In the Spotlight: A Tenant's Right to Offset

However, perhaps the most immediate and effective remedy after a default by the landlord, from the tenant's perspective, would be to perform the landlord's obligation itself and then deduct the costs incurred from future rental payments owed to the landlord. The right to offset is typically difficult for a tenant to achieve, and the tenant should consult with an experienced real estate leasing attorney before pursuing that strategy. The two main obstacles preventing the tenant from exercising this right of self-help and offset are the common law rule of independent covenants and the landlord-favored provisions found in most commercial leases.

Theories of Recovery

Under the traditional common law rule known as the independent covenants rule, the obligations of the landlord and the tenant are independent of one another. This is based on the traditional view of leases as a conveyance of real property as opposed to a contract, and relates back to the time of agricultural feudalism when the use of the land was primary and the improvements, if any, built upon the land were far less important. Under the old feudal leases, the tenant's obligation to pay rent survived a complete destruction of the building.

Under this traditional view, a tenant is obligated to pay rent even if the landlord fails to perform its obligations owed to the tenant under the lease. The tenant would instead have to seek the equitable and legal remedies listed above. Many states have reconsidered this traditional view given that, in most commercial settings today, it is the building that is paramount with the land mostly meaningless.

The modern commercial tenant has bargained for the benefit of certain critical services such as utilities, elevators, structural soundness like a paved parking area and a sound roof, all of which are critical to the tenant's conduct of its business upon the premises. The minority of states that have rejected the traditional view and adopted the modern rule include Arizona, Massachusetts, Pennsylvania and Utah. These states have instead adopted the contract-law based mutually dependent covenants rule for commercial leases. Note that this rule is already the standard nationwide for most residential leases.

The mutually dependent covenants rule is based on the proposition that if two parties have made significant promises to each other, then the failure of one party to perform its duties provides a defense for the other party against performing its corresponding promise. Or, in a real estate lease, the rule means that a tenant who entered into the lease because of the use of the premises should not be obligated to continue to pay rent if the use of such premises was adversely affected by the landlord's failure to meet its obligations.

In the important Massachusetts case of Wesson v. Leone Enterprises, Inc., 437 Mass. 708 (2002), the court held that “[i]n applying the rule of mutually dependent covenants to the facts present in this case, we conclude that a landlord's failure to keep the roof of his building in good repair deprived the tenant of a substantial benefit significant to the purpose for which the lease was entered.” The Massachusetts court went on to find that the tenant had the right to terminate the lease and recover the reasonable relocation costs.'

The American Law Institute's Restatement (Second) of Property (Landlord and Tenant), Section 7.1 (1977) adopted the modern rule of mutually dependent covenants in the context of real estate leases as follows: “Except to the extent that the parties to a lease validly agree otherwise, if the landlord failed to perform a valid promise contained in the lease ' and as a consequence thereof, the tenant is deprived of a significant inducement to the making of the lease, and if the landlord does not perform his promise within a reasonable amount of time after being requested to do so, the tenant may terminate the lease.”

Therefore, if you are a tenant of premises located in a state that has adopted the mutually dependent covenants rule, and your lease is either completely silent on the issue or permits offsets, then you may be within your rights to perform self-help and deduct the costs against your future rent obligations. However, almost all commercial lease forms of any length will contain language to the effect that “rent is due without abatement, counterclaim, deduction or setoff under any circumstances.” Most sophisticated landlord form leases go much further, and contain independent covenant provisions that further prohibit any offsetting by tenants against the rental stream.

Thus, the better strategy for the larger tenants is to negotiate for this right before signing the lease. Because landlords will strongly resist such a provision, it is recommended that such a right be included as a business issue in the letter of intent. Without express language in the lease, a tenant would be wise to reconsider before deciding unilaterally to exercise self-help and deduct the costs against rental payments. However reasonable its claim may seem to be, the tenant would be risking an event of default, lease termination and severe damages.

Right to Offset

As mentioned above, landlords will strongly resist including an offset provision in the lease. In many cases, their lenders will prohibit such provisions for most ordinary lease transactions. The landlord and its lender demand and anticipate an uninterrupted income stream of rental payments and may consider this a deal point in the lease negotiations. In most situations, only the most creditworthy tenant taking sizeable premises with leverage in the transaction should demand the right to offset (perhaps an anchor or near-anchor tenant in the retail context, or a financially sound national tenant taking significant multiple floors in an office building).

Even if the landlord agrees to the tenant's demand for the offset right, it will typically impose certain limitations including limiting the right to those situations where the landlord's failure results in a material and adverse effect on the tenant's business, providing the landlord with written notice and a reasonable chance to cure, limiting the costs to only those reasonably and actually incurred and perhaps limiting the amount of the offset to a specific percentage of the rent otherwise due each month until repaid.

Since only those tenants with a material bargaining advantage will likely succeed in gaining offset rights or in declaring the covenants mutually dependent under their lease, a good back-up strategy for the wise tenant is to include in its lease a prevailing party attorney's fees provision. Such a provision, in the event of litigation between the landlord and tenant, entitles the winning party to recover its legal fees and costs from the losing party. While not as immediate and effective as an offset right, a prevailing party attorney's fees provision tends to keep the parties operating fairly and honestly. A tenant with such a provision, but without an offset right, could move forward with a legal or an equitable action against the landlord without the worry that the costs of bringing the action make any potential recovery impractical.

Included below is a sample landlord's default provision containing the right of offset by tenant to be included in your lease agreement.

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Sample Offset Provision

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Landlord will in no event be charged with a default in the performance of any obligations under this Lease unless and until Landlord has failed to perform such obligations for a period of thirty (30) days, except in cases of emergency, to cure any such default after written notice by Tenant is received by Landlord properly specifying Landlord's failure to perform any such obligations; provided, however, that if the nature of Landlord's obligation is such that more than thirty (30) days are required for performance, then Landlord shall not be in default if Landlord commences performance within such thirty (30)-day period and thereafter diligently prosecutes the same to completion (but not to exceed an additional sixty (60) days). If Landlord fails to perform Landlord's obligations within such time frame after receipt of written notice of such default, except in cases of emergency, Tenant may at its option (but shall not be required to) perform such obligations on Landlord's behalf, and the actual and reasonable costs thereof shall be due and payable by Landlord within thirty (30) days after written notice to Landlord. Notwithstanding anything in this Lease to the
contrary, in the event Tenant has not received such payment within such thirty (30)-day period, then Tenant may offset said amounts against Base Rent subject to the Offset Limit (as such term is defined herein). The maximum amount that Tenant may deduct in any one month (the “Offset Limit”) shall be limited to the greater of (i) twenty-five percent (25%) of the then monthly base rent or (ii) the amount necessary to fully amortize in equal monthly amounts the amount due (including interest of 8% per annum) over the remainder of the Term (assuming no extensions of the Term beyond its then current expiration date).

John G. Kelly, a member of this newsletter's Board of Editors, is a partner with Bean Kinney & Korman in Arlington, VA. He represents national retailers and regional landlords, and can be reached at [email protected].

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A commercial tenant's right to remedy a default by the landlord by performing the required work itself, and then offsetting the costs of such work against future rental payments, is likely the most immediate and effective remedy a tenant could ever have. But a tenant needs to review the lease agreement closely and know the local applicable law before ever deciding to take such an aggressive measure. Most leases (and the laws of most states, if the lease is silent) essentially prohibit the right of offset, so the sophisticated and creditworthy tenant will need to negotiate for such a right before the lease is finalized.

Defaults and Remedies

Landlords have many obligations under commercial leases, which can be the cause of a landlord default if such obligations are not met. For example, the landlord could fail to maintain the parking lot or common areas properly in a retail shopping center, or the landlord could fail to maintain the elevator or HVAC system properly in a high-rise office building. Depending on the terms and conditions of the lease agreement and the laws of the local jurisdiction, the commercial tenant can avail itself of various remedies under both equity and law. Equitable remedies include the following: 1) rescission, if the landlord breaches a material term of the lease before the term of the lease has commenced; 2) constructive eviction, if a landlord either takes an action or fails to perform something that it has a legal duty to provide, which action or failure to act results in the premises being essentially uninhabitable; 3) a petition for declaratory judgment; 4) specific performance, in cases of unique fact patterns such as when a landlord breaches its contract to lease; or 5) injunctive relief, in emergency level situations when the tenant is facing immediate and irreparable harm. Alternatively, the tenant could respond to a defaulting landlord by suing for monetary damages.

However, perhaps the most immediate and effective remedy after a default by the landlord, from the tenant's perspective, would be to perform the landlord's obligation itself and then deduct the costs incurred from future rental payments owed to the landlord. The right to offset is typically difficult for a tenant to achieve, and the tenant should consult with an experienced real estate leasing attorney before pursuing that strategy. The two main obstacles preventing the tenant from exercising this right of self-help and offset are the common law rule of independent covenants and the landlord-favored provisions found in most commercial leases.

Theories of Recovery

Under the traditional common law rule known as the independent covenants rule, the obligations of the landlord and the tenant are independent of one another. This is based on the traditional view of leases as a conveyance of real property as opposed to a contract, and relates back to the time of agricultural feudalism when the use of the land was primary and the improvements, if any, built upon the land were far less important. Under the old feudal leases, the tenant's obligation to pay rent survived a complete destruction of the building.

Under this traditional view, a tenant is obligated to pay rent even if the landlord fails to perform its obligations owed to the tenant under the lease. The tenant would instead have to seek the equitable and legal remedies listed above. Many states have reconsidered this traditional view given that, in most commercial settings today, it is the building that is paramount with the land mostly meaningless.

The modern commercial tenant has bargained for the benefit of certain critical services such as utilities, elevators, structural soundness like a paved parking area and a sound roof, all of which are critical to the tenant's conduct of its business upon the premises. The minority of states that have rejected the traditional view and adopted the modern rule include Arizona, Massachusetts, Pennsylvania and Utah. These states have instead adopted the contract-law based mutually dependent covenants rule for commercial leases. Note that this rule is already the standard nationwide for most residential leases.

The mutually dependent covenants rule is based on the proposition that if two parties have made significant promises to each other, then the failure of one party to perform its duties provides a defense for the other party against performing its corresponding promise. Or, in a real estate lease, the rule means that a tenant who entered into the lease because of the use of the premises should not be obligated to continue to pay rent if the use of such premises was adversely affected by the landlord's failure to meet its obligations.

In the important Massachusetts case of Wesson v. Leone Enterprises, Inc. , 437 Mass. 708 (2002), the court held that “[i]n applying the rule of mutually dependent covenants to the facts present in this case, we conclude that a landlord's failure to keep the roof of his building in good repair deprived the tenant of a substantial benefit significant to the purpose for which the lease was entered.” The Massachusetts court went on to find that the tenant had the right to terminate the lease and recover the reasonable relocation costs.'

The American Law Institute's Restatement (Second) of Property (Landlord and Tenant), Section 7.1 (1977) adopted the modern rule of mutually dependent covenants in the context of real estate leases as follows: “Except to the extent that the parties to a lease validly agree otherwise, if the landlord failed to perform a valid promise contained in the lease ' and as a consequence thereof, the tenant is deprived of a significant inducement to the making of the lease, and if the landlord does not perform his promise within a reasonable amount of time after being requested to do so, the tenant may terminate the lease.”

Therefore, if you are a tenant of premises located in a state that has adopted the mutually dependent covenants rule, and your lease is either completely silent on the issue or permits offsets, then you may be within your rights to perform self-help and deduct the costs against your future rent obligations. However, almost all commercial lease forms of any length will contain language to the effect that “rent is due without abatement, counterclaim, deduction or setoff under any circumstances.” Most sophisticated landlord form leases go much further, and contain independent covenant provisions that further prohibit any offsetting by tenants against the rental stream.

Thus, the better strategy for the larger tenants is to negotiate for this right before signing the lease. Because landlords will strongly resist such a provision, it is recommended that such a right be included as a business issue in the letter of intent. Without express language in the lease, a tenant would be wise to reconsider before deciding unilaterally to exercise self-help and deduct the costs against rental payments. However reasonable its claim may seem to be, the tenant would be risking an event of default, lease termination and severe damages.

Right to Offset

As mentioned above, landlords will strongly resist including an offset provision in the lease. In many cases, their lenders will prohibit such provisions for most ordinary lease transactions. The landlord and its lender demand and anticipate an uninterrupted income stream of rental payments and may consider this a deal point in the lease negotiations. In most situations, only the most creditworthy tenant taking sizeable premises with leverage in the transaction should demand the right to offset (perhaps an anchor or near-anchor tenant in the retail context, or a financially sound national tenant taking significant multiple floors in an office building).

Even if the landlord agrees to the tenant's demand for the offset right, it will typically impose certain limitations including limiting the right to those situations where the landlord's failure results in a material and adverse effect on the tenant's business, providing the landlord with written notice and a reasonable chance to cure, limiting the costs to only those reasonably and actually incurred and perhaps limiting the amount of the offset to a specific percentage of the rent otherwise due each month until repaid.

Since only those tenants with a material bargaining advantage will likely succeed in gaining offset rights or in declaring the covenants mutually dependent under their lease, a good back-up strategy for the wise tenant is to include in its lease a prevailing party attorney's fees provision. Such a provision, in the event of litigation between the landlord and tenant, entitles the winning party to recover its legal fees and costs from the losing party. While not as immediate and effective as an offset right, a prevailing party attorney's fees provision tends to keep the parties operating fairly and honestly. A tenant with such a provision, but without an offset right, could move forward with a legal or an equitable action against the landlord without the worry that the costs of bringing the action make any potential recovery impractical.

Included below is a sample landlord's default provision containing the right of offset by tenant to be included in your lease agreement.

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Sample Offset Provision

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Landlord will in no event be charged with a default in the performance of any obligations under this Lease unless and until Landlord has failed to perform such obligations for a period of thirty (30) days, except in cases of emergency, to cure any such default after written notice by Tenant is received by Landlord properly specifying Landlord's failure to perform any such obligations; provided, however, that if the nature of Landlord's obligation is such that more than thirty (30) days are required for performance, then Landlord shall not be in default if Landlord commences performance within such thirty (30)-day period and thereafter diligently prosecutes the same to completion (but not to exceed an additional sixty (60) days). If Landlord fails to perform Landlord's obligations within such time frame after receipt of written notice of such default, except in cases of emergency, Tenant may at its option (but shall not be required to) perform such obligations on Landlord's behalf, and the actual and reasonable costs thereof shall be due and payable by Landlord within thirty (30) days after written notice to Landlord. Notwithstanding anything in this Lease to the
contrary, in the event Tenant has not received such payment within such thirty (30)-day period, then Tenant may offset said amounts against Base Rent subject to the Offset Limit (as such term is defined herein). The maximum amount that Tenant may deduct in any one month (the “Offset Limit”) shall be limited to the greater of (i) twenty-five percent (25%) of the then monthly base rent or (ii) the amount necessary to fully amortize in equal monthly amounts the amount due (including interest of 8% per annum) over the remainder of the Term (assuming no extensions of the Term beyond its then current expiration date).

John G. Kelly, a member of this newsletter's Board of Editors, is a partner with Bean Kinney & Korman in Arlington, VA. He represents national retailers and regional landlords, and can be reached at [email protected].

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