In the Spotlight: Commercial Landlord Protections in Difficult Economic Times

Start with the Lease

The most important place for any landlord to start is the four corners of the lease agreement. It is imperative, especially in these economic times, that the lease agreement is drafted clearly. A reader must be able to tell where the demised premises are located on the property, who is responsible for which costs and expenses, the manner in which those costs and expenses increase ' basically even who is the actual landlord and tenant. Is the party named as the tenant the party in actual occupancy of the space or was the sponsor/parent company mistakenly included as “tenant”? Additionally, all of the blanks should be filled in when the parties execute the lease agreement. When the market was booming, many parties would simply insert the new agreed-upon terms into pre-negotiated forms. When reading the text of the lease agreement, there may have been provisions that did not seem very clear, even on the second, third or tenth read-through. However, one might have argued that there was no problem since the parties had already agreed to this form. Somebody must understand it if they have agreed to it before.

This approach is dangerous for many reasons. First, if the drafter does not understand the provision or does not understand the provision's function, then it is very possible that the clients do not understand either, and the clients may think that they are obtaining or preserving a right that they are, in fact, forfeiting. Second, if the matter were to come to litigation, any provision that the court must examine and interpret leaves the parties vulnerable to an interpretation that was not contemplated by the parties and may be unfavorable to both the landlord and the tenant. Finally, it just does not make sense to have a provision in a form document that no one understands. Review these provisions and clarify them so that these mistakes are not continued in further agreements. If the language of a provision is not clear, then the liability that it may impose and/or its potential effect on the landlord is not clear.

Maintain Close Contact with Tenants

As tenant bankruptcies become more and more prevalent, commercial landlords should maintain close contact with any tenant that they feel may be in jeopardy. Particularly with the larger, anchor tenants, landlords should monitor the financial health of their tenants to the extent they can (i.e., require additional financial statements, initiate conversational calls to higher management). In addition, landlords should consult those knowledgeable about bankruptcy filings so that the landlord may develop a plan in case a tenant files for bankruptcy. Bankruptcy hearings move very quickly, so it is crucial to be proactive ' not reactive ' in these situations. Also, landlords should review their lease agreements to confirm the notice address for each lease, confirm that such address remains current and instruct the property manager or other key personnel at that location what to do upon receipt of the notice and whom to contact (and ensure that each person ultimately understands the urgent need for a quick response to notice of a tenant's bankruptcy filing).

Bankruptcy or Other Defaults

If a tenant does become bankrupt or vacates the demised premises for some other reason, the landlord must take action to protect its cash flow. Here, again, clear drafting in the lease is key to the landlord's next step. When can the landlord take over possession; how much notice is required; how long and in what ways does the tenant stay on the hook; what if the landlord cannot find another tenant? Is the tenant required to notify the landlord if the tenant chooses to dissolve and wind up its business? Once a tenant ceases its business, the landlord is left in a position of scrambling to find another tenant, usually on an abbreviated timeline and with the added pressure of a mortgagee's careful supervision. What is the landlord entitled to do with the former tenant's unoccupied property? When selecting potential tenants, the landlord must carefully review the co-tenancy provisions in other leases relating to the property to determine whether any tenant consent is required or whether the proposed tenant satisfies the restrictions set forth in the prior leases. Are there any use restrictions? At a time when the landlord is trying to move rapidly to protect its cash flow, it does not want to be tied down to cumbersome and unclear mitigation provisions and use restrictions. Therefore, it is important to revisit these provisions in a lease agreement prior to any tenant vacancy so that the landlord may fully consider each provision and devise a plan for addressing each restriction.

Restrictions

In many instances, nothing as formal as a tenant bankruptcy or vacation of the premises will occur. Most often, the tenant will simply commit an event of default or even a potential default. Financial statements will not be delivered on time; leased square footage will not be maintained; operating hours may be reduced; the store may not remain adequately staffed, stocked and/or maintained ' if a tenant is new to the space, perhaps the tenant improvements have been reduced and/or modified for cost-savings. It is possible ' and even when the market was booming ' likely, that the tenant is maintaining insurance but not in the amounts required pursuant to the lease agreement. The question then becomes, how should the landlord address these issues? Declare a default? Terminate the lease? Waive the default? Enter into work-out negotiations with the tenant? The landlord must make the business decision about whether this tenant is worth keeping, whether the tenant is worth keeping on good terms and whether the landlord will be able to replace the tenant with another tenant that satisfies the landlord's needs for that space.

Types of Tenants

The answers to most of these questions squarely depend on the type of tenant. If the tenant pays its rent on time, is easy to deal with and has a strong credit history and/or a significant sponsor or parent company, it is highly likely that the landlord will agree to negotiate with the tenant to resolve the default. If the tenant is always late with its rent and other deliverables, consistently challenges every reconciliation of operating expenses and creates access or other environmental issues (excess noise, odor, etc.) for other tenants, then the landlord's decision is much more difficult. The decision to declare a tenant in default and possibly terminate the lease could be costly for the landlord. Any new tenant will likely require additional build-outs and improvements, not to mention the negotiation of another lease agreement. In addition, it is possible that the tenant may fight the landlord, especially if the event of default provisions are not clear in the lease agreement, and attorneys' fees will quickly add up as well.

Check Financing Documents

At this point, if the property is subject to a mortgage lien, it is also very important that the landlord have a clear grasp of its financing documents, to determine when its lender must be notified and/or involved in these decisions. Usually the leasing covenants relate to the size of the tenant, and the lender will most likely need to be contacted if the default occurs by a tenant that meets certain leased square footage thresholds. The second question would be to whom the landlord should deliver notice. Many loan agreements state that if the landlord does not deliver adequate and/or proper notice, any lease amendment or modification will be void at the election of the lender. Therefore, if a loan has been securitized or if there is some uncertainty as to whether the original lender still holds the loan, it is important for the landlord to contact its lender for the appropriate notice address, especially if a deemed acceptance provision has been negotiated into the loan documents. Last, when negotiating any modifications with the tenant, particularly with respect to permitting a tenant to go dark for any reason and/or period of time or changing tenant's use, the landlord must remember that its lender will likely have a response to the altered terms of the lease. For example, the lender may require a partial principal repayment of the loan amount or require that the landlord start depositing certain reserves with the lender due to the potentially reduced cash flow. Even worse, the entry into a lease modification may result in a hard cash management arrangement or require the landlord and its guarantors to become personally liable for the loan. No matter how eager the landlord may be to protect its relationship with its tenant, it is important that the landlord protect itself as well and be cognizant of its lender's potential response to any proposed lease amendments and modifications.

Conclusion

In any economic environment, clear drafting should be a key concern in the landlord's negotiation of any lease agreement, but especially in difficult economic times. Landlords should be prepared for any eventuality, and have plans set out in advance so that they may appropriately and quickly protect their interests in the case of a tenant bankruptcy or other event. Also, the landlord must take the complete 365-degree view when determining whether or not to enter into negotiations with a tenant relating to a default or a potential default. Landlord protections exist both within the lease agreement and in the landlord's choices and actions, provided that the landlord is knowledgeable about its options and is aware of the risks to its interests.

Gary A. Goodman is a partner, and Kerri M. Deruyter is an associate, in the real estate practice group of the New York and Charlotte, NC (respectively), offices of Sonnenschein Nath & Rosenthal LLP.

In these troubling economic times, commercial landlords find their attention focused on a multitude of issues with which they may not be familiar. The concerns that landlords see today are not new: These concerns regarding tenants were always in the back of the underwriting analysis, buried deep amid an array of charts, graphs and comparable statistics. Today, however, landlords are particularly worried about tenant bankruptcies. True, this has always been a concern for commercial landlords, but previously their focus may have centered on smaller, start-up businesses rather than the large anchor tenants that are currently seen knocking on the bankruptcy court's door.

In addition, landlords are now seeing tenants close up their shops and go dark. What may have been a viable shopping center or office building 18 months ago is now full of dark windows and empty doorways. The new issue for commercial landlords is that there is not a wide selection of potential tenants to replace the departing ones. Funds are much tighter these days, and tenants are not looking to expand to multiple locations or grow to additional floors. Therefore, it becomes more and more difficult for commercial landlords to maintain the ongoing business of their property following a tenant vacancy. This difficulty can have further negative effects when one considers the domino effect of co-tenancy clauses in other leases.

Last, many commercial landlords are left in a position where they must make a business call regarding whether to work out a default, or potential default, with a tenant. If it is a significant tenant, the landlord has to be aware of the terms of its financing documents to determine whether and when it must consult its lender. Furthermore, if the loan has been securitized, the landlord must determine which party must receive the proper notice. While these concerns are not new to commercial landlords, the practical matter is that commercial landlords may not have had a lot of experience handling these issues in the booming market that they have enjoyed for the last several years. Therefore, it is important for the parties to understand their options and their responsibilities, and to keep a close eye on the financial health of their tenants.

Start with the Lease

The most important place for any landlord to start is the four corners of the lease agreement. It is imperative, especially in these economic times, that the lease agreement is drafted clearly. A reader must be able to tell where the demised premises are located on the property, who is responsible for which costs and expenses, the manner in which those costs and expenses increase ' basically even who is the actual landlord and tenant. Is the party named as the tenant the party in actual occupancy of the space or was the sponsor/parent company mistakenly included as “tenant”? Additionally, all of the blanks should be filled in when the parties execute the lease agreement. When the market was booming, many parties would simply insert the new agreed-upon terms into pre-negotiated forms. When reading the text of the lease agreement, there may have been provisions that did not seem very clear, even on the second, third or tenth read-through. However, one might have argued that there was no problem since the parties had already agreed to this form. Somebody must understand it if they have agreed to it before.

This approach is dangerous for many reasons. First, if the drafter does not understand the provision or does not understand the provision's function, then it is very possible that the clients do not understand either, and the clients may think that they are obtaining or preserving a right that they are, in fact, forfeiting. Second, if the matter were to come to litigation, any provision that the court must examine and interpret leaves the parties vulnerable to an interpretation that was not contemplated by the parties and may be unfavorable to both the landlord and the tenant. Finally, it just does not make sense to have a provision in a form document that no one understands. Review these provisions and clarify them so that these mistakes are not continued in further agreements. If the language of a provision is not clear, then the liability that it may impose and/or its potential effect on the landlord is not clear.

Maintain Close Contact with Tenants

As tenant bankruptcies become more and more prevalent, commercial landlords should maintain close contact with any tenant that they feel may be in jeopardy. Particularly with the larger, anchor tenants, landlords should monitor the financial health of their tenants to the extent they can (i.e., require additional financial statements, initiate conversational calls to higher management). In addition, landlords should consult those knowledgeable about bankruptcy filings so that the landlord may develop a plan in case a tenant files for bankruptcy. Bankruptcy hearings move very quickly, so it is crucial to be proactive ' not reactive ' in these situations. Also, landlords should review their lease agreements to confirm the notice address for each lease, confirm that such address remains current and instruct the property manager or other key personnel at that location what to do upon receipt of the notice and whom to contact (and ensure that each person ultimately understands the urgent need for a quick response to notice of a tenant's bankruptcy filing).

Bankruptcy or Other Defaults

If a tenant does become bankrupt or vacates the demised premises for some other reason, the landlord must take action to protect its cash flow. Here, again, clear drafting in the lease is key to the landlord's next step. When can the landlord take over possession; how much notice is required; how long and in what ways does the tenant stay on the hook; what if the landlord cannot find another tenant? Is the tenant required to notify the landlord if the tenant chooses to dissolve and wind up its business? Once a tenant ceases its business, the landlord is left in a position of scrambling to find another tenant, usually on an abbreviated timeline and with the added pressure of a mortgagee's careful supervision. What is the landlord entitled to do with the former tenant's unoccupied property? When selecting potential tenants, the landlord must carefully review the co-tenancy provisions in other leases relating to the property to determine whether any tenant consent is required or whether the proposed tenant satisfies the restrictions set forth in the prior leases. Are there any use restrictions? At a time when the landlord is trying to move rapidly to protect its cash flow, it does not want to be tied down to cumbersome and unclear mitigation provisions and use restrictions. Therefore, it is important to revisit these provisions in a lease agreement prior to any tenant vacancy so that the landlord may fully consider each provision and devise a plan for addressing each restriction.

Restrictions

In many instances, nothing as formal as a tenant bankruptcy or vacation of the premises will occur. Most often, the tenant will simply commit an event of default or even a potential default. Financial statements will not be delivered on time; leased square footage will not be maintained; operating hours may be reduced; the store may not remain adequately staffed, stocked and/or maintained ' if a tenant is new to the space, perhaps the tenant improvements have been reduced and/or modified for cost-savings. It is possible ' and even when the market was booming ' likely, that the tenant is maintaining insurance but not in the amounts required pursuant to the lease agreement. The question then becomes, how should the landlord address these issues? Declare a default? Terminate the lease? Waive the default? Enter into work-out negotiations with the tenant? The landlord must make the business decision about whether this tenant is worth keeping, whether the tenant is worth keeping on good terms and whether the landlord will be able to replace the tenant with another tenant that satisfies the landlord's needs for that space.

Types of Tenants

The answers to most of these questions squarely depend on the type of tenant. If the tenant pays its rent on time, is easy to deal with and has a strong credit history and/or a significant sponsor or parent company, it is highly likely that the landlord will agree to negotiate with the tenant to resolve the default. If the tenant is always late with its rent and other deliverables, consistently challenges every reconciliation of operating expenses and creates access or other environmental issues (excess noise, odor, etc.) for other tenants, then the landlord's decision is much more difficult. The decision to declare a tenant in default and possibly terminate the lease could be costly for the landlord. Any new tenant will likely require additional build-outs and improvements, not to mention the negotiation of another lease agreement. In addition, it is possible that the tenant may fight the landlord, especially if the event of default provisions are not clear in the lease agreement, and attorneys' fees will quickly add up as well.

Check Financing Documents

At this point, if the property is subject to a mortgage lien, it is also very important that the landlord have a clear grasp of its financing documents, to determine when its lender must be notified and/or involved in these decisions. Usually the leasing covenants relate to the size of the tenant, and the lender will most likely need to be contacted if the default occurs by a tenant that meets certain leased square footage thresholds. The second question would be to whom the landlord should deliver notice. Many loan agreements state that if the landlord does not deliver adequate and/or proper notice, any lease amendment or modification will be void at the election of the lender. Therefore, if a loan has been securitized or if there is some uncertainty as to whether the original lender still holds the loan, it is important for the landlord to contact its lender for the appropriate notice address, especially if a deemed acceptance provision has been negotiated into the loan documents. Last, when negotiating any modifications with the tenant, particularly with respect to permitting a tenant to go dark for any reason and/or period of time or changing tenant's use, the landlord must remember that its lender will likely have a response to the altered terms of the lease. For example, the lender may require a partial principal repayment of the loan amount or require that the landlord start depositing certain reserves with the lender due to the potentially reduced cash flow. Even worse, the entry into a lease modification may result in a hard cash management arrangement or require the landlord and its guarantors to become personally liable for the loan. No matter how eager the landlord may be to protect its relationship with its tenant, it is important that the landlord protect itself as well and be cognizant of its lender's potential response to any proposed lease amendments and modifications.

Conclusion

In any economic environment, clear drafting should be a key concern in the landlord's negotiation of any lease agreement, but especially in difficult economic times. Landlords should be prepared for any eventuality, and have plans set out in advance so that they may appropriately and quickly protect their interests in the case of a tenant bankruptcy or other event. Also, the landlord must take the complete 365-degree view when determining whether or not to enter into negotiations with a tenant relating to a default or a potential default. Landlord protections exist both within the lease agreement and in the landlord's choices and actions, provided that the landlord is knowledgeable about its options and is aware of the risks to its interests.

Gary A. Goodman is a partner, and Kerri M. Deruyter is an associate, in the real estate practice group of the New York and Charlotte, NC (respectively), offices of Sonnenschein Nath & Rosenthal LLP.