"Leasing Review - Landlord, Tenant, Subtenants, and Assignees – Who’s Liable to Whom" originally published on the NAIOP Minnesota online blog.
Many tenants have been unable to survive in the current economy or have been looking for ways to reduce their overhead. To help solve their financial woes they have tried to offload that extra office space they no longer need or want. Although landlords are hesitant to release tenants from their leases outright, landlords are willing to consider subleases for a portion of a tenant’s space, or an assignment of the leasehold interest to new financially viable tenants. These arrangements, however, do not always work out for the best and many of these assignees or subtenants invariably breach the terms of their leases. Landlords need to know their rights before they consent to any sublease or assignment, and must be cautious with how they structure such a consent so that when the deal falls apart they have their rights protected. Tenants should also correctly structure transactions so as to avoid or reduce potential future exposure.
Liability Under Assignments
When executing a lease, a landlord and tenant develop what is referred to as privity of estate (a relationship based on the tenant’s occupancy of the landlord’s property) and privity of contract (a relationship based on the contract that is entered into between the landlord and the tenant). The liability of a tenant, any assignee, and any subtenant varies depending on whether privity of estate and/or privity of contract exists between the various parties. At the onset of the lease, the landlord can go after the tenant for any covenants that “run with the land” (e.g. any covenant that is intertwined with the possessor of the premises) based on privity of estate, and the landlord can go after the tenant for any personal covenants (e.g. covenants that are personal to the original tenant) based on privity of contract.
Once the tenant assigns its leasehold interest to an assignee, the tenant no longer has the right to occupy its premises and therefore no longer has privity of estate with the landlord. However, unless the landlord expressly releases the original tenant from its obligations under the lease, privity of contract continues to exist between the landlord and the tenant. The landlord can pursue all remedies set forth in the lease against the original tenant based on a violation of the original contract terms.
When the original tenant assigns its leasehold interest to its assignee, the assignee occupies the premises and therefore establishes privity of estate with the landlord. The landlord can therefore go after the assignee if any of the covenants that run with the land are violated including the payment of rent and taxes, the obligation to repair the premises, and many other covenants contained in the lease. However, unless the assignee expressly assumes all obligations under the lease, the assignee is not liable for a breach of any personal covenant. The assignee’s liability will also end (absent the existence of fraud) once the assignee assigns the leasehold interest to a third party as privity of estate will end. Such an assignment is especially problematic if the financial strength of the assignee is stronger than both the original tenant and the new assignee, which is usually the case. Note also that the result is the same regardless if the lease contains restrictions on or prohibitions of assignments without the landlord’s consent.
As for the original tenant, it can recover damages it owes to the landlord from the assignee, but such damages are limited. As stated above, the assignee is not liable for personal covenants contained in the lease unless it has specifically assumed them. The original tenant also does not have the right to re-enter the premises and evict the assignee unless it specifically reserves such a right in the assignment document.
Liability Under Subleases
A sublease does not affect the relationship of a landlord and its tenant. Privity of estate and privity of contract continue to exist between the landlord and the tenant as if no sublease had been entered into. The landlord can continue to pursue all remedies set forth in the lease against its tenant regardless of the existence of the sublease.
The landlord’s rights are more limited in a sublease scenario vis-à-vis a subtenant. No privity of estate or privity of contract exists between a landlord and a subtenant so the landlord has no right to seek damages from a subtenant. A landlord does have the right to terminate the prime lease if any covenant set forth in the prime lease is violated, and such a termination will automatically terminate the sublease. The landlord therefore has just as much control over the premises in a sublease as in an assignment, but it does not have as many sources of potential funds to recoup damages.
The tenant under the prime lease, however, has more rights under a sublease scenario. The sublease is treated like a lease between the prime tenant and the subtenant, and the prime tenant will generally reserve remedies under the sublease including the right to terminate the sublease, the right for damages, and the right to evict the subtenant upon the occurrence of a default. A sublease is therefore far more beneficial to the prime tenant.
The Name of the Instrument
Note that courts will not recognize the label of the instrument attempting to create an assignment or a sublease and will analyze the conveyance to determine the nature of the relationship. If a tenant attempts to sublease some or all of its premises for the remaining portion of the term of the lease, the law will treat such a sublease as an assignment of the lease as it applies to that portion of the premises. The prime tenant will lose most, if not all, of the remedies that are set forth in the sublease and may not be able to evict its subtenant from its premises upon the occurrence of a default.
If a tenant attempts to assign the lease, but holds a reversionary interest (e.g. if the assignee is obligated to assign the lease back to the original tenant a day before the expiration of the prime lease), the law will treat such an assignment as a sublease. Such a relationship will benefit the prime tenant, but the landlord will lose the right to go after the assignee as the assignee will be treated as a subtenant of the original tenant.
Landlords should be cognizant of ways to minimize their risk. Before consenting to any assignment or sublease, landlords should confirm that the relationship is as it purports to be. A landlord should condition any consent to an assignment upon the original tenant remaining liable under the lease and upon the assignee expressly assuming all covenants under the lease. Prior to consenting to any sublease, the landlord should confirm that there are sufficient safeguards in place so that the landlord will have adequate assets from which to draw upon if a default occurs, and should further consider requiring that the subtenant enter into an assumption agreement with the landlord under which the subtenant assumes the obligations under the prime lease.
Tenants should also consider the potential ramifications of the structure of their assignment or sublease, and should find ways to reduce their risk. Tenants should obtain a release from the landlord in connection with any assignment, and should include assumption language in any assignment document where the assignee assumes all covenants under the lease. They should also retain a reversionary interest in any premises that they sublease so that they do not inadvertently create an assignment.
Finally, both landlords and tenants should consider consulting a real estate attorney before entering into either of these transactions. Far too often tenants and landlords create a potentially catastrophic scenario that could have been avoided if they would have engaged a qualified attorney.
DISCLAIMER: These articles are to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through these articles.