Common And Uncommon Assignment/Subletting Problems

Part One of this article, which ran in the May 2009, issue of this newsletter, discussed the differences between assignment and subletting and assignments pro tanto. Part Two herein explores some of the problems that can arise in a transaction involving assignment or subletting.

General Assignment/Subletting Issues

A prohibition against assignment does not prohibit subletting, and vice versa. In most jurisdictions, merely agreeing that there is to be no subletting of the premises does not prohibit subletting of less than the entire leased premises. A bar against assignment in the lease does not bar a subtenant from assigning its sublease. It may not bar a further subletting by a subtenant. Remember, there is no privity between a subtenant and the prime landlord.

There are myriad transfers that happen by operation of law, and not all “triggers” are involuntary. An individual tenant's death transfers the deceased tenant's interest to her or his estate and then to one or more beneficiaries. Similarly, dissolution of an entity-tenant results in a distribution of its assets to the tenant's interest holders ' shareholders, members, partners, and the like. Then, there is a matter of reading some (innocent?) “boilerplate.” Doing so may lead to discovering that the lease's provisions “are binding upon, inure to the benefit of heirs, successors, administrators, and personal representatives.” Moreover, not all jurisdictions analyze the same set of facts in the same way. If this form of transfer is not addressed in a lease, the result may be unsettling. Addressing it incorrectly can also be unsettling to the tenant's family if the lease is lost upon the family member's death and the business goes down with the lease.

Another issue to address is the outcome of a creditor's levy and sale at auction of a tenant's particular asset ' such as the tenant's interest in its lease. A landlord may have joint or co-tenants until one of those tenants assigns to the other.

Does consent to the first assignment or subletting result in a landlord's consent to subsequent assignments or sublets? That appears to be the majority rule as to assignments, but not as to sublets. What if the consent was by acquiescence or silence? If an assignee succeeds to the original tenant's possessory right to the leased premises, but does not assume the lease itself, does it need the landlord's consent when it wants to further assign its interest in the lease or sublet the leased premises?

Typically, when a small business is sold, the seller will assign its lease to the buyer and take back “paper” secured by the buyer's assets. However, what good are the buyer's assets if the seller cannot get the lease back at the same time? Would reserving a reversionary right in the assignment protect the seller? Similarly, an assigning tenant will be helpless to mitigate its damages if it cannot “get the lease back” when its assignee defaults under the lease. While a conditional reassignment document can be executed in connection with an assignment, if the landlord agrees to such an arrangement at the time, a lease could cover the same contingency when it is first crafted. By doing so, a lease could require the landlord to re-let to the original tenant pursuant to an identical lease, for the remaining lease term (provided the original tenant makes the landlord whole).

Is a leasehold mortgage an assignment of the lease? If it is not, especially because courts construe restrictions on assignments very narrowly, can a tenant force an assignment on its landlord? Although a leasehold lender taking over as tenant under a lease may be hampered in assigning the lease to someone who might be able to use the leased premises, if it sells the defaulted mortgage to a party that wants to use the leased property for itself, a different situation exists. What if the mortgagee was a “friend” of the tenant?

Can a tenant assign a single right it holds under the lease, such as its purchase option, without running afoul of a no-assignment provision? If a lease allows assignment but not subletting, what keeps a tenant from assigning the lease to a new tenant and taking back an assignment that becomes effective in three or five years?

Creative Use of Entity Tenant Structuring

In most cases and most jurisdictions, the transfer of an ownership interest in a tenant does not constitute an assignment and will not violate a bare-boned “no assignment” provision in a lease. According to the case law, “the landlord should have anticipated such transfers.”

Allowing assignment to an affiliate of the tenant and not dealing with changes in ownership interests will allow the assignee-affiliate to change its ownership and defeat any restrictions dealing with assignments to non-affiliates. Freely allowing a tenant to sublet to an affiliate without barring or restricting an assignment of the sublease or a further subletting can result in an otherwise prohibited subtenancy. Merely saying that a transfer of ownership interests is deemed to be an assignment will not avoid all circumventions. For example, a corporate tenant or an LLC may restructure itself by bringing in entirely new owners by issuing new ownership interests and making the old owner a non-economic owner or only an economic participant once the tenant has a net worth of more than, say, $900 trillion.

Under the doctrine of independent covenants, a tenant may be able to accomplish indirectly what it could not effectuate directly. A merger or other corporate or entity restructuring can be seen as resulting in a transfer of the entity's assets by operation of law, and if the restructuring does not trigger a no-transfer lease provision, the lease transfer by operation of law can bring about what would otherwise have been a prohibited assignment. This allows a tenant with the right to assign its leasehold interest to an affiliate to drop the lease into the affiliate and merge the affiliate into a stranger.

On the other hand, some jurisdictions treat transfers from a parent to a subsidiary as an assignment, but do not see a transfer from a subsidiary to its parent the same way. Perhaps those decisions were influenced by the facts, stated or not. With that in mind, tenants may not want to face the issue at the time they need to make such transfers.

Entity reorganizations pose additional issues. Suppose a tenant wants to reorganize in a different jurisdiction? At one time, such a reorganization effectively resulted in the creation of a brand new entity, albeit with all of the assets and liabilities of the old entity. Traditional lease provisions may have relied upon the technical creation of a new entity. To the extent that made a difference and gave a landlord comfort or a tenant grief, today, in an increasing number of jurisdictions, an entity can be “domesticated.” The purpose of domestication is to keep the same legal entity intact, thus permitting what previously may have been prohibited.

Circumvention Traps

Including restrictions in a lease to deal solely with assignees and subtenants does not address the entire range of possible occupants or capture all those who, holding under the tenant, effectively control the leased space. For example, a tenant may allow another to manage its business, and in effect step-in for the tenant. The tenant may effectively turn its business over to someone else through use of an operating or profit-sharing agreement. It might or might not retain some management control over the resulting business, but never exercise those rights. This is not to say that every such and similar arrangement will pass muster. To the extent one can summarize the “test,” it is whether the tenant still holds some effective, economic interest in the real estate. If it does, there is no assignment; no subletting. This is a fact sensitive, “feel and taste” area, where it is difficult to predict what a court would do. As a result of such uncertainty, settlements are common. If the matter can be settled when it happens, the lease could ' and should ' have covered it in the first place. Because a concessionaire looks like a subtenant for some purposes and not for others, it is unclear whether a restriction against subletting would apply in that situation.

Conclusion

The conclusion of this article will discuss inadvertent waivers of consent, remedies of the parties, back door issues, the trouble with subtenants, and guaranty issues.

Ira Meislik is a principal at the Montclair, NJ, law firm of Meislik & Meislik. His commercial real estate practice, though broad in scope, has a special focus on retail real estate law. In addition to crafting space and ground leases, he has extensive experience in the acquisition, disposition, and financing of real property. He has written and spoken in the areas of real estate, business entity selection, attorney ethics, limited liability entities, and unincorporated business associations.

Part One of this article, which ran in the May 2009, issue of this newsletter, discussed the differences between assignment and subletting and assignments pro tanto. Part Two herein explores some of the problems that can arise in a transaction involving assignment or subletting.

General Assignment/Subletting Issues

A prohibition against assignment does not prohibit subletting, and vice versa. In most jurisdictions, merely agreeing that there is to be no subletting of the premises does not prohibit subletting of less than the entire leased premises. A bar against assignment in the lease does not bar a subtenant from assigning its sublease. It may not bar a further subletting by a subtenant. Remember, there is no privity between a subtenant and the prime landlord.

There are myriad transfers that happen by operation of law, and not all “triggers” are involuntary. An individual tenant's death transfers the deceased tenant's interest to her or his estate and then to one or more beneficiaries. Similarly, dissolution of an entity-tenant results in a distribution of its assets to the tenant's interest holders ' shareholders, members, partners, and the like. Then, there is a matter of reading some (innocent?) “boilerplate.” Doing so may lead to discovering that the lease's provisions “are binding upon, inure to the benefit of heirs, successors, administrators, and personal representatives.” Moreover, not all jurisdictions analyze the same set of facts in the same way. If this form of transfer is not addressed in a lease, the result may be unsettling. Addressing it incorrectly can also be unsettling to the tenant's family if the lease is lost upon the family member's death and the business goes down with the lease.

Another issue to address is the outcome of a creditor's levy and sale at auction of a tenant's particular asset ' such as the tenant's interest in its lease. A landlord may have joint or co-tenants until one of those tenants assigns to the other.

Does consent to the first assignment or subletting result in a landlord's consent to subsequent assignments or sublets? That appears to be the majority rule as to assignments, but not as to sublets. What if the consent was by acquiescence or silence? If an assignee succeeds to the original tenant's possessory right to the leased premises, but does not assume the lease itself, does it need the landlord's consent when it wants to further assign its interest in the lease or sublet the leased premises?

Typically, when a small business is sold, the seller will assign its lease to the buyer and take back “paper” secured by the buyer's assets. However, what good are the buyer's assets if the seller cannot get the lease back at the same time? Would reserving a reversionary right in the assignment protect the seller? Similarly, an assigning tenant will be helpless to mitigate its damages if it cannot “get the lease back” when its assignee defaults under the lease. While a conditional reassignment document can be executed in connection with an assignment, if the landlord agrees to such an arrangement at the time, a lease could cover the same contingency when it is first crafted. By doing so, a lease could require the landlord to re-let to the original tenant pursuant to an identical lease, for the remaining lease term (provided the original tenant makes the landlord whole).

Is a leasehold mortgage an assignment of the lease? If it is not, especially because courts construe restrictions on assignments very narrowly, can a tenant force an assignment on its landlord? Although a leasehold lender taking over as tenant under a lease may be hampered in assigning the lease to someone who might be able to use the leased premises, if it sells the defaulted mortgage to a party that wants to use the leased property for itself, a different situation exists. What if the mortgagee was a “friend” of the tenant?

Can a tenant assign a single right it holds under the lease, such as its purchase option, without running afoul of a no-assignment provision? If a lease allows assignment but not subletting, what keeps a tenant from assigning the lease to a new tenant and taking back an assignment that becomes effective in three or five years?

Creative Use of Entity Tenant Structuring

In most cases and most jurisdictions, the transfer of an ownership interest in a tenant does not constitute an assignment and will not violate a bare-boned “no assignment” provision in a lease. According to the case law, “the landlord should have anticipated such transfers.”

Allowing assignment to an affiliate of the tenant and not dealing with changes in ownership interests will allow the assignee-affiliate to change its ownership and defeat any restrictions dealing with assignments to non-affiliates. Freely allowing a tenant to sublet to an affiliate without barring or restricting an assignment of the sublease or a further subletting can result in an otherwise prohibited subtenancy. Merely saying that a transfer of ownership interests is deemed to be an assignment will not avoid all circumventions. For example, a corporate tenant or an LLC may restructure itself by bringing in entirely new owners by issuing new ownership interests and making the old owner a non-economic owner or only an economic participant once the tenant has a net worth of more than, say, $900 trillion.

Under the doctrine of independent covenants, a tenant may be able to accomplish indirectly what it could not effectuate directly. A merger or other corporate or entity restructuring can be seen as resulting in a transfer of the entity's assets by operation of law, and if the restructuring does not trigger a no-transfer lease provision, the lease transfer by operation of law can bring about what would otherwise have been a prohibited assignment. This allows a tenant with the right to assign its leasehold interest to an affiliate to drop the lease into the affiliate and merge the affiliate into a stranger.

On the other hand, some jurisdictions treat transfers from a parent to a subsidiary as an assignment, but do not see a transfer from a subsidiary to its parent the same way. Perhaps those decisions were influenced by the facts, stated or not. With that in mind, tenants may not want to face the issue at the time they need to make such transfers.

Entity reorganizations pose additional issues. Suppose a tenant wants to reorganize in a different jurisdiction? At one time, such a reorganization effectively resulted in the creation of a brand new entity, albeit with all of the assets and liabilities of the old entity. Traditional lease provisions may have relied upon the technical creation of a new entity. To the extent that made a difference and gave a landlord comfort or a tenant grief, today, in an increasing number of jurisdictions, an entity can be “domesticated.” The purpose of domestication is to keep the same legal entity intact, thus permitting what previously may have been prohibited.

Circumvention Traps

Including restrictions in a lease to deal solely with assignees and subtenants does not address the entire range of possible occupants or capture all those who, holding under the tenant, effectively control the leased space. For example, a tenant may allow another to manage its business, and in effect step-in for the tenant. The tenant may effectively turn its business over to someone else through use of an operating or profit-sharing agreement. It might or might not retain some management control over the resulting business, but never exercise those rights. This is not to say that every such and similar arrangement will pass muster. To the extent one can summarize the “test,” it is whether the tenant still holds some effective, economic interest in the real estate. If it does, there is no assignment; no subletting. This is a fact sensitive, “feel and taste” area, where it is difficult to predict what a court would do. As a result of such uncertainty, settlements are common. If the matter can be settled when it happens, the lease could ' and should ' have covered it in the first place. Because a concessionaire looks like a subtenant for some purposes and not for others, it is unclear whether a restriction against subletting would apply in that situation.

Conclusion

The conclusion of this article will discuss inadvertent waivers of consent, remedies of the parties, back door issues, the trouble with subtenants, and guaranty issues.

Ira Meislik is a principal at the Montclair, NJ, law firm of Meislik & Meislik. His commercial real estate practice, though broad in scope, has a special focus on retail real estate law. In addition to crafting space and ground leases, he has extensive experience in the acquisition, disposition, and financing of real property. He has written and spoken in the areas of real estate, business entity selection, attorney ethics, limited liability entities, and unincorporated business associations.