Traps to Avoid When Negotiating a Commercial Sublease

Sometimes leasing space from another tenant (subleasing) may appear to be a more advantageous business decision in terms of price, location and size compared with leasing the space directly from the property owner. However, a commercial sublease actually triggers a variety of legal issues simply not present in a direct lease. This therefore leads to the misperception that negotiating and drafting a sublease is easier and quicker than negotiating and drafting a new lease. In reality, it is actually the opposite – subleases will most often be more difficult and time consuming (and possibly involve much higher legal fees) to draft. Therefore, a party considering a subtenant transaction must not only consider all the potential legal risks involved, but also engage in specific due diligence before moving forward.

Risks Involved in a Commercial Sublease Transaction
Becoming a subtenant means taking on risk in certain areas of vulnerability. For instance, a subtenant is not in privity of contract with the master lessor. That means that the master landlord gets to decide whether or not to communicate directly with the subtenant. If the master landlord will not communicate with the subtenant, then all communication must go through the sublandlord. The sublandlord may have little interest in this responsibility.

As a subtenant, it is imperative to explicitly require the sublandlord to timely pay rent under the master lease, and to agree to be a conduit to the master landlord on behalf of the subtenant. If the sublandlord defaults under the master lease, the sublease is subject to being wiped out unless the subtenant can negotiate a recognition and attornment agreement directly with the master landlord. It is rare for a master landlord to offer such protection to a subtenant absent specific economic incentives built into the deal.

A Commercial Sublease Incorporates Terms of the Master Lease
When evaluating a sublease transaction, the potential subtenant must (i) carefully read the master lease, (ii) review or draft the sublease, (iii) dovetail the provisions between the two documents, and (iv) if required by the master lease, negotiate the master landlord’s consent to the sublease.

Fundamental to a sublease transaction is the concept that any right a subtenant has with respect to the subleased space derives from the rights of the sublandlord and are subject to the existing lease (which in a sublease setting is commonly referred to as the “master lease” or “prime lease”). The master lease is, therefore, effectively the lease agreement between the sublandlord and the master landlord. Given this fact, a potential subtenant’s careful review of all of the terms of the master lease is critical. Sometimes (if not commonly) the sublease agreement will be explicit that the sublease agreement is subject to all of the terms and conditions set forth in the master lease. Yet, even in the absence of such language, the parties should understand this concept as the fundamental underpinning of the rights of the parties in the transaction. In other words, each provision of the master lease is included in the sublease unless it is specifically excluded, and the master landlord agrees to such exclusion in a consent to sublease (discussed below).

The parties should therefore undertake a very detailed level of review of each and every provision in the master lease to determine if it applies to the sublease. Oftentimes, the parties will spell out which provisions of the master lease apply to the sublease and which provisions of the master lease are excluded from the sublease. Provisions of the master lease which should apply to the sublease should be incorporated by reference into the sublease. It is legally insufficient to say “whatever shouldn’t apply from master lease doesn’t in the sublease” or words to that effect.

A Consent to Sublease
When the sublandlord and subtenant want to change some of the sublease terms as compared to the master lease, those changes must be approved by the master landlord in a Consent to Sublease. A Consent to Sublease is a tri-party agreement among the master landlord, its tenant (the sublandlord) and the subtenant. When reflecting that change in the sublease, the sublease should say “as long as the Master Landlord agrees.”

A common provision that is approved in the Consent to Sublease is the sublease termination date. A sublandlord may want to terminate the sublease prior to the expiration of the master lease. This is particularly important to avoid liability. An example: upon the termination of the sublease, a subtenant is often required to “walk the space” with the sublandlord to make sure the subleased premises are returned to the condition required by the master lease. If the sublease expires on the same day as the master lease, and the subleased property is not returned in the condition required by the master lease, the sublandlord stands to be liable to the master landlord for the subtenant’s failures. That may effectively put the sublandlord in a holdover situation – often with a substantial financial penalty owed to the master landlord. In this case, a Consent to Sublease would therefore be a tool to avoid this type of liability by setting the sublease termination date reasonably in advance of the master lease termination date.

Due Diligence in a Commercial Sublease Transaction
A subtenant contemplating a sublease transaction is well advised to conduct its due diligence before signing any sublease or letter of intent. As explained above, the fundamental concept of a sublease transaction is that the subtenant “steps into the shoes” of the tenant under the master lease as it relates to the subleased premises. A careful attorney will make sure that its client is not stepping into any existing liability or opening the door to any reasonably foreseeable future liability.

The following is a list of just some of the issues a subtenant must consider before entering into a sublease agreement:

1. A subtenant should independently assess and verify the rights the tenant/sublandlord has to the space.

2. A subtenant should verify that the term of the sublease agreement is shorter than or the same as the term under the master lease. The sublease cannot be for a term that extends beyond the term of the master lease.

3. Since the sublease is subject to the master lease, the subtenant needs to understand the legal ramifications of the possibility that the master lease may terminate before the term provided for in the sublease due to tenant default, landlord default, or any other reason.

4. A subtenant should ensure that the sublease agreement properly provides for the exact terms and conditions of the master lease. This is often done by attaching that master lease and incorporating it as an exhibit into the sublease.

5. A subtenant should determine if there are provisions in the master lease that differ from the business deal between the subtenant and the sublandlord. If there are, it will be important to specifically: (a) exclude these provisions from the sublease, (b) modify these provisions in the sublease, or (c) address the differences in a Consent to Sublease.

As an example, for the fifth point just described, a subtenant often requires alterations or improvements to make the sublease premises ready for the subtenant’s use. Under these circumstances, which party is required to pay for the work (i.e. is the sublandlord offering a tenant improvement allowance)? If the alterations require consent from the master landlord (and those alternations likely will trigger a need for the master landlord’s consent), then this consent needs to be included in the Consent to Sublease. The master landlord’s consent will commonly include attaching plans and specifications for the subtenant buildout, evidence of insurance from the contractor/subcontractor, permits and approvals, and potentially many other specifications. The parties should also consider whether these alterations must be removed from the sublease premises at the end of the term, and if so by when, by whom, and at whose expense.

It is important to note that due diligence also extends to the entity that will be the sublandlord. Be sure that the sublandlord can perform its duties as “Tenant” under the master lease so that the subtenant does not end in default with the master lease terminating – thus terminating the sublease. Theoretically, all rent paid by the subtenant to the tenant should then be turned over and paid by the tenant to the master landlord to the extent necessary to satisfy any rent obligation under the master lease and any “profit” sharing as may be specifically set forth in the master lease. Such due diligence can therefore include conducting a litigation and bankruptcy search on the tenant in the jurisdictions where the sublandlord conducts business.

While a sublease agreement may involve leasing the same or less space to a subtenant than the tenant is leasing from the master landlord, or for a term that is equal to or less than the entire term of the master lease, the legal issues and due diligence involved in commercial sublease transactions often involve more detailed drafting, careful analysis, and more due diligence than entering into a direct lease with the owner of the property. Given that a sublease transaction is often more complex than a direct lease transaction, the wise potential subtenant will engage a qualified and seasoned real estate attorney early in every commercial sublease transaction to avoid the minefield of issues that come up in these seemingly “short and simple” deals.

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