As markets continue to contract, more businesses are considering subleasing space. It has been reported that the amount of sublease space available in downtown Chicago during the 4th quarter of 2008 was twice the five-year average. In New York City, vacancies created by downsizing of financial services and law firms has led to similar results. Based on current conditions, the increase in subleasing activity is expected to continue throughout 2009. This article is a brief overview of subleasing issues for those companies who may be considering a sublease arrangement for the first time.
A business that finds itself with more leased space than it needs may be motivated to cut costs by subleasing excess space at a below-market rate. A company struggling to pay rent under a long-term lease may consider subleasing as a means to avoid defaulting on its lease obligations, and to survive the economic downturn. One company's excess space can be an opportunity for a start-up or growing company looking for affordable space, or a company nearing the end of its existing lease term and looking for ways to reduce expenses. However, nothing comes without a price. Potential subtenants and sublandlords need to understand that there are both financial and legal risks in a sublease arrangement that do not exist in a direct leasing relationship.
Because a potential sublandlord cannot lease something greater or different than it has, the existence and terms of a sublease are entirely dependent upon on the existence and terms of the underlying lease. Accordingly, when considering any sublease arrangement, the starting point must be a thorough analysis of the existing lease. A landlord or potential sublandlord may be reluctant to disclose all of the terms of the existing lease to a potential subtenant. However, subtenants should insist on reviewing the entire lease, while perhaps allowing the financial terms that will not be applicable to the subtenant to be redacted.
The first step of the analysis is to review any conditions to subleasing that are contained in the existing lease. A tenant is generally free to sublease a portion of its premises, unless the lease provides otherwise. However, most leases provide that the tenant may not enter into subleases without the consent of the landlord. Most leases state (and if the lease is silent the common law usually provides) that the landlord may not unreasonably withhold its consent to a sublease. Whether a landlord's denial of consent is reasonable is a subjective determination. As a general rule, however, a landlord may reasonably refuse to consent to a sublease to a subtenant who lacks sufficient financial strength, or that intends to use the leased premises in a manner that differs significantly from the existing use. In addition, leases often contain specific requirements for obtaining the landlord's consent, such as minimum notice requirements, the submission of detailed financial and other information with respect to the proposed subtenant, or the payment of landlord's fees and costs associated with the review of the proposed sublease.
The existing lease may also include conditions that further limit the type or character of acceptable subtenants, or significantly reduce the potential financial benefit to the sublandlord. For instance, leases often provide that a tenant cannot sublease to another tenant of the project, or to a governmental entity. The lease may restrict subleases for particular uses, such as a use that might increase traffic in the premises or increase the risk of environmental contamination. A restriction that the leased premises can only be used for a specific purpose (i.e., a financial institution) may effectively prevent a sublease to any other type of tenant. The lease may also include provisions granting the landlord the right to recapture the proposed sublease space, or to collect all or a portion of any profit made by the sublandlord in connection with the sublease.
After determining whether the underlying lease will permit a sublease upon reasonable and acceptable terms, the next step is to determine the extent to which the terms of the sublease can or should be different from the terms of the underlying lease. Basic sublease forms often consist of little more than a blanket statement that all of the terms of the underlying lease are incorporated by reference into the sublease. However, it is important to look carefully at each provision of the underlying lease and determine whether it should apply to the sublease relationship exactly as written, or whether modifications are necessary. In many cases, the business terms and other circumstances surrounding the sublease are so different, that simply incorporating the terms of the underlying lease as written will lead to unacceptable, unintended, or simply confusing results. While the parties might not have the ability to change any of the terms of the underlying lease, the sublease can be drafted to accurately reflect the intended terms of the sublease even when they diverge from the terms of the underlying lease.
The sublease payment terms will undoubtedly be different from the underlying lease. The amount of base rent payable by the subtenant may bear absolutely no relation to the amount of rent due pursuant to the underlying lease. The allocation of other costs to the subtenant, such as utilities and other operating expenses, may also vary widely. For instance, in cases where the leased premises are separately metered and utility costs are paid directly to the provider, the subleased premises may not be separately metered, and utility costs will need to be apportioned between sublandlord and subtenant.
The provisions regarding payment defaults, grace periods for curing payment defaults, and remedies for defaults will usually need to be modified. For example, because the sublandlord will be reliant upon receiving the rent from the subtenant in order to meet its payment obligation under the underlying lease, the grace period for payment of rent under the sublease may need to be shorter than the grace period under the underlying lease, so that the sublandlord will have sufficient time to make its payment. Similarly, if the underlying lease provides for payment of other amounts (such as operating expenses) within a certain number of days after receipt of an invoice from the landlord, the corresponding obligation under the sublease must be tailored to allow time to provide an invoice to subtenant and collect from subtenant prior to the due date of the payment owed to landlord. Additionally, if the sublandlord is obligated to pay interest or late charges for late payments, the sublease should impose at least the same obligation on the subtenant. However, if the subtenant pays timely but the sublandlord fails to make its payment on time, the subtenant should not be obligated to contribute to the payment of interest or other penalties due to the landlord.
Other provisions of the underlying lease that should be carefully reviewed, and may need to be varied in the sublease, include: the obligations for tenant improvements; representations regarding the condition of the premises; maintenance and repair obligations; and liability for repairs or restoration or rights to terminate the lease following casualty damage. For instance, upon commencement of the original lease term, the sublandlord, as tenant, may have made significant tenant improvements. Representations and warranties that were reasonable and appropriate in the lease of the "vanilla box" are quite different from the representations and warranties that are reasonable and appropriate in a sublease of finished space. Further, the sublandlord may want to impose stricter requirements on the performance of alterations and improvements by the subtenant than those imposed pursuant to the underlying lease, particularly if the sublease term does not extend to the end of the term of the underlying lease and the sublandlord may need to recapture the subleased space.
Similarly, the division of responsibility for maintenance and repairs between landlord and tenant that made sense in the underlying lease may not be appropriate as between the sublandlord and subtenant. This may be especially true in cases where one party occupies only a small portion of the entire leased premises. The party that occupies the majority of the premises, whether it is the sublandlord or subtenant, may prefer to maintain control over the repairs and maintenance so as to insure that its premises remain in good condition. In such cases, it may make more sense for the sublease to designate which of the parties will maintain the premises, and to provide for the pass-through of a proportionate share of the maintenance expense to the other party. The determination of how to appropriately share and allocate obligations and expenses is even more difficult in circumstances where the sublandlord is subleasing space to more than one subtenant.
Careful attention should also be paid to the casualty damage provision. Often the landlord's obligation to restore the premises—and the parties' rights to terminate the lease—after a casualty are dependent upon how significant a portion of the premises has been affected. The appropriate allocation of risk may be quite different in a sublease of only a small portion of the leased space, or in a sublease for only a portion of the remaining term of the lease.
A crucial point to keep in mind is that, practically, if not legally, subleasing is a tri-party relationship. When reviewing or drafting a sublease, and determining which provisions of the underlying lease should be applicable, the rights and obligations of all three parties to the transaction must be considered. However, unless the parties otherwise agree, there is no contractual relationship between the landlord and the subtenant. This lack of privity limits both the rights and remedies of the landlord and subtenant vis-à-vis each other. The sublandlord is the middleman, and unless the parties otherwise agree, both the landlord and the subtenant are reliant upon the sublandlord, and any rights or remedies that they may have in the event of a default are against the sublandlord. This distinction should be considered in evaluating each provision of the lease and sublease.
Potential subtenants need to be cognizant of the fact that in the absence of an agreement to the contrary, if the sublandlord defaults under the underlying lease, the landlord will have the right to terminate the lease and the sublease will automatically terminate. Thus, the subtenant could be evicted even though it has completely fulfilled all of its obligations under the sublease. If the sublease is for a significant portion of the leased premises, both the landlord and subtenant may consider it beneficial to create a direct contractual relationship so that if the sublandlord defaults, the landlord and subtenant will be able to look to each other for relief. A landlord may want to condition its consent to a sublease upon the subtenant's agreement to pay rent directly to the landlord, or to attorn to the landlord in the event of a sublandlord's default. Similarly, a subtenant may request that the landlord agree to allow the subtenant to remain in possession of the subleased premises, so long as the subtenant is not in default under the terms of the sublease.
The lack of a direct contractual relationship between the landlord and subtenant could also lead to unfortunate results for the subtenant in the event of the landlord or sublandlord's bankruptcy. If a sublandlord files for bankruptcy, it will have the option to either accept or reject the underlying lease. If the sublandlord rejects the underlying lease, the sublease may automatically terminate and the subtenant may be evicted, unless it enters into a separate agreement with the landlord. When a landlord files for bankruptcy, it also has the right to either accept or reject the lease. In the event that a landlord rejects a lease, bankruptcy law provides protection for the tenant, allowing the tenant to either terminate the lease or remain in possession of the premises. However, a subtenant is not provided the same protection. The subtenant will be completely dependent on the sublandlord, and may be without any remedy if the sublandlord elects to terminate the lease.
The cost of a sublease is usually below the market rate for direct leases, and for good reason. Because it is a tri-party relationship, a sublease arrangement is riskier than a direct leasing relationship. As with most business transactions, the inherent risks in a sublease arrangement can be reduced by careful drafting and knowledgeable negotiation of the sublease terms. The crucial element in crafting a successful sublease arrangement is to understand the ways in which the sublease relationship is, or should be, different from a direct landlord-tenant relationship.