Given gloomy economic forecasts for 2009, we are likely to see more situations where some tenants may wish to cease operations either temporarily or permanently. Situations will arise where some tenants fail to pay rent or meet other obligations. Landlords and tenants must be aware of the legal ramifications of their next steps. This Alert sets out for landlords and tenants typical issues that arise and pitfalls to be avoided.
- Rights and obligations under the lease triggered on default – Leases usually contain a default and remedies section, but there are also covenants and rights throughout the lease that could be relevant. For example, administrative charges for late or non-payment of rent, as well as the interest rate on overdue rent are usually included in the rent clause rather than the default clause. Accordingly, landlords and tenants must consider the whole lease to ensure a thorough understanding of any potential issues that could arise at the time of a default.
- Cure period – The cure period afforded a tenant in a lease often varies depending on the type of default. Consequently, the landlord and the tenant should be careful in determining when the cure period starts and ends. Timing could be affected by the "deemed notice" clause in the lease as well as other concerns. A landlord should not attempt to exercise certain remedies when a tenant still has a cure period available.
- Enforcement by landlord – The remedy or remedies chosen by the landlord at the time of default may affect the landlord's ability to recover all of its losses or its ability to later choose alternative remedies. For example, a landlord cannot exercise its distress or seizure rights and also terminate the lease. As most remedies have very particular processes that must be followed when being enforced, the landlord must carefully consider the path it is going to take. Being aware of market leasing conditions will be critical for the landlord in limiting its losses and for the tenant in assessing its exposure.
- Continuing to operate – The tenant must be aware of the risks to its business operations where it wants to continue operating, in whole or in part, but cannot meet its financial obligations. The tenant needs to have a practical strategy in the event the landlord takes steps to enforce its remedies such as distress of the tenant’s goods or changes the locks on the premises.
- Recovery of costs / Administrative charges – Leases typically contain methods for landlords to recover the landlord's costs associated with any action the landlord takes to enforce performance of a covenant or obligation of the tenant (the landlord should carefully review with its lawyer the risk of self-help remedies and compliance with notice requirements as a tenant may argue that the landlord's right to do so is less than clear). In addition to the landlord's ability to recover these costs, leases regularly contain a provision providing for an additional charge (in some jurisdictions these can be as high as 15 to 20%) on top of the landlord's costs if the landlord exercises a self-help remedy. A landlord should ensure that if it acts to fulfill the tenant's obligation, it collects its costs relating to any administrative and supervision/co-ordination charges. The tenant should be concerned with and aware of these amounts when determining its strategy surrounding a potential default.
- Security deposit / Letter of credit – The tenant and landlord should consider whether money advanced prior to the term of the lease is a security deposit or a deposit on last month's rent. If the monies are a security deposit, the lease may provide that, if the landlord uses or applies a part or all of the security deposit to a cost associated with a tenant default, the tenant is obliged to replenish those monies to the original amount. Landlords will want to ensure that such replenishment occurs. Similarly, where a letter of credit is provided, the lease may provide that the tenant has an obligation to deliver further letters of credit to the landlord up to the original amount whenever the landlord has drawn down all or a portion of the letter of credit in response to the tenant's default.
- Indemnifier / Guarantors – Landlords should confirm whether they have the right to seek enforcement against an indemnifier/guarantor, usually an individual or parent company. Landlords must comply with any additional notice obligations pertaining to enforcing an indemnity/guarantee. Tenants should consider the impact of any discontinuance of business or lease default on its indemnifier or guarantor.
- Surrender of lease – Landlords and tenants may agree upon terms (financial or otherwise) for a surrender of the lease if the tenant is unable to satisfy its financial obligations. This may be an attractive option for landlords to receive a stipulated payment (likely based on present value of rent payments for a specified period) for assumption of the risk of reletting. A surrender agreement can avoid the costs of litigation, obtain a "clean break" from the former tenant and confer control of the premises back upon the landlord. The surrender of lease should take into consideration removal of trade fixtures; removal of leasehold improvements and restoration obligations; passing of insurable risks; the date of vacant possession; termination of rights and obligations under the lease; latent environmental contamination; transfer in ownership of tangible and intangible rights associated with the premises and of the goods and fixtures remaining on the premises; payments of surrender; and waiver and release of specified claims on satisfaction of conditions of surrender. If all of these items are not adequately dealt with, the parties may end up revisiting a lease that they had hoped was behind them.
- Business status – The landlord should be proactive if there are any indications that suggest the tenant's business is not performing well, including anything mentioned in casual conversation. A proactive landlord can gain insight on the status of the tenant's business when inspecting the premises for other purposes provided under the lease. Landlords who have this type of active awareness of tenants' businesses will have fair warning that a tenant may be on the brink of default.
Commercial leasing exposes a potential minefield of risk and liability. There are numerous situations that require special advice and guidance from legal counsel to avoid costly pitfalls. By identifying situations where legal advice is required, more significant and costly problems can be avoided. Furthermore, it is important to keep in mind that each of the issues raised in this Alert could be further complicated if the tenant is involved in restructuring or bankruptcy proceedings. Insolvency proceedings typically introduce a number of concepts of enhanced rights for the benefit of debtors/tenants in their dealings with landlords and a number of methods of restricting or eliminating landlord rights during the proceeding. In these situations, expert advice from lawyers practicing in this area must be sought.