Most physicians lease office space for terms of five or ten years, initially considering immediate needs, but often not negotiating appropriately for unexpected future developments. The purpose of this article is to give you – the prospective tenant – some guidance for developing strategies that give you some flexibility in dealing with future changes.
The need to exit a lease frequently arises when a business is expanding, downsizing, selling, or merging – or relocating because it’s simply the wrong location or the neighborhood has changed. In most cases the lease is already in place and exit options are limited by what the lease provides.
The best time to develop an exit strategy is when your lease is being negotiated. Signing a lease is your financial commitment to stay at a location for an extended period of time. While it is impossible to anticipate all of the events that can occur during the lease which will impact your operations, it is helpful in negotiating the assignment and subletting provision to project your space needs and business operations for the entire term of the lease. Your space needs may change substantially over that time, so the more flexible your lease is, the better.
Understand that your interests may potentially compete with those of the landlord. It is naturally a landlord’s desire to control and protect its investment. The landlord wants to select tenants who can meet the financial obligations under the lease, who provide a good tenant mix, who don’t violate any exclusive rights given to other tenants, and who won’t place an undue burden on the services provided by the landlord. If you want to sublet your space but your landlord has excess space in the building, you would be in direct competition with one another. These opposing concerns impact your negotiation of the assignment and subletting clause.
Space Expansion/Reduction: If you project growth in your business and the need for more space down the road, your options would be either to request additional adjacent space, or move to a larger location. (Negotiating upfront with the landlord for a right of first refusal to rent additional space in the building as it becomes available would be a wise idea.) If you project a reduction in your operations and staff, the options would be to sublease excess space to cut overhead, or move to a smaller location. If the assignment and subletting provision does not allow you to assign the lease or sublet the premises without landlord consent, and the landlord refuses, you are stuck in that location.
New York law has the principle of free alienation (transferability) of interests in real property. If the lease has no assignment and subletting clause (an unlikely event), a tenant may freely assign the lease or sublet the premises. A restriction against assignment does not prohibit subletting and vice versa. A restriction against assignment does not prohibit the transfer of a controlling interest in the tenant.
Owing to this, the standard landlord assignment and subletting clause contains an express prohibition against assigning the lease and subletting the premises, e.g. “Tenant shall not assign this Lease, nor shall Tenant sublet or permit the Demised Premises or any part thereof to be used by others [without the prior written consent of Landlord in each instance]. This Lease may not be assigned by operation of law.” This gives the landlord the right to arbitrarily refuse to permit the proposed assignment or sublease. In New York law, there is no implied obligation that landlord act reasonably with respect to a requested assignment or sublease of a commercial lease. Therefore, it is recommended that tenants negotiate for an addition to this provision stating that “Landlord will not unreasonably withhold, condition or delay its consent.”
In New York, the four objective criteria to be applied by the landlord in evaluating a tenant’s request are: (1) financial responsibility of proposed assignee or subtenant; (2) “identity” or “business character” of the proposed assignee or subtenant (its suitability for the particular building); (3) legality of the proposed use; and (4) nature of the occupancy (office, factory, clinic, etc.).
Sale/Merger: In the case of a business transfer or merger, a lease is an important asset, and the ability to transfer that lease may impact the proposed transaction. A prohibition against assignment by operation of law will prevent the tenant from transferring the lease to the surviving entity in a merger or consolidation transaction. It is wise for an entity tenant’s lease to contain one of the following provisions: “Notwithstanding anything to the contrary contained herein, Tenant may assign this Lease to any purchaser of all of Tenant’s business and assets provided such purchaser assumes all of Tenant’s obligations under this Lease.” or “Notwithstanding anything to the contrary contained herein, this Lease may be assigned or the leased premises sublet, in whole or in part, to any company into which or with which Tenant may be merged or consolidated, or to any company which is an affiliate, subsidiary, parent or successor of Tenant.” If a lease does not prohibit assignment by operation of law, the lease will automatically transfer to the estate of a deceased individual tenant, or if an entity, to the surviving entity.
Note that if a purchaser acquires a controlling interest in a corporation, LLC or partnership, it is not necessary to obtain the landlord’s consent even though the lease contains a prohibition against assigning the lease. Thus, if it is feasible from the business perspective, one way to circumvent a non-assignment clause is to transfer a controlling interest in the tenant. Technically there has been no change in the identity of the tenant, only in the ownership of the tenant. Therefore, a savvy landlord may try to include a provision in the lease that a prohibited assignment includes the transfer of a controlling interest in the tenant.
Permitted Use Important: It’s also important to understand the interrelationship between the use clause and the assignment/subletting clause. A use clause which is very restrictive will impact your ability to assign or sublet, as your assignee or subtenant must comply with the use clause.
Assignment and Subletting Distinctions. There are certain distinctions between assignments and subletting which are important in negotiating this provision. Assigning a lease transfers all of tenant’s right, title and interest in the lease for the balance of the term to the assignee, but the assignor continues to be primarily liable for the performance of all tenant obligations under the lease, including the obligation to pay rent, even if the assignee specifically assumes the lease. The landlord is actually doubly protected because the assignee is also liable for all tenant obligations if it assumes the lease.
On the other hand, a tenant who subleases the premises transfers less than its entire interest in the lease. The subtenant deals directly only with the tenant and has no enforceable rights against the landlord, and the landlord has no enforceable rights against the subtenant. The tenant is responsible to the landlord for the acts and omissions of its subtenant. The sublease is automatically subordinate to the prime lease and falls if the prime lease is terminated or expires. The sublease cannot have a term greater than the term of the prime lease. Finally, the primary tenant retains a reversionary interest – thus the sublease must be for a term which is less than the balance of the term of the prime lease (as a sublease for the balance of the term could be construed as an assignment), and sometimes for only a portion of the space.
Landlords may prohibit assignments but allow subletting since they are still dealing with the same party and the financial stability of the subtenant is not the landlord’s risk but the tenant’s. You as tenant may also prefer to sublease rather than to assign, for the following reasons: If you as tenant assign the lease, you remain primarily liable and can seek indemnification against the assignee if the assignee defaults, but cannot terminate the relationship. A sublease, on the other hand, gives you greater control over the subtenant for (1) recovery of past due rent payments, (2) enforcement of the terms of the sublease and (3) if necessary, termination of the sublease, thus regaining possession of the premises and subleasing it another subtenant. Your sublease can be more restrictive than the prime lease, and you can charge a different rental rate than is payable under the prime lease.
Keeping this advice in mind when negotiating your next office lease will put you in a stronger position for a more flexible business future.
Originally publised in Western NY Physician magazine.
