workable or where less than all of the leased space is to be transferred, subleasing is the preferred choice.

[Here’s a confession – today’s blog posting is plagiarized (if one can plagiarize one’s own work) from an article we wrote a very long time ago, one that is in some published works. Admittedly, a handful of readers will have seen it before, but our thinking is that it will be new, helpful, and interesting to a whole new audience.]

Subletting might be planned or unplanned. A tenant might project a need for more space than it needs at the outset of its lease term. Common approaches to deal with such a situation are negotiating for expansion options or rights of first refusal. Another one is to lease extra space up front and find a subtenant for part of the lease term. More commonly, however, subletting results from economic factors first occurring after the lease term has begun. A tenant may find that its space is too small, or that its operational needs require relocation, or that it may just plain need to ‘skinny down.’ Whichever is the problem, finding a subtenant is the solution.

Subtenants have the right to feel insecure. Not only must they obey the terms of their own sublease, but they take the risk that their own landlord (the “sublandlord”) loses the underlying lease. The rights of a subtenant are derivative of those in the underlying lease. Without some sort of direct agreement with the (over)landlord, a subtenant’s right to remain in possession disappears when the underlying lease is terminated. Some risks can be handled by giving the subtenant the right to step into its sublandlord’s shoes. For example, a subtenant may be given a right to receive notice of default directly from the landlord and may have the right to cure those defaults. Also, a subtenant may be given the right to exercise renewal options on behalf of the tenant itself. Nonetheless, there are limits. If the underlying lease is terminated by reason of the sublandlord’s default or bankruptcy, the subtenant may find itself on the street. To avoid homelessness upon termination of the underlying lease, a subtenant will want to have the overlandlord accept the sublease as if it were a direct lease with the subtenant, i.e., to have the landlord recognize the subtenant as if it were its own tenant. For greatest comfort, such an agreement should be in place when the sublease is executed.

A subtenant’s risk of losing its sublease is not dissimilar to what a tenant faces when a mortgagee forecloses on its lien and wipes out inferior interests such as most leases. Even tenants with relatively little bargaining power ask for, and are able to obtain, non-disturbance and attornment agreements. Those agreements leave the original lease in place upon a mortgage foreclosure (or related transfer of the landlord’s interest in the property) and, in return, the tenant agrees to continue as if the mortgagee or other transferee were the original landlord. The agreement between a tenant and its landlord’s lender is called a “Non-disturbance and Attornment Agreement” or “NDA.” In the case of a subtenant seeking to have its subtenant’s landlord (the “overlandlord”) accept the subtenancy, it is preferable to speak of the agreement that preserves the subtenant’s right of possession as a “Recognition Agreement.”

Landlords chant what is almost a rubric – “I’m in the real estate business; you, the tenant, are not.” But, as an economic matter, that’s not true. Once a tenant has committed to lease space, those premises become that tenant’s real estate for the entire lease term. The tenant isn’t free to walk away without consequence. Essentially, the landlord has exchanged control of its property for the tenant’s promise to pay rent for the entire lease term. The real reason that a tenant may not have the unencumbered right to transfer its own rights to others is that the parties have bargained for such restrictions. And, that’s a matter of bargaining power, not natural law.

Almost without exception, tenants of large spaces are large companies with strong bargaining power. Likewise, those having large spaces to lease usually have the same intrinsic power. Vacancy rates and competitive demands for the same space increase or decrease each party’s strength, but it is rare for one to lord over the other. That’s the framework for the negotiation over a recognition agreement.

A wise tenant provides for the future. In this context, that means having its lease impose an obligation on its landlord to recognize subtenants. After all, subtenants, especially those needing large blocks of space, don’t want to be dependent on the continuing viability of a sublandlord or on the continued existence of the underlying lease. Sublet rent may be favorable, but facing the prospect of business disruption makes subletting without a recognition agreement a risky choice. For example, retailers fear loss of a strong retail business. No business needs the distraction. With that in mind, a tenant knows that it is a lot easier to sublease space, especially large space, if it can promise its subtenant that the overlandlord will execute a recognition agreement.

As in matters of romance, the parties are more willing to give and take when love abounds and marriage is on the horizon than when facing divorce. Although landlords abhor empty space nearly as much as nature abhors a vacuum, they also fear the unknown. As a rule a landlord would rather reserve decision on accepting a subtenant as its own until faced with loss of the underlying tenant. That way, the landlord can gauge the market and evaluate the subtenant, qua tenant, when all of the facts are in. That’s not comforting for a prospective subtenant and negotiations at the time of subleasing over whether the landlord will even grant recognition can delay and then kill the subleasing deal. Thus, the time to strike the basic agreement over recognition is before the lease is signed – when the landlord and prospective tenant are ‘courting’ and have comparable bargaining power.

A tenant would love for its landlord to agree to recognize any and every subtenant. That’s unlikely to happen. What is more likely is that the parties will negotiate over a set of objective standards which will define an acceptable subtenant and sublease. What constitutes an acceptable subtenant? Generally, the criteria focus on financial strength, the nature of its business, and its management ability. What constitutes an acceptable sublease? The factors most cited by landlords have to do with the terms of the sublease itself and the physical characteristics of the subleased space.

Although these factors are relevant when confronting whether a landlord should or even must grant consent to a lease assignment or to a subletting, they are far more critical in the context of recognition discussions. Further, while most factors apply whether negotiations take place at the time of initial lease negotiation or when an actually sublease is “on the table,” there are significant differences. If the parties are looking at a specific subtenant and a specific sublease, each of them can control the outcome. When a landlord is being asked to agree to recognize a hypothetical, future sublease, it needs to anticipate what that sublease might look like.

[Today, we’ll sign off as does Porky Pig – “Th-th-th-that’s all folks!” (at least, for today). If this topic interests you, you’ll have to wait to read about some of the “solutions” Ruminations has up its sleeves. We’ll “see” you next week.]

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