To Recognize Or Not To Recognize? That Is The Question (Part 2)

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Last week, we began a discussion about a particular dilemma that arises out of “subletting.” [You can see that blog posting by clicking: HERE.] Basically, a subtenant has no greater rights against the actual landlord than does its sublandlord. Absent an agreement with the “real” landlord, if the underlying lease is terminated, the sublease is “over.” What kind of subtenant would invest in the subleased space or (especially in a retail project) spend time and effort to build location-specific good will if the vitality of  its sublease depends on the health of its sublandlord? In a lot of cases, the reason a tenant seeks a subtenant in the first place is because the tenant can’t “handle” the space. There is a solution, and it is called a “recognition agreement.” Last week, we presented the “problem” in some detail. Today, we’ll explore various approaches to a solution. As we disclosed last week, today’s blog is heavily based on an article we wrote more than 10 years ago. So, to the few readers who find today’s posting vaguely familiar, we apologize.

Where a tenant is “still on the lease,” the landlord gets to look to recover from its tenant, as it could all along, and it also gets an enhancement, i.e., the credit behind an assignee or subtenant. On the other hand, by definition, an agreement to recognize a subtenant takes effect when the original tenant has disappeared from the scene. Thus, a landlord can no longer take comfort that it has its original ‘choice’ on the hook. At the point that recognition is relevant, only the subtenant’s wallet is open. For that reason, negotiations almost always focus on the subtenant’s financial capability. The negotiations are not just about the amount of a subtenant’s net worth or shareholder equity. They include whether one looks at ‘tangible’ net worth (thereby excluding items such as good will). Landlords prefer to make financial determinations at the time the underlying lease is terminated, whereas subtenants (thusly, tenants as well) would choose to bind the landlord at the time of subleasing. Discussions of credit enhancements for a qualifying subtenant are as relevant in the recognition agreement discussion as they are in the basic leasing discussion.

The underlying lease sets the boundaries within which a tenant must operate. By simple example, if the leased premises may only be used for general offices, the subleased space may only be used for general offices. Nonetheless, landlords make certain assumptions about their chosen tenant’s business and how it will be run. Consequently, a landlord may be willing to permit its own tenant to make use of the leased premises in a way that it would not have allowed a different party, such as one who later becomes a prospective subtenant. Another example is that to get a department store as a tenant, the landlord might have agreed to allow the premises to be used for “any legal retail purpose,” but would not have done so for a particular electronics retailer. More commonly, a landlord may make compromises in order to sign a particular lease with a desirable, but resolute tenant, but would not have done so for a subtenant who might not even be occupying dominant space within the project. In many of those cases, that same resolute tenant will yield to the landlord’s wishes when it comes to the rights of a yet unidentified subtenant.

A landlord often points out that it has chosen “you, the tenant” because of “your special attractiveness.” In a retail project, that might mean that it perceives a particular prospective tenant as one who will flood its shopping center with the revered “traffic.” It might be enamored with the “prestige” that a particular tenant can bring to a project and how that prestige can translate into attracting other tenants at even higher rent. Whatever be the case, if a landlord agrees to a lease provision requiring it to recognize hypothetical, future subtenants, it stands to lose that particular attractive quality or qualities. To militate against such a possibility, a landlord may insist that before it becomes obligated to recognize a subtenant the qualifying subtenant must have certain attributes. In the retail context, this could mean that to qualify in advance for a recognition agreement, the subtenant might need to operate or franchise an agreed-upon minimum number of retail stores under a common trade name. In the alternative, the qualifying subtenant might need to be a national or regional retailer. Office landlords might insist that to qualify, a subtenant must be a Fortune 500 company or in a particular industry. The nature and quality of the project will determine what would make a landlord comfortable in accepting a yet unidentified subtenant as its own tenant in the future.

Ordinarily, if a sublease terminates when the underlying lease terminates, the landlord regains possession of the entire leased premises. Essentially, it then can relet all or part of the space and reconfigure it at will. On the other hand, if it has agreed to recognize a subtenant, it doesn’t have the same flexibility. Obviously, it won’t have as much space to market. That may or may not be desirable at the time, but that’s a fundamental result of agreeing that the subtenant can remain in place. On the other hand, a landlord shouldn’t have to accept whatever configuration its tenant might work out with a subtenant. Each space created upon subletting must be economically viable. After all, if the lease is terminated, the prospect of which being what creates the need for recognition in the first place, the tenant’s retained space must be remarketed. When the sublease is over, the sublet space must then be relet. Perforce, each space must “work.” Landlords cannot take comfort that a “tenant knows best.” When a tenant carves up space for subletting it has a specific, known need in mind. It may be willing to share a common entranceway or share utility services with a subtenant, but that doesn’t mean that anyone else would be so willing.

Specific projects may dictate specific qualifying criteria, but the following requirements are common ones:

(a) that the subleased space be of a minimum size;

(b) that it is separately demised from the balance of the leased premises;

(c) that it have its own entrances;

(d) that it has a means of accepting freight and shipping packages without the need for passage through any other space;

(e) that each resulting space be what is considered to be of a generally, commercially leasable shape, either by stating the general requirement or by outlining specific criteria such as being “rectangular” in shape or having a minimum frontage;

(f) that there are separate utility services or submetered services to the sublet space or by requiring the subtenant to create separate utility services or submetered services at the time the underlying lease is terminated;

(g) that it have its own restrooms and other similar critical features;

(h) that each space have adequate and appropriate access and, in the case of retail spaces, visibility; and

(i) that the sublet space be located within a particular portion of the leased premises, such as to the far right or left of a retail store.

When it agrees to accept or recognize a not yet existent sublease as its own direct lease, a landlord has agreed to the terms of that sublease. Even though the subtenant will have no greater rights under its sublease than the sublandlord-tenant had under its own lease, the sublease might have imposed lesser obligations on the subtenant than those imposed on its sublandlord by the underlying lease. For that reason, a landlord should not agree to step into the shoes of its tenant (who would have been the sublandlord) under just any sublease. Its tenant may have agreed to provide services to the subtenant where those services are not ones the landlord is furnishing. Also, the landlord may have given special rights to its tenant that it might not have given to others. Frequently those rights are deal-specific. They might include favorable renewal terms, early termination rights, the right to self-insure, prominent signage, or any of a myriad of negotiated benefits to attract a specific tenant in the first place. For that reason, a landlord will want to consider whether those tenant-tailored rights should inure to the benefit of a subtenant when the original tenant is entirely out of the picture. Similarly, a tenant will want to negotiate for specific rights that will enhance its ability to sublet all or part of the leased premises. Guarantying that a qualified subtenant will get a recognition agreement is a major right. Making sure that the subtenant will get adequate signage or directory listings is another.

While each project and each leasing situation will call for a deal-specific analysis of what must be in an acceptable sublease, the following factors are common to all situations:

(a) that the sublease obligate the subtenant to pay rent in an amount not less than a proportionate share of the rent payable under the lease, frequently, but not always, based upon the size of the subleased premises compared to the leased premises;

(b) that the subtenant pay taxes, utilities, and all other charges with respect to the subleased premises to at least the same extent for which the tenant was obligated;

(c) that, if the subleased space is of better quality or character than the leased space is, on average, the rent payable per square foot be appropriately higher;

(d) that, upon termination of the underlying lease, the subtenant assume all of the non-monetary obligations that its sublandlord had to the landlord;

(e) that, upon termination of the underlying lease, the landlord does not become obligated to more than what it was bound under its lease with the sublandlord; and

(f) that the landlord has the benefit of the more favorable of the exculpatory provisions of the underlying lease or of the sublease.

Separate and apart from the terms of either the underlying lease or of the sublease, and separate and apart from the nature of the parties or of the property, a landlord should be concerned about “successor” liability. That is, it should seek to insulate itself from prior problems between its own tenant and the subtenant. These concerns are similar to those faced by a lender when agreeing to give its borrower’s tenant a non-disturbance agreement. The most common ones are the following. A landlord will not want to be: (i) liable for any previous act or omission or default by its tenant under the sublease; (ii) subject to any offset of rent, counterclaims or defenses that may have accrued to the subtenant against its tenant; (iii) bound by any previous prepayment of rent made by the subtenant to the tenant; or (iv) liable to the subtenant for any security deposit unless the tenant paid the security deposit to the landlord. A tenant, even if agreeing with everything on this list, will want the landlord to cure any default that was the landlord’s default on the date the underlying lease was terminated.

One other frequently encountered landlord’s preference is that it not be obligated to recognize a sublease if, at the time the underlying lease is terminated, the subtenant is in default of its own obligations under its sublease or the subtenant, in some way, has contributed to the reason that the underlying lease was terminated. Appealing as this requirement might be on an emotional level, making it a condition precedent to the effectiveness of a recognition agreement seriously undermines whatever carefully crafted default provisions may have been negotiated into the sublease itself. The tenant and its subtenant have bargained for a mutually acceptable set of tests, the failure of which puts the subtenant at jeopardy of losing its right of possession. Further, the subtenant has bargained for the sublandlord to have specific, limited remedies in the event of a default or alleged default. As a result, tenants resist giving in to such a demand by a landlord, arguing that the landlord always has the right to evict the subtenant if the default is serious enough to allow for such a remedy.

In sum, a subtenant wants to be protected from losing its right to possession if its sublandlord defaults on the underlying lease. Thus, to enhance its ability to find a subtenant, a tenant wants its landlord’s to agree, in advance if possible, to recognize a subtenant should the underlying lease be terminated for any reason. A landlord wants to sign a lease with its chosen tenant, but not necessarily with some subtenant it didn’t choose in the first place. That’s what a recognition agreement was designed for and that’s what the negotiations are about.

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