Self-Help and Set-Off Rights: A Primer

'Rent is an independent covenant.' These are words historically coveted by nearly every landlord. In most cases, interestingly, the independent nature of the payment of rent is not troubling to tenants or their counsel. In some jurisdictions, the concept of 'dependant covenants' is surfacing if the parties do not specify otherwise. From time to time, however, a tenant will require the landlord to insert provisions providing the right to self-help and/or the ability to set-off against rent, concepts that are contrary to the independent covenant doctrine. For well-heeled landlords, this is problem enough. Add a lender to the mix, particularly in instances where consent to the lease is required, and the matter quickly becomes complicated. The landlord's interests lie in keeping others from acting on its behalf with respect to its property and preserving its cash flow. The tenant's interests lie in making sure that the landlord performs its obligations under the lease and, if the tenant is required to act for the landlord, that the tenant has a source of funds to reimburse it for doing so. Finally, lenders are most interested in stable cash flow, continued loan repayment, and the avoidance of disputes to which they may become a party.

Reasons for Tenant Requests

Though reasons for tenant requests for self-help and the right to set-off against rent vary, the main reason for tenant self-help rights is to complete an unfinished landlord maintenance or construction obligation, while the main reason for the right to set-off against rent is related to the initial construction of the tenant's space. With tenant improvement allowances exceeding $50 per square foot for new construction or complete renovation, a 10,000-square-foot-tenant will recognize a half-million dollar construction risk. If the landlord does not perform its construction obligation, and the tenant takes over the work and pays for it, the tenant will not recover its half-million dollar investment for 20 months, assuming a $30-per-square-foot annual gross rent to set-off against. On the other hand, and notwithstanding its default in performance, lost rent is a disaster for both the landlord and the lender who is counting on the same to service its debt.

Is It an Emergency?

Landlords should strongly resist allowing tenant self-help rights and should only grant self-help rights to sophisticated tenants who will act accordingly. Where self-help rights cannot be avoided, one could bifurcate the right between emergency and non-emergency situations. The primary difference between the two classifications is advance notice to the landlord before the tenant takes action. Emergencies should be limited to potential loss of life or limb, or imminent and serious damage to property. In such cases, advance notice by telephone or e-mail should be required if reasonable under the circumstances. In any emergency, however, notice should be required after the fact in the manner required by the lease. In non-emergency situations, advance notice ' usually 30 days or more ' should be required, in addition to the normal default notice under the lease. In either case, the tenant should not be permitted to act until the landlord is afforded the opportunity to act ' as is reasonable under the circumstances ' and has failed to act. Further, care should be taken not to allow the self-help right to extend beyond the premises or into common areas.

A Tenant's Right to Proceed

After the notice requirements are met in a self-help situation, the tenant should be permitted to act in a commercially reasonable manner, at reasonable cost, and thereafter present the landlord with the costs expended for reimbursement pursuant to detailed supporting documentation. Documentation should include contractor waivers of lien as required. When dealing with non-emergency repairs or replacements involving items covered by warranty, the tenant should be required to contact the original warranty provider or assure that its repairs or replacements do not void existing warranties. Finally, some tenants take the position that a landlord performance failure that interferes with the tenant's right to operate its business constitutes an emergency. The self-help provision should be narrowly drafted so that such an argument does not exist. However, if the concept is acceptable to the landlord, such requests should be treated as non-emergency situations, provided consideration can be given to shortening the notice period where a major or anchor tenant can provide competent evidence that the landlord failure is costing the tenant a material portion of its business.

Is Set-Off Appropriate?

A tenant may request a rent set-off provision in conjunction with its self-help provision or for other landlord payment defaults. As stated above, the right to set-off against rent is problematic for landlords, and landlords should avoid permitting set-off rights in their leases. Both the existence of a landlord payment default and the outlay of funds by the tenant (for instance, for the cost of construction or to cure a landlord maintenance default), with required supporting documentation, are generally key requirements for the initiation of the set-off process. As most landlord lease forms do not contain 'landlord default' provisions, the specific landlord payment default to which the set-off right exists must be added to the lease document. Parties should be specific as to the nature of the default to which the set-off right applies. For instance, the landlord should avoid a provision that states the set-off right applies to any landlord default. Once specificity is achieved (e.g., landlord fails to pay any construction allowance when due), the landlord should request that two separate notices be required before the tenant has the right to set-off against rent. A standard provision might require a specified notice and cure period (30 days notice), state whether a diligent cure exception applies, and then require a second notice of nonpayment with a shorter cure period (five to 10 days notice). The second notice should contain a conspicuous provision stating that: 'TENANT SHALL HAVE THE RIGHT TO OFFSET AGAINST RENT FOR FAILURE TO COMPLY WITH THIS SECOND NOTICE ON OR BEFORE [INSERT APPLICABLE DATE].' Some landlords may further wish to protect their lenders by requiring the second notice be sent to the lender together with a separate 'cure' period. This issue typically arises where the lender has an approval right under the lease.

The Landlord's Right to Dispute

The set-off provision should also provide the landlord with an opportunity to dispute the legitimacy of the tenant's default notice. The landlord should not be subject to offset for amounts it legitimately believes are not due. The landlord should be required to notify the tenant of the dispute by responding to either the first or second notice that there is a bona fide dispute with the tenant's claim or that the amount in issue is not due and owing. Disputes can be handled in the set-off provision itself or by reference to the lease's other dispute resolution procedures, such as arbitration, mediation, or litigation. Since tenants will not be amenable to long, drawn-out remedy provisions dealing with the landlord's nonpayment of money, most set-off provisions will have their own dispute resolution procedures before the other lease dispute resolution procedures apply. Possible ways to resolve disputes include payment of undisputed amounts; the referral of claims to professionals, such as the architect, for resolution; or the institution of additional tenant rights, such as interest at a default rate (as permitted by law) and attorneys' fees for disputes not successfully pursued by the landlord. The dispute provisions are generally not available to the lender unless, during the course of the landlord default, it becomes a successor landlord.

Rent

If a rent set-off provision is included in the lease, the parties will have to determine what 'rent' is available to be set-off against by the tenant. 'Rent' under most leases includes all monetary remuneration due from tenant to landlord. To permit the tenant to offset against 'Rent' would mean that no monies would be paid to the landlord until the tenant has been repaid in full. While tenants desire full rent abatements, landlords should limit set-off rights to base rent and percentage rent (in retail leases). All other rent in the nature of reimbursement of landlord costs, such as operating expenses and real estate taxes, should not be subject to offset. In fact, since rent set-off rights are typically granted only in major leases, the offset should be limited to a percentage of base rent such that the landlord will be able to continue to make its debt service payments. By limiting the set-off right to 25% of the rent due in any month, the landlord will continue to have 75% of the rent available to pay debt service. The right to set-off against rent would apply to rent next accruing and due under the lease. If the tenant 'holds' rent during the notice period, the same should remain a default under the lease. Finally, tenants will argue that they are entitled to interest on their monies until repaid by the landlord. The parties are free to negotiate this provision as they see fit.

Lender Rights (If Any)

One might ask, 'Where is the lender during the negotiation of these provisions?' If the lender's consent to lease is not required, the lender is usually not included in the process. If the lender's consent to the lease is required, it has a place at the negotiating table. Most landlords and their counsel are remiss to include the lender in the process until after a few drafts of the lease have been exchanged. While this may make sense from the standpoint that the lease transaction may not move forward, where offset rights are requested, it is wise to seek the lender's counsel early. In fact, where national lenders and national tenants are involved, they may have addressed similar issues a number of times before and amicably resolved any differences. This may be helpful to a landlord, provided the terms are acceptable to the landlord. Alternatively, the lender may request its own 'deal' under the terms of a separate subordination, nondisturbance, and attornment agreement. In any case, where the lender's consent is required, it is wise for the parties to include the lender in the negotiating process once the tenant makes a request for a set-off right.

Is Rent Still an Independent Covenant?

What happens to the concept that rent is an independent covenant after completing the self-help and set-off provisions in a lease? In many cases, as the result of an oversight, the 'rent is an independent covenant' provision is not deleted from the lease if the landlord's lease form is used. A 'rent is an independent covenant' provision usually does not appear in most tenant form leases. In either case, it would be wise for the landlord to include a 'rent is an independent covenant' provision in the lease to cover all of the other situations not covered by the set-off provision, and it would be wise for the tenant specifically to refer to those provisions in the lease to which it does not apply, specifically the set-off provision.

David Pezza is a partner in Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago. He may be contacted at 312-915-3167 or [email protected].

'Rent is an independent covenant.' These are words historically coveted by nearly every landlord. In most cases, interestingly, the independent nature of the payment of rent is not troubling to tenants or their counsel. In some jurisdictions, the concept of 'dependant covenants' is surfacing if the parties do not specify otherwise. From time to time, however, a tenant will require the landlord to insert provisions providing the right to self-help and/or the ability to set-off against rent, concepts that are contrary to the independent covenant doctrine. For well-heeled landlords, this is problem enough. Add a lender to the mix, particularly in instances where consent to the lease is required, and the matter quickly becomes complicated. The landlord's interests lie in keeping others from acting on its behalf with respect to its property and preserving its cash flow. The tenant's interests lie in making sure that the landlord performs its obligations under the lease and, if the tenant is required to act for the landlord, that the tenant has a source of funds to reimburse it for doing so. Finally, lenders are most interested in stable cash flow, continued loan repayment, and the avoidance of disputes to which they may become a party.

Reasons for Tenant Requests

Though reasons for tenant requests for self-help and the right to set-off against rent vary, the main reason for tenant self-help rights is to complete an unfinished landlord maintenance or construction obligation, while the main reason for the right to set-off against rent is related to the initial construction of the tenant's space. With tenant improvement allowances exceeding $50 per square foot for new construction or complete renovation, a 10,000-square-foot-tenant will recognize a half-million dollar construction risk. If the landlord does not perform its construction obligation, and the tenant takes over the work and pays for it, the tenant will not recover its half-million dollar investment for 20 months, assuming a $30-per-square-foot annual gross rent to set-off against. On the other hand, and notwithstanding its default in performance, lost rent is a disaster for both the landlord and the lender who is counting on the same to service its debt.

Is It an Emergency?

Landlords should strongly resist allowing tenant self-help rights and should only grant self-help rights to sophisticated tenants who will act accordingly. Where self-help rights cannot be avoided, one could bifurcate the right between emergency and non-emergency situations. The primary difference between the two classifications is advance notice to the landlord before the tenant takes action. Emergencies should be limited to potential loss of life or limb, or imminent and serious damage to property. In such cases, advance notice by telephone or e-mail should be required if reasonable under the circumstances. In any emergency, however, notice should be required after the fact in the manner required by the lease. In non-emergency situations, advance notice ' usually 30 days or more ' should be required, in addition to the normal default notice under the lease. In either case, the tenant should not be permitted to act until the landlord is afforded the opportunity to act ' as is reasonable under the circumstances ' and has failed to act. Further, care should be taken not to allow the self-help right to extend beyond the premises or into common areas.

A Tenant's Right to Proceed

After the notice requirements are met in a self-help situation, the tenant should be permitted to act in a commercially reasonable manner, at reasonable cost, and thereafter present the landlord with the costs expended for reimbursement pursuant to detailed supporting documentation. Documentation should include contractor waivers of lien as required. When dealing with non-emergency repairs or replacements involving items covered by warranty, the tenant should be required to contact the original warranty provider or assure that its repairs or replacements do not void existing warranties. Finally, some tenants take the position that a landlord performance failure that interferes with the tenant's right to operate its business constitutes an emergency. The self-help provision should be narrowly drafted so that such an argument does not exist. However, if the concept is acceptable to the landlord, such requests should be treated as non-emergency situations, provided consideration can be given to shortening the notice period where a major or anchor tenant can provide competent evidence that the landlord failure is costing the tenant a material portion of its business.

Is Set-Off Appropriate?

A tenant may request a rent set-off provision in conjunction with its self-help provision or for other landlord payment defaults. As stated above, the right to set-off against rent is problematic for landlords, and landlords should avoid permitting set-off rights in their leases. Both the existence of a landlord payment default and the outlay of funds by the tenant (for instance, for the cost of construction or to cure a landlord maintenance default), with required supporting documentation, are generally key requirements for the initiation of the set-off process. As most landlord lease forms do not contain 'landlord default' provisions, the specific landlord payment default to which the set-off right exists must be added to the lease document. Parties should be specific as to the nature of the default to which the set-off right applies. For instance, the landlord should avoid a provision that states the set-off right applies to any landlord default. Once specificity is achieved (e.g., landlord fails to pay any construction allowance when due), the landlord should request that two separate notices be required before the tenant has the right to set-off against rent. A standard provision might require a specified notice and cure period (30 days notice), state whether a diligent cure exception applies, and then require a second notice of nonpayment with a shorter cure period (five to 10 days notice). The second notice should contain a conspicuous provision stating that: 'TENANT SHALL HAVE THE RIGHT TO OFFSET AGAINST RENT FOR FAILURE TO COMPLY WITH THIS SECOND NOTICE ON OR BEFORE [INSERT APPLICABLE DATE].' Some landlords may further wish to protect their lenders by requiring the second notice be sent to the lender together with a separate 'cure' period. This issue typically arises where the lender has an approval right under the lease.

The Landlord's Right to Dispute

The set-off provision should also provide the landlord with an opportunity to dispute the legitimacy of the tenant's default notice. The landlord should not be subject to offset for amounts it legitimately believes are not due. The landlord should be required to notify the tenant of the dispute by responding to either the first or second notice that there is a bona fide dispute with the tenant's claim or that the amount in issue is not due and owing. Disputes can be handled in the set-off provision itself or by reference to the lease's other dispute resolution procedures, such as arbitration, mediation, or litigation. Since tenants will not be amenable to long, drawn-out remedy provisions dealing with the landlord's nonpayment of money, most set-off provisions will have their own dispute resolution procedures before the other lease dispute resolution procedures apply. Possible ways to resolve disputes include payment of undisputed amounts; the referral of claims to professionals, such as the architect, for resolution; or the institution of additional tenant rights, such as interest at a default rate (as permitted by law) and attorneys' fees for disputes not successfully pursued by the landlord. The dispute provisions are generally not available to the lender unless, during the course of the landlord default, it becomes a successor landlord.

Rent

If a rent set-off provision is included in the lease, the parties will have to determine what 'rent' is available to be set-off against by the tenant. 'Rent' under most leases includes all monetary remuneration due from tenant to landlord. To permit the tenant to offset against 'Rent' would mean that no monies would be paid to the landlord until the tenant has been repaid in full. While tenants desire full rent abatements, landlords should limit set-off rights to base rent and percentage rent (in retail leases). All other rent in the nature of reimbursement of landlord costs, such as operating expenses and real estate taxes, should not be subject to offset. In fact, since rent set-off rights are typically granted only in major leases, the offset should be limited to a percentage of base rent such that the landlord will be able to continue to make its debt service payments. By limiting the set-off right to 25% of the rent due in any month, the landlord will continue to have 75% of the rent available to pay debt service. The right to set-off against rent would apply to rent next accruing and due under the lease. If the tenant 'holds' rent during the notice period, the same should remain a default under the lease. Finally, tenants will argue that they are entitled to interest on their monies until repaid by the landlord. The parties are free to negotiate this provision as they see fit.

Lender Rights (If Any)

One might ask, 'Where is the lender during the negotiation of these provisions?' If the lender's consent to lease is not required, the lender is usually not included in the process. If the lender's consent to the lease is required, it has a place at the negotiating table. Most landlords and their counsel are remiss to include the lender in the process until after a few drafts of the lease have been exchanged. While this may make sense from the standpoint that the lease transaction may not move forward, where offset rights are requested, it is wise to seek the lender's counsel early. In fact, where national lenders and national tenants are involved, they may have addressed similar issues a number of times before and amicably resolved any differences. This may be helpful to a landlord, provided the terms are acceptable to the landlord. Alternatively, the lender may request its own 'deal' under the terms of a separate subordination, nondisturbance, and attornment agreement. In any case, where the lender's consent is required, it is wise for the parties to include the lender in the negotiating process once the tenant makes a request for a set-off right.

Is Rent Still an Independent Covenant?

What happens to the concept that rent is an independent covenant after completing the self-help and set-off provisions in a lease? In many cases, as the result of an oversight, the 'rent is an independent covenant' provision is not deleted from the lease if the landlord's lease form is used. A 'rent is an independent covenant' provision usually does not appear in most tenant form leases. In either case, it would be wise for the landlord to include a 'rent is an independent covenant' provision in the lease to cover all of the other situations not covered by the set-off provision, and it would be wise for the tenant specifically to refer to those provisions in the lease to which it does not apply, specifically the set-off provision.

David Pezza is a partner in Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago. He may be contacted at 312-915-3167 or [email protected].