How to Create Common and Uncommon Assignment/Subletting Problems

Landlords are less black and white about the subject; however, as any leasing attorney will tell you, there are landlords at each extreme. Basically, landlords have a fear of the unknown. Although they have given up possession of the leased space to their tenant, they still own the premises and want to retain as much control over the space and the balance of their property as possible. To varying degrees, they want to control “who” will actually be using the space and “what” the space will be used for. It is not enough to have made a deal with an acceptable tenant in the first place and allow that tenant, with the confines of the balance of its lease, to use the space as and how it sees fit. Outside of the bankruptcy context, the lease's limitations on use and the obligations imposed on the tenant remain fully in force.

The parties, wanting to acquire their respective benefits from the leasing arrangement, will reach an agreement as to the breadth and scope of the lease's assignment and subletting limitations, and then they will wait until a prospective transfer of the tenant's interests arises, if at all. What follows below is an exposition on the kinds of things that can happen if the leasing parties lack the foresight or energy to address them up front, in a well crafted lease.

Obviously, the law in each jurisdiction differs. This article addresses issues that arise in the leasehold assignment and subletting context. If, in a given jurisdiction, a particular “situation” is “no problem,” more the better, but remember: Another jurisdiction may not be so forgiving. Further, it makes no sense to rely on a given jurisdiction's law when the lease itself can almost always spell out the rules for assignments and subletting. One more caveat. This two-part article is not a treatise on crafting a lease. Its purpose is to identify situations that give rise to common and uncommon problems that arise in the assignment and subletting context. The simplest way to get there from here is to lay out what happens if a lease does not cover a given situation.

Assignment and Subletting Distinguished

Assignment

An assignment is not a subletting, and vice versa. The underlying considerations are not the same. By assignment, the new occupant (the assignee) becomes the tenant itself. Its right to possession of the premises is grounded in real property law ' the law of conveyances. At the same time, only if the assignee assumes the lease will it be accepting a direct, contractual relationship with the landlord. If it does not assume the lease, the landlord and the assignee have possessory obligations to each other, i.e., those obligations that run with the land, but not contractual obligations. Absent an express agreement by the landlord to the contrary or the occurrence of some subsequent “releasing” event, the original (assigning) tenant is not let off the hook. To effectuate a novation, i.e., a full substitution of the assignee for the assignor, the landlord must accept that result. After an assignment, unless the lease or any other document says otherwise, the landlord does not have to deal with its original tenant, even though its original tenant remains on the hook. Of course, if the original tenant is granted bankruptcy protection, the lease will remain in effect and the assignee will remain in possession, but the original tenant may no longer have the secondary liability it once had as a former tenant under the lease.

Letting the law run its course may not lead to favorable or even expected results. For example, absent an agreement to the contrary, an assigning tenant, though still liable to its old landlord, is no longer primarily on the hook for a tenant's lease obligations. Upon assignment, it becomes a surety for the obligations; its assignee becomes primarily liable for those obligations. If the assignee has not assumed the lease, but has only taken possession, it may not even be liable for some moneys owed under the lease, such as obligations to repay a loan. It will not be financially liable for a prior default by its assignor, even though it might lose the lease by reason of such a default. It will not be liable for the obligations of a subsequent assignee, just for what happens while it is in possession of the leased premises.

So, think of the common and uncommon situations that can arise if a lease does not cover these gaps. If the lease (or a separate document, such as the consent to assignment document) does not make the named tenant primarily liable for the obligations of subsequent tenants by assignment, a landlord may find itself with the equivalent of a guaranty of collection, not a guaranty of payment. That would delay the landlord's collection of what it is owed, and “to delay is to deny.” The antidote is for the lease to state that the named tenant, following an assignment of its leasehold interest, remains primarily liable for all the tenant's obligations under the lease, including those of all subsequent assignees. A more potent provision would make the tenant and all assignees jointly and severally liable for all tenant obligations under the lease, no matter when incurred.

As to each assignee, if a landlord wants it to be contractually bound to the terms of the lease as if the assignee were the original, named tenant, the parties need make that happen by way of the lease or by requiring an express assumption of the lease by each assignee as a condition of a valid assignment.

Subletting

A subletting does not change the original landlord-tenant relationship. The subtenant is not in privity of contract with the landlord. It is not even in privity of estate with the landlord. It may have possession of the premises through its own (sub)landlord, the original tenant, but it is not liable for the debts and obligations of the named tenant. Notwithstanding the subletting, its landlord, the named tenant, remains in possession of the leased premises by reason of the lease. What the tenant has done, vis-'-vis the subletting, is to encumber its right of possession by conveying a portion (in time, space or both) to its selected subtenant. By that conveyance, it is in privity of estate with its subtenant.

It should not go unnoted that parties may self-characterize their transaction as a subletting or as an assignment, but the details of the actual possessory grant will trump any labels. The essential distinction between an assignment and a subletting is that in a subletting, the transferring tenant reserves some reversionary right. With the possible twists inherent in an “assignment pro tanto,” to be a subletting, the quantum of rights granted to a subtenant cannot be the entirety of what the purported sublandlord possesses. Plainly speaking, a subletting for the entire lease term and for the entire leased space will be characterized as an assignment. Whether a withholding of some element of a contractual right, as distinguished from a possessory right, alone, will cause a purported sublease of the entire leased premises for the entire lease term to be treated as a subletting is a question of state law, with the answer to be found ' if at all ' in that state's case law.

Assignments Pro Tanto

Having raised the specter of an “assignment pro tanto,” it is only proper that this unusual and possibly dangerous hybrid be described ' especially in a treatment of common and uncommon assignment/subletting problems. Simply speaking, this animal is the transfer to another, of a tenant's entire interest in a portion of leased premises, for the entire lease term. Describing this creation as an animal may be an apt choice of terms as it may be somewhat uncontrollable. In most jurisdictions, but not all, the landlord now has two tenants and, in effect, two leases. The assignee may, and the operative word is may, have a contractual relationship with the landlord. If the original tenant defaults under its lease, giving rise to a lease termination, the landlord may still have a tenant, the assignee, for the portion of the leased space that was thought merely to be sublet. The law is uncertain; there is not a lot of guiding case law. However, if a tenant can assign freely under its lease, but not sublet freely, there is always the possibility of enjoying both “existences” by use of an assignment pro tanto.

If you are looking for uncommon situations that can arise out of an assignment or subletting, just think of the mischief that can be created by a tenant structuring an assignment pro tanto. So, a landlord might want to prohibit assignments of less than its tenant's entire interest under the lease. Allowing (or consenting to) assignments, even to a tenant's affiliates, may result in everyone's rushing to research the intended and unintended consequences of the “pro tanto” assignment.

Distaste for Restraints on Alienation

Almost every lease endeavors to set out some rules for a tenant's transfer of all or part of its leasehold interest. Depending on the bargaining power of the parties, their ability to predict the future, their tolerance for comprehensiveness, the amount of time they have allotted to the task, their knowledge of the law (and where it is heading), and the talent of the draftsperson, the lease may avoid or invite one or more of the issues below. The task is greatly complicated by the law's disfavor of restrictions against alienation, and an assignment or subletting is such an alienation. Prohibitions and restrictions against assignment and subletting are scrutinized and catalogued by the courts.

Conclusion

The next part of this article will discuss some of the problems that can arise if certain issues are not covered by the lease or another enforceable document.

Ira Meislik is a principal at the Montclair, NJ, law firm of Meislik & Meislik. Mr. Meislik's commercial real estate practice, though broad in scope, has a special focus on retail real estate law. In addition to crafting space and ground leases, he has extensive experience in the acquisition, disposition, and financing of real property. He has written and spoken in the areas of real estate, business entity selection, attorney ethics, limited liability entities, and unincorporated business associations.

Under common law, absent a lease restriction, tenants had been free to assign their leasehold interest to others or to sublet all or part of their leased space. That rule of law is of little consequence today because virtually all leases restrict assignment and subletting rights, often in excruciating detail. In addition, a small number of jurisdictions have reversed the rule by statute and there are certain kinds of leases, generally tied into personal services, that are not, as a default matter, freely assignable. This article deals with what can happen when those restrictions are poorly crafted or entirely absent, and the problems that arise as a consequence thereof.

'Exit Strategies'

What tenants want is to be able to have an “exit strategy.” A time may come when they cannot afford the space and, being obligated to continue paying for it, need to find someone else to cover those costs. Perhaps their leased space becomes too large or too small. Perhaps the neighborhood has changed, and their products or services no longer fit the location, but someone else's business could thrive. To a tenant, its leasehold interest is an asset, just like a piece of equipment. Thus it wants to be able to sell or rent the asset freely.

Landlords are less black and white about the subject; however, as any leasing attorney will tell you, there are landlords at each extreme. Basically, landlords have a fear of the unknown. Although they have given up possession of the leased space to their tenant, they still own the premises and want to retain as much control over the space and the balance of their property as possible. To varying degrees, they want to control “who” will actually be using the space and “what” the space will be used for. It is not enough to have made a deal with an acceptable tenant in the first place and allow that tenant, with the confines of the balance of its lease, to use the space as and how it sees fit. Outside of the bankruptcy context, the lease's limitations on use and the obligations imposed on the tenant remain fully in force.

The parties, wanting to acquire their respective benefits from the leasing arrangement, will reach an agreement as to the breadth and scope of the lease's assignment and subletting limitations, and then they will wait until a prospective transfer of the tenant's interests arises, if at all. What follows below is an exposition on the kinds of things that can happen if the leasing parties lack the foresight or energy to address them up front, in a well crafted lease.

Obviously, the law in each jurisdiction differs. This article addresses issues that arise in the leasehold assignment and subletting context. If, in a given jurisdiction, a particular “situation” is “no problem,” more the better, but remember: Another jurisdiction may not be so forgiving. Further, it makes no sense to rely on a given jurisdiction's law when the lease itself can almost always spell out the rules for assignments and subletting. One more caveat. This two-part article is not a treatise on crafting a lease. Its purpose is to identify situations that give rise to common and uncommon problems that arise in the assignment and subletting context. The simplest way to get there from here is to lay out what happens if a lease does not cover a given situation.

Assignment and Subletting Distinguished

Assignment

An assignment is not a subletting, and vice versa. The underlying considerations are not the same. By assignment, the new occupant (the assignee) becomes the tenant itself. Its right to possession of the premises is grounded in real property law ' the law of conveyances. At the same time, only if the assignee assumes the lease will it be accepting a direct, contractual relationship with the landlord. If it does not assume the lease, the landlord and the assignee have possessory obligations to each other, i.e., those obligations that run with the land, but not contractual obligations. Absent an express agreement by the landlord to the contrary or the occurrence of some subsequent “releasing” event, the original (assigning) tenant is not let off the hook. To effectuate a novation, i.e., a full substitution of the assignee for the assignor, the landlord must accept that result. After an assignment, unless the lease or any other document says otherwise, the landlord does not have to deal with its original tenant, even though its original tenant remains on the hook. Of course, if the original tenant is granted bankruptcy protection, the lease will remain in effect and the assignee will remain in possession, but the original tenant may no longer have the secondary liability it once had as a former tenant under the lease.

Letting the law run its course may not lead to favorable or even expected results. For example, absent an agreement to the contrary, an assigning tenant, though still liable to its old landlord, is no longer primarily on the hook for a tenant's lease obligations. Upon assignment, it becomes a surety for the obligations; its assignee becomes primarily liable for those obligations. If the assignee has not assumed the lease, but has only taken possession, it may not even be liable for some moneys owed under the lease, such as obligations to repay a loan. It will not be financially liable for a prior default by its assignor, even though it might lose the lease by reason of such a default. It will not be liable for the obligations of a subsequent assignee, just for what happens while it is in possession of the leased premises.

So, think of the common and uncommon situations that can arise if a lease does not cover these gaps. If the lease (or a separate document, such as the consent to assignment document) does not make the named tenant primarily liable for the obligations of subsequent tenants by assignment, a landlord may find itself with the equivalent of a guaranty of collection, not a guaranty of payment. That would delay the landlord's collection of what it is owed, and “to delay is to deny.” The antidote is for the lease to state that the named tenant, following an assignment of its leasehold interest, remains primarily liable for all the tenant's obligations under the lease, including those of all subsequent assignees. A more potent provision would make the tenant and all assignees jointly and severally liable for all tenant obligations under the lease, no matter when incurred.

As to each assignee, if a landlord wants it to be contractually bound to the terms of the lease as if the assignee were the original, named tenant, the parties need make that happen by way of the lease or by requiring an express assumption of the lease by each assignee as a condition of a valid assignment.

Subletting

A subletting does not change the original landlord-tenant relationship. The subtenant is not in privity of contract with the landlord. It is not even in privity of estate with the landlord. It may have possession of the premises through its own (sub)landlord, the original tenant, but it is not liable for the debts and obligations of the named tenant. Notwithstanding the subletting, its landlord, the named tenant, remains in possession of the leased premises by reason of the lease. What the tenant has done, vis-'-vis the subletting, is to encumber its right of possession by conveying a portion (in time, space or both) to its selected subtenant. By that conveyance, it is in privity of estate with its subtenant.

It should not go unnoted that parties may self-characterize their transaction as a subletting or as an assignment, but the details of the actual possessory grant will trump any labels. The essential distinction between an assignment and a subletting is that in a subletting, the transferring tenant reserves some reversionary right. With the possible twists inherent in an “assignment pro tanto,” to be a subletting, the quantum of rights granted to a subtenant cannot be the entirety of what the purported sublandlord possesses. Plainly speaking, a subletting for the entire lease term and for the entire leased space will be characterized as an assignment. Whether a withholding of some element of a contractual right, as distinguished from a possessory right, alone, will cause a purported sublease of the entire leased premises for the entire lease term to be treated as a subletting is a question of state law, with the answer to be found ' if at all ' in that state's case law.

Assignments Pro Tanto

Having raised the specter of an “assignment pro tanto,” it is only proper that this unusual and possibly dangerous hybrid be described ' especially in a treatment of common and uncommon assignment/subletting problems. Simply speaking, this animal is the transfer to another, of a tenant's entire interest in a portion of leased premises, for the entire lease term. Describing this creation as an animal may be an apt choice of terms as it may be somewhat uncontrollable. In most jurisdictions, but not all, the landlord now has two tenants and, in effect, two leases. The assignee may, and the operative word is may, have a contractual relationship with the landlord. If the original tenant defaults under its lease, giving rise to a lease termination, the landlord may still have a tenant, the assignee, for the portion of the leased space that was thought merely to be sublet. The law is uncertain; there is not a lot of guiding case law. However, if a tenant can assign freely under its lease, but not sublet freely, there is always the possibility of enjoying both “existences” by use of an assignment pro tanto.

If you are looking for uncommon situations that can arise out of an assignment or subletting, just think of the mischief that can be created by a tenant structuring an assignment pro tanto. So, a landlord might want to prohibit assignments of less than its tenant's entire interest under the lease. Allowing (or consenting to) assignments, even to a tenant's affiliates, may result in everyone's rushing to research the intended and unintended consequences of the “pro tanto” assignment.

Distaste for Restraints on Alienation

Almost every lease endeavors to set out some rules for a tenant's transfer of all or part of its leasehold interest. Depending on the bargaining power of the parties, their ability to predict the future, their tolerance for comprehensiveness, the amount of time they have allotted to the task, their knowledge of the law (and where it is heading), and the talent of the draftsperson, the lease may avoid or invite one or more of the issues below. The task is greatly complicated by the law's disfavor of restrictions against alienation, and an assignment or subletting is such an alienation. Prohibitions and restrictions against assignment and subletting are scrutinized and catalogued by the courts.

Conclusion

The next part of this article will discuss some of the problems that can arise if certain issues are not covered by the lease or another enforceable document.

Ira Meislik is a principal at the Montclair, NJ, law firm of Meislik & Meislik. Mr. Meislik's commercial real estate practice, though broad in scope, has a special focus on retail real estate law. In addition to crafting space and ground leases, he has extensive experience in the acquisition, disposition, and financing of real property. He has written and spoken in the areas of real estate, business entity selection, attorney ethics, limited liability entities, and unincorporated business associations.