In the Spotlight: Commercial Tenant Considerations in a Troubled Economy

First, the tenant most often will have invested substantial funds in the build-out of its premises with the understanding that it will be there for a period of years, absent a default of the lease by the tenant. It is an unfortunate tenant that learns that even though it has not defaulted under its lease obligations, because its leasehold interest is subordinate to the lender's interest, it could have its lease obligations terminated based upon a foreclosure proceeding against the landlord. This foreclosure proceeding will also divest the tenant from its leasehold improvement interest in the premises.

Second, the tenant has spent considerable funds marketing, advertising and growing a business at a particular location, and the tenant could lose this going concern business in a foreclosure proceeding against the landlord, even though the tenant has abided by the terms of the tenant's lease in all respects.

As a result, tenants should be careful to obtain a written subordination, non-disturbance and attornment agreement from the landlord's lender at the time the lease is executed. Very often in leases, a landlord will seek to include language that it will use “reasonable efforts” to obtain the subordination, non-disturbance and attornment agreement, but the landlord has no affirmative obligation to obtain that document. This provision will not help a tenant in the event the property is foreclosed upon and the lender seeks to remove the tenant from possession, because no written subordination, non-disturbance and attornment agreement was ever established between the tenant and the lender. Consequently, careful consideration should be given to making the subordination, non-disturbance and attornment agreement an absolute requirement for the execution of the lease by the tenant.

Expanded Use Clause

As it becomes more difficult to sustain viable businesses in troubled economic times, a tenant will want to reserve the right to have the widest possible use clause that the tenant can obtain. If the tenant is unable to obtain a use clause that provides the tenant with the right to operate for “any lawful use,” a tenant will want to make sure that the use clause at least exceeds the tenant's product line as of the date the lease is executed. While expanding the use clause is always a good practice for the tenant to engage in when negotiating a tenant's lease obligations, in these troubled economic times, the expanded use clause could allow the tenant more flexibility not only to sell additional products, but also to assign the lease to another entity that may not operate with the same use as the tenant (since most leases require the assignee to operate for the same use as stated in the lease). By expanding the use clause, an entity that may have a similar use to that of the tenant (but not the same) may become a viable assignee of the tenant's leasehold interest.

For instance, if a tenant primarily sells athletic footwear, the use clause should be broad enough to allow the tenant to sell athletic wear, sunglasses, ancillary products associated with athletic footwear, and such other items as are customarily sold in other athletic footwear stores. As a result of expanding the use clause, a prospective assignee could sell sunglasses, athletic wear or similar type products and still qualify under the use clause of the lease. While this expanded use clause may require the tenant to address certain “exclusive” issues to which the landlord may be subject at a particular location, it does permit the tenant flexibility in both the tenant's business use and the tenant's ability to assign its leasehold interest.

Assignment Rights

In a troubled economy, an exit strategy is an absolute must for any tenant entering into lease obligations. While a possible exit strategy could be a termination right (as discussed later in this article), another possible exit strategy could be the right to assign the tenant's business, including the lease, to another person or entity, without the landlord's consent. Very often, the landlord will require certain parameters of the assignee, which parameters may include, but are not limited to, the assignee having a certain net worth, a certain level of retail business experience, and that the tenant not be released from the tenant's lease obligations following the assignment. While the assignment rights are entirely negotiable between the landlord and the tenant, a tenant should consider what parameters are reasonably feasible to allow the tenant to sell its business, as well as what limitations are reasonably required by the landlord to protect landlord's business interests.

In addition, a tenant should be careful not to allow terms in the assignment provision that would prevent or greatly diminish its ability to sell its business. For instance, many leases include a provision that in the event of an assignment, the rent payable by the tenant will be increased to the highest rent level payable by the tenant under the lease in any year during the term. Obviously, by increasing the rental obligation of the tenant, this provision would have the potential to curtail certain assignment transactions that would otherwise be viable under the tenant's current rental obligations.

Also, a tenant should be very careful of landlord recapture rights, in the event of an assignment. A recapture right allows the landlord to recapture the premises and terminate the lease, instead of agreeing to consent to an assignment by the tenant. While at first blush, this would seem to help the tenant by creating an exit strategy for the tenant, in reality, by the time the landlord exercises its recapture right, the tenant has already gone forward and negotiated a deal with a prospective assignee, negotiated all the terms, and spent considerable time, effort and money in trying to cause the assignment to occur. As a result, if the landlord requires that a recapture right be included in the lease, the right should only be exercisable upon notice from the tenant that the tenant is seeking to assign the lease.

Review of Financial Statements

Most landlords and tenants are familiar with the landlord's request to review financial statements of a tenant before entering into a lease with the tenant. However, it is becoming more and more common for the tenant to ask to see a financial statement of the landlord, especially if the landlord is obligated to pay a construction allowance, perform certain work to the premises before delivering the premises to the tenant, or if certain obligations of the landlord are to occur later in the lease term (e.g., an obligation to renovate a certain portion of the property within a certain period of time). A tenant should consider whether to request a financial statement from the landlord, in order to determine whether the landlord can reasonably meet its obligations under the proposed lease. In the absence of a sound financial condition of the landlord, a tenant may want to consider whether a letter of credit or other security is necessary from the landlord, in order to guarantee that the landlord is able to satisfy its financial obligations. While this concept may seem farfetched and not what is done in the normal course of business, these troubled times will cause all parties to reevaluate their approach to engaging in lease transactions. At this point in time, there really should not be any subject that is not worthy of discussion, as long as the party making the request has a reasonable basis for making it. In the same way that landlords do not want to provide a construction allowance to the tenant until all documentation is furnished by the tenant and all construction is completed, a tenant should take a similar approach in the event there are financial obligations of the landlord to be satisfied in the future.

Termination Rights

While a termination right is always a good exit strategy for a tenant to consider in any lease the tenant is entering into, since forecasting success in a given market is always a difficult proposition, a termination right is even more important as the troubled economy makes it more difficult to project how a particular business will fair. A tenant should consider whether a termination right based upon a certain level of gross sales not being achieved is necessary, or whether a shorter term with a unilateral tenant option period is a better avenue to pursue. Either way, the tenant should hedge its long term financial obligations, so that it can vacate a particular location if it is not proving to be profitable.

There are many permutations of a termination right, including a mutual termination right for both the landlord and the tenant, a termination based upon a level of gross sales not being achieved, a termination based upon the occupancy cost of the tenant's exceeding a certain percentage of the tenant's gross sales, etc., however, given the state of the economy, the concept of a termination right should be carefully considered by the tenant before agreeing to lease a particular location for an extended period of years.

Conclusion

Tenants must always consider their options when leasing space, even in the best of times. However, given the troubled economy, tenants would be wise to consider additional rights and protections they may not usually request, including those outlined above, before proceeding forward with a potential lease transaction.

Glenn A. Browne, a member of this newsletter's Board of Editors, is a shareholder in the law firm Braun, Browne & Associates, P.C., Riverwoods, IL. Mr. Browne's law practice is concentrated in the areas of purchase and sale of real estate, commercial leasing and lease related matters.

Recently, this newsletter has published many articles involving lease-related issues that are highlighted by the difficult economy we are presently experiencing. (See Commercial Leasing Law & Strategy, Vol. 22. No. 1, June 2009.) Since we are being inundated on what seems to be a daily basis with potential bankruptcies from very prominent landlords across the country, the article herein addresses certain terms, provisions and concerns that should be covered in a tenant's lease transaction, which will not only be important if the landlord experiences financial difficulties, but will also assist the tenant if it should confront a difficult financial situation on its own account. This article specifically covers the important areas of subordination, non-disturbance and attornment agreements, expanded use clauses, assignment rights, review of financial statements, and termination rights.

Subordination, Non-Disturbance and Attornment Agreements

Most commercial leases contain a provision whereby the tenant will agree that the tenant's lease is subordinate to the lien of landlord's lender that is placed upon the property and that in the event of a default by the landlord under the landlord's financing documents, the tenant will attorn to the lender as the landlord, if the lender shall succeed to landlord's interest in the property. An often overlooked component of the subordination process is that the tenant should request that the lender agree in writing with the tenant not to disturb the tenant's use or possession of the premises pursuant to the terms of the lease in the event of a foreclosure proceeding against the landlord. This non-disturbance provision is becoming increasingly important for at least two reasons, as landlords default on their financial obligations to their lenders.

First, the tenant most often will have invested substantial funds in the build-out of its premises with the understanding that it will be there for a period of years, absent a default of the lease by the tenant. It is an unfortunate tenant that learns that even though it has not defaulted under its lease obligations, because its leasehold interest is subordinate to the lender's interest, it could have its lease obligations terminated based upon a foreclosure proceeding against the landlord. This foreclosure proceeding will also divest the tenant from its leasehold improvement interest in the premises.

Second, the tenant has spent considerable funds marketing, advertising and growing a business at a particular location, and the tenant could lose this going concern business in a foreclosure proceeding against the landlord, even though the tenant has abided by the terms of the tenant's lease in all respects.

As a result, tenants should be careful to obtain a written subordination, non-disturbance and attornment agreement from the landlord's lender at the time the lease is executed. Very often in leases, a landlord will seek to include language that it will use “reasonable efforts” to obtain the subordination, non-disturbance and attornment agreement, but the landlord has no affirmative obligation to obtain that document. This provision will not help a tenant in the event the property is foreclosed upon and the lender seeks to remove the tenant from possession, because no written subordination, non-disturbance and attornment agreement was ever established between the tenant and the lender. Consequently, careful consideration should be given to making the subordination, non-disturbance and attornment agreement an absolute requirement for the execution of the lease by the tenant.

Expanded Use Clause

As it becomes more difficult to sustain viable businesses in troubled economic times, a tenant will want to reserve the right to have the widest possible use clause that the tenant can obtain. If the tenant is unable to obtain a use clause that provides the tenant with the right to operate for “any lawful use,” a tenant will want to make sure that the use clause at least exceeds the tenant's product line as of the date the lease is executed. While expanding the use clause is always a good practice for the tenant to engage in when negotiating a tenant's lease obligations, in these troubled economic times, the expanded use clause could allow the tenant more flexibility not only to sell additional products, but also to assign the lease to another entity that may not operate with the same use as the tenant (since most leases require the assignee to operate for the same use as stated in the lease). By expanding the use clause, an entity that may have a similar use to that of the tenant (but not the same) may become a viable assignee of the tenant's leasehold interest.

For instance, if a tenant primarily sells athletic footwear, the use clause should be broad enough to allow the tenant to sell athletic wear, sunglasses, ancillary products associated with athletic footwear, and such other items as are customarily sold in other athletic footwear stores. As a result of expanding the use clause, a prospective assignee could sell sunglasses, athletic wear or similar type products and still qualify under the use clause of the lease. While this expanded use clause may require the tenant to address certain “exclusive” issues to which the landlord may be subject at a particular location, it does permit the tenant flexibility in both the tenant's business use and the tenant's ability to assign its leasehold interest.

Assignment Rights

In a troubled economy, an exit strategy is an absolute must for any tenant entering into lease obligations. While a possible exit strategy could be a termination right (as discussed later in this article), another possible exit strategy could be the right to assign the tenant's business, including the lease, to another person or entity, without the landlord's consent. Very often, the landlord will require certain parameters of the assignee, which parameters may include, but are not limited to, the assignee having a certain net worth, a certain level of retail business experience, and that the tenant not be released from the tenant's lease obligations following the assignment. While the assignment rights are entirely negotiable between the landlord and the tenant, a tenant should consider what parameters are reasonably feasible to allow the tenant to sell its business, as well as what limitations are reasonably required by the landlord to protect landlord's business interests.

In addition, a tenant should be careful not to allow terms in the assignment provision that would prevent or greatly diminish its ability to sell its business. For instance, many leases include a provision that in the event of an assignment, the rent payable by the tenant will be increased to the highest rent level payable by the tenant under the lease in any year during the term. Obviously, by increasing the rental obligation of the tenant, this provision would have the potential to curtail certain assignment transactions that would otherwise be viable under the tenant's current rental obligations.

Also, a tenant should be very careful of landlord recapture rights, in the event of an assignment. A recapture right allows the landlord to recapture the premises and terminate the lease, instead of agreeing to consent to an assignment by the tenant. While at first blush, this would seem to help the tenant by creating an exit strategy for the tenant, in reality, by the time the landlord exercises its recapture right, the tenant has already gone forward and negotiated a deal with a prospective assignee, negotiated all the terms, and spent considerable time, effort and money in trying to cause the assignment to occur. As a result, if the landlord requires that a recapture right be included in the lease, the right should only be exercisable upon notice from the tenant that the tenant is seeking to assign the lease.

Review of Financial Statements

Most landlords and tenants are familiar with the landlord's request to review financial statements of a tenant before entering into a lease with the tenant. However, it is becoming more and more common for the tenant to ask to see a financial statement of the landlord, especially if the landlord is obligated to pay a construction allowance, perform certain work to the premises before delivering the premises to the tenant, or if certain obligations of the landlord are to occur later in the lease term (e.g., an obligation to renovate a certain portion of the property within a certain period of time). A tenant should consider whether to request a financial statement from the landlord, in order to determine whether the landlord can reasonably meet its obligations under the proposed lease. In the absence of a sound financial condition of the landlord, a tenant may want to consider whether a letter of credit or other security is necessary from the landlord, in order to guarantee that the landlord is able to satisfy its financial obligations. While this concept may seem farfetched and not what is done in the normal course of business, these troubled times will cause all parties to reevaluate their approach to engaging in lease transactions. At this point in time, there really should not be any subject that is not worthy of discussion, as long as the party making the request has a reasonable basis for making it. In the same way that landlords do not want to provide a construction allowance to the tenant until all documentation is furnished by the tenant and all construction is completed, a tenant should take a similar approach in the event there are financial obligations of the landlord to be satisfied in the future.

Termination Rights

While a termination right is always a good exit strategy for a tenant to consider in any lease the tenant is entering into, since forecasting success in a given market is always a difficult proposition, a termination right is even more important as the troubled economy makes it more difficult to project how a particular business will fair. A tenant should consider whether a termination right based upon a certain level of gross sales not being achieved is necessary, or whether a shorter term with a unilateral tenant option period is a better avenue to pursue. Either way, the tenant should hedge its long term financial obligations, so that it can vacate a particular location if it is not proving to be profitable.

There are many permutations of a termination right, including a mutual termination right for both the landlord and the tenant, a termination based upon a level of gross sales not being achieved, a termination based upon the occupancy cost of the tenant's exceeding a certain percentage of the tenant's gross sales, etc., however, given the state of the economy, the concept of a termination right should be carefully considered by the tenant before agreeing to lease a particular location for an extended period of years.

Conclusion

Tenants must always consider their options when leasing space, even in the best of times. However, given the troubled economy, tenants would be wise to consider additional rights and protections they may not usually request, including those outlined above, before proceeding forward with a potential lease transaction.

Glenn A. Browne, a member of this newsletter's Board of Editors, is a shareholder in the law firm Braun, Browne & Associates, P.C., Riverwoods, IL. Mr. Browne's law practice is concentrated in the areas of purchase and sale of real estate, commercial leasing and lease related matters.