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To Recognize or Not to Recognize - That is the Question: Sublease Recognition Agreements

One important exit strategy for a large space tenant seeking to shed itself of leased space is to have the option of assigning its lease or of subletting all or part of its premises. Generally, a tenant who no longer needs its space will prefer assignment if it can be simultaneously relieved of its lease obligations or if the prospective assignee is adjudged to be rock solid. Otherwise, subletting is preferred because the departing tenant, stuck with continuing contingent liability, can retain control of its space. However, to get rid of the old tenant as an intermediary between it and the landlord, an incoming tenant would prefer to take an assignment of the existing tenant’s leasehold interest. Sometimes, such as when the incoming tenant’s rent is substantially lower than the rent payable under the lease, a lease assignment just won’t work. Thus, where assignment of the lease is not workable or where less than all of the leased space is to be transferred, subleasing is the preferred choice.

Subletting might be planned or unplanned. A tenant might project a need for more space than it needs at the outset of its lease term. Common approaches to deal with such a situation are negotiating for expansion options or rights of first refusal. Another one is to lease extra space up front and find a subtenant for part of the lease term. More commonly, however, subletting results from economic factors first occurring after the lease term has begun. A tenant may find that its space is too small, or that its operational needs require relocation, or that it may just plain need to ‘skinny down.’ Whichever is the problem, finding a subtenant is the solution.

Subtenants have the right to feel insecure. Not only must they obey the terms of their own sublease, but they take the risk that their own landlord (the sublandlord) loses the underlying lease. The rights of a subtenant are derivative of those in the underlying lease. Without some sort of direct agreement with the (over)landlord, a subtenant’s right to remain in possession disappears when the underlying lease is terminated. Some risks can be handled by giving the subtenant the right to step into its sublandlord’s shoes. For example, a subtenant may be given a right to receive notice of default directly from the landlord and may have the right to cure those defaults. Also, a subtenant may be given the right to exercise renewal options on behalf of the tenant itself. Nonetheless, there are limits. If the underlying lease is terminated by reason of the sublandlord’s default or bankruptcy, the subtenant may find itself on the street. To avoid homelessness upon termination of the underlying lease, a subtenant looks to have the overlandlord accept the sublease as if it were a direct lease with the subtenant, i.e., to have the landlord recognize the subtenant as if it were its own. For greatest comfort, such an agreement should be in place when the sublease is executed.

A subtenant’s risk of losing its sublease is not dissimilar to what a tenant faces when a mortgagee forecloses on its lien and wipes out inferior interests such as most leases. Even tenants with relatively little bargaining power ask for, and are able to obtain, non-disturbance and attornment agreements. Those agreements leave the original lease in place upon a mortgage foreclosure (or related transfer of the landlord’s interest in the property) and, in return, the tenant agrees to continue as if the mortgagee or other transferee were the original landlord. The agreement between a tenant and its landlord’s lender is called a “Non-disturbance and Attornment Agreement” or “NDA.” In the case of a subtenant seeking to have its subtenant’s landlord accept the subtenancy, it is preferable to speak of the agreement that preserves the subtenant’s right of possession as a “Recognition Agreement.”

Landlords chant what is almost a rubric – “I’m in the real estate business; you, the tenant, are not.” But, as an economic matter, that’s not true. Once a tenant has committed to lease space, those premises become that tenant’s real estate for the entire lease term. The tenant isn’t free to walk away without consequence. Essentially, the landlord has exchanged control of its property for the tenant’s promise to pay rent for the entire lease term. The real reason that a tenant may not have the unencumbered right to transfer its own rights to others is that the parties have bargained for such restrictions. And, that’s a matter of bargaining power, not natural law.

Almost without exception, tenants of large spaces are large companies with strong bargaining power. Likewise, those having large spaces to lease usually have the same intrinsic power. Vacancy rates and competitive demands for the same space increase or decrease each party’s strength, but it is rare for one to lord over the other. That’s the framework for the negotiation over a recognition agreement.

A wise tenant provides for the future. In this context, that means having its lease impose an obligation on its landlord to recognize subtenants. After all, subtenants, especially those needing large blocks of space, don’t want to be dependant on the continuing viability of a sublandlord or on the continued existence of the underlying lease. Sublet rent may be favorable, but facing the prospect of business disruption makes subletting without a recognition agreement a risky choice. For example, retailers fear loss of a strong retail business. No business needs the distraction. With that in mind, a tenant knows that it is a lot easier to sublease space, especially large space, if it can promise its subtenant that the landlord will execute a recognition agreement.

As in matters of romance, the parties are more willing to give and take when love abounds and marriage is on the horizon than when facing divorce. Although landlords abhor empty space nearly as much as nature abhors a vacuum, they also fear the unknown. As a rule a landlord would rather reserve decision on accepting a subtenant as its own until faced with loss of the underlying tenant. That way, the landlord can gauge the market and evaluate the subtenant, qua tenant, when all of the facts are in. That’s not comforting for a prospective subtenant and negotiations, at the time of subleasing, over whether the landlord will even grant recognition can delay and then kill the subleasing deal. Thus, the time to strike the basic agreement over recognition is before the lease is signed – when the landlord and prospective tenant are ‘courting’ and have comparable bargaining power.

A tenant would love for its landlord to agree to recognize any and every subtenant. That’s unlikely to happen. What is more likely is that the parties will negotiate over a set of objective standards which will define an acceptable subtenant and sublease. What constitutes an acceptable subtenant? Generally, the criteria focus on financial strength, the nature of its business, and its management ability. What constitutes an acceptable sublease? The factors most cited by landlords have to do with the terms of the sublease itself and the physical characteristics of the subleased space.

Although these factors are relevant when confronting whether a landlord should or even must grant consent to a lease assignment or to a subletting, they are far more critical in the context of recognition discussions. Further, while most factors apply whether negotiations take place at the time of initial lease negotiation or when an actually sublease is “on the table,” there are significant differences. If the parties are looking at a specific subtenant and a specific sublease, each of them can control the outcome. When a landlord is being asked to agree to recognize a hypothetical, future sublease, it needs to anticipate what that sublease might look like.

Where a tenant is “still on the lease,” the landlord gets to look to recover from its tenant, as it could all along, and it also gets an enhancement, i.e., the credit behind an assignee or subtenant. On the other hand, by definition, an agreement to recognize a subtenant takes effect when the original tenant has disappeared from the scene. Thus, a landlord can no longer take comfort that it has its original ‘choice’ on the hook. At the point that recognition is relevant, only the subtenant’s wallet is open. For that reason, negotiations almost always focus on the subtenant’s financial capability. The negotiations are not just about the amount of a subtenant’s net worth or shareholder equity. They include whether one looks at ‘tangible’ net worth (thereby excluding items such as good will). Landlords prefer to make financial determinations at the time the underlying lease is terminated, whereas subtenants (thusly, tenants as well) would choose to bind the landlord at the time of subleasing. Discussions of credit enhancements for a qualifying subtenant are as relevant in the recognition agreement discussion as they are in the basic leasing discussion.

The underlying lease sets the boundaries within which a tenant must operate. By simple example, if the leased premises may only be used for general offices, the subleased space may only be used for general offices. Nonetheless, landlords make certain assumptions about their chosen tenant’s business and how it will be run. Consequently, a landlord may be willing to permit its own tenant to make use of the leased premises in a way that it would not have allowed a different party, such as one who later becomes a prospective subtenant. Another example is that to get a department store as a tenant, the landlord might have agreed to allow the premises to be used for “any legal retail purpose,” but would not have done so for a particular electronics retailer. More commonly, a landlord may compromise certain favored lease provisions to sign a particular lease with a desirable, but resolute tenant, but would not have done so for a subtenant who might not even be occupying dominant space within the project. In many of those cases, that same resolute tenant will yield to the landlord’s wishes when it comes to the rights of a yet unidentified subtenant.

A landlord often points out that it has chosen “you, the tenant” because of “your special attractiveness.” In a retail project, that might mean that it perceives a particular prospective tenant as one who will flood its shopping center with the revered “traffic.” It might be enamored with the “prestige” that a particular tenant can bring to a project and how that prestige can translate into attracting other tenants at even higher rent. Whatever be the case, if a landlord agrees to a lease provision requiring it to recognize hypothetical, future subtenants, it stands to lose that particular attractive quality or qualities. To militate against such a possibility, a landlord may insist that before it becomes obligated to recognize a subtenant, that the qualifying subtenant possesses certain attributes. In the retail context, this could mean that to qualify, in advance, for a recognition agreement, the subtenant might need to operate or franchise an agreed-upon minimum number of retail stores under a common trade name. In the alternative, the qualifying subtenant might need to be a national or regional retailer. Office landlords might insist that to qualify, a subtenant must be a Fortune 500 company or in a particular industry. The nature and quality of the project will determine what would make a landlord comfortable in accepting a yet unidentified subtenant as its own tenant in the future.

Ordinarily, if a sublease terminates when the underlying lease terminates, the landlord regains possession of the entire leased premises. Essentially, it then can relet all or part of the space and reconfigure it at will. On the other hand, if it has agreed to recognize a subtenant, it doesn’t have the same flexibility. Obviously, it won’t have as much space to market. That may or may not be desirable at the time, but that’s a fundamental result of agreeing that the subtenant can remain in place. On the other hand, a landlord shouldn’t have to accept whatever configuration its tenant might work out with a subtenant. Each space created upon subletting must be economically viable. After all, if the lease is terminated, the prospect of which being what creates the need for recognition in the first place, the tenant’s retained space must be remarketed. When the sublease is over, the sublet space must then be relet. Perforce, each space must “work.” Landlords can not take comfort that a “tenant knows best.” When a tenant carves up space for subletting it has a specific, known need in mind. It may be willing to share a common entranceway or share utility services with a subtenant, but that doesn’t mean that anyone else would be so willing.

Specific projects may dictate specific qualifying criteria, but the following requirements are common ones:

(a) that the subleased space be of a minimum size;

(b) that it is separately demised from the balance of the leased premises;

(c) that its has own entrances;

(d) that it has a means of accepting freight and shipping packages without the need for passage through any other space;

(e) that each resulting space be what is considered to be of a generally, commercially leasable shape, either by stating the general requirement or by outlining specific criteria such as being “rectangular” in shape or having a minimum frontage;

(f) that there are separate utility services or submetered services to the sublet space or by requiring the subtenant to create separate utility services or submetered services at the time the underlying lease is terminated;

(g) that it have its own restrooms and other similar critical features;

(h) that each space have adequate and appropriate access and, in the case of retail spaces, visibility; and

(h) that the sublet space be located within a particular portion of the leased premises, such as to the far right or left of a retail store.

When it agrees to accept or recognize a not yet existent sublease as its own direct lease, a landlord has agreed to the terms of that sublease. Even though the subtenant will have no greater rights under its sublease than the sublandlord-tenant had under its own lease, the sublease might have imposed lesser obligations on the subtenant than those imposed on its sublandlord by the underlying lease. For that reason, a landlord should not agree to take on just any sublease as a direct lease upon loss of its original tenant. For one, the landlord may have given special rights to its tenant that it might not have given to others. Frequently those rights are deal-specific. They might include favorable renewal terms, early termination rights, the right to self-insure, prominent signage, or any of a myriad of negotiated benefits to attract a specific tenant in the first place. For that reason, a landlord will want to consider whether those tenant-tailored rights should inure to the benefit of a subtenant when the original tenant is entirely out of the picture. Similarly, a tenant will want to negotiate for specific rights that will enhance its ability to sublet all or part of the leased premises. Guarantying that a qualified subtenant will get a recognition agreement is a major right. Making sure that the subtenant will get adequate signage or directory listings is another.

While each project and each leasing situation will call for a deal-specific analysis of what must be in an acceptable sublease, the following factors are common to all situations:

(a) that the sublease obligate the subtenant to pay rent in an amount not less than a proportionate share of the rent payable under the lease, frequently, but not always, based upon the size of the subleased premises compared to the leased premises;

(b) that the subtenant pay taxes, utilities, and all other charges with respect to the subleased premises to at least the same extent for which the tenant was obligated;

(c) that, if the subleased space is of better quality or character than the leased space is, on average, the rent payable per square foot be appropriately higher;

(d) that, upon termination of the underlying lease, the subtenant assume all of the non-monetary obligations that its sublandlord had to the landlord;

(e) that, upon termination of the underlying lease, the landlord does not become obligated to more than what it was bound under its lease with the sublandlord; and

(f) that the landlord has the benefit of the more favorable of the exculpatory provisions of the underlying lease or of the sublease.

Separate and apart from the terms of either the underlying lease or of the sublease, and separate and apart from the nature of the parties or of the property, a landlord should be concerned about “successor” liability. That is, it should seek to insulate itself from prior problems between its own tenant and the subtenant. These concerns are similar to those faced by a lender when agreeing to give its borrower’s tenant a non-disturbance agreement. The most common ones are the following. A landlord will not want to be: (i) liable for any previous act or omission or default by its tenant under the sublease; (ii) subject to any offset of rent, counterclaims or defenses that may have accrued to the subtenant against its tenant; (iii) bound by any previous prepayment of rent made by the subtenant to the tenant; or (iv) liable to the subtenant for any security deposit unless the tenant paid the security deposit to the landlord. A tenant, even if agreeing with everything on this list, will want the landlord to cure any default that was the landlord’s default on the date the underlying lease was terminated.

One other frequently encountered landlord’s preference is that it not be obligated to recognize a sublease if, at the time the underlying lease is terminated, the subtenant is in default of its own obligations under its sublease or the subtenant, in some way, has contributed to the reason that the underlying lease was terminated. Appealing as this requirement might be on an emotional level, making it a condition precedent to the effectiveness of a recognition agreement seriously undermines whatever carefully crafted default provisions may have been negotiated into the sublease itself. The tenant and its subtenant have bargained for a mutually acceptable set of tests, the failure of which puts the subtenant at jeopardy of losing its right of possession. Further, the subtenant has bargained for the sublandlord to have specific, limited remedies in the event of a default or alleged default. As a result, tenants resist giving in to such a demand by a landlord, arguing that the landlord always has the right to evict the subtenant if the default is serious enough to allow for such a remedy.

In sum, a subtenant wants to be protected from losing its right to possession if its sublandlord defaults on the underlying lease. Thus, to enhance its ability to find a subtenant, a tenant wants its landlord’s to agree, in advance if possible, to recognize a subtenant should the underlying lease be terminated for any reason. A landlord wants to sign a lease with its chosen tenant, but not necessarily with some subtenant it didn’t choose in the first place. That’s what a recognition agreement was designed for and that’s what the negotiations are about.

SCENARIO ONE – NEGOTIATING FOR THE RIGHT TO GET RECOGNITION AGREEMENTS IN THE FIRST PLACE

A strong national retailer utilizes prototypical stores ranging in size from 60,000 to 100,000 square feet. It has selected a shopping center site owned by a strong national developer. The shopping center has seen better days, but its demographic characteristics are ideal for the retailer. There is an empty space measuring 95,000 square feet, vacated 1-1/2 years earlier when its prior tenant rejected its lease in bankruptcy.

The prospective tenant is willing to take the entire space and open a full size store, but wants to be in a position to cut back on the size of its store should the location not support a 95,000 square foot store. Its preference is to have the right to sublet part or parts of its space so that it can retain control over the entire 95,000 square foot space should it later want to increase the size of its store. It knows that serious subtenants want to minimize the risk of losing their sublease if the superior lease is terminated. With all of that in mind, the national retailer always negotiates for an obligation on the part of its landlords to recognize subleases.

LEASE CLAUSE:

Requirement That Landlord Recognize All Subleases - From a Tenant’s Form Lease

Within ten (10) days after Tenant’s request, Landlord shall execute and deliver to a sublessee of all or any part of the Demised Premises, an agreement confirming that, in the event this Lease is terminated for any reason, if such sublessee shall observe and perform all of its obligations under such sublease, then the sublease and the sublessee’s rights thereunder shall not be disturbed by Landlord but shall continue in full force and effect so long as such sublessee continues to observe and perform all of its obligations under the sublease. Provided that Landlord delivers such an acknowledgment, the sublessee shall attorn to Landlord and, after termination of this Lease, shall pay Landlord an amount equal to the minimum or base rent, percentage rent (if any), and additional rent provided for in its sublease. Upon termination of this Lease, the sublease shall become a direct lease between Landlord and sublessee and the parties will execute and deliver any further reasonable documents as are necessary or desirable to more fully effectuate the foregoing. Notwithstanding the foregoing, in the event of any such attornment, Landlord shall not be: (a) liable for any previous act or omission by Tenant under any such sublease (except for breaches of a continuing nature which are curable by Landlord); (b) subject to any offset of rent that had previously accrued in favor of the sublessee against Tenant; (c) bound by any prepayment of rent made by the sublessee to Tenant other than for the current month; or (d) liable to the sublessee for any security deposit given by the sublessee to Tenant unless Tenant turns such security deposit over to Landlord. Landlord’s obligation not to disturb a sublessee’s tenancy and to enter into a direct lease with a sublessee shall only apply where the applicable sublease: (m) obligates the sublessee to pay base or minimum rent in an amount not less than a proportionate share of the Minimum Rent payable under this Lease (which proportionate share shall be based upon the square footage of the premises sublet by any sublessee as compared with the total square footage of the Demised Premises); and (n) obligates such sublessee to pay a pro rata share of Additional Rent for the premises covered by the sublease.

LEASE CLAUSE:

Lease Provision Requiring Landlord to Recognize Certain Subtenants - Negotiated Between Sophisticated Landlord and Sophisticated Tenant

Provided that a particular sublease: (a) is for space with a floor area of at least ten thousand (10,000) square feet; (b) is to a subtenant (together with that of any guarantor of such subtenant’s obligation) with a net worth of at least one hundred dollars ($100.00) per square foot of floor area of sublet premises; (c) is for space that is fully demised from the balanced of the Demised Premises and has a separate entrance and separate electrical service; and (d) leaves the balance of the Demised Premises as a reasonably, commercially viable and leasable unit in Landlord’s reasonable discretion, (e) with respect to the subleased premises, imposes upon sublessee substantially all of the duties and liabilities imposed upon Tenant under this Lease, adjusted for the size, location, and configuration of the subleased space, and (f) is otherwise acceptable to Landlord in its reasonable discretion as a direct lease between Landlord and subtenant (and shall be deemed unacceptable if the rent per square foot fails to reflect the characteristics and quality of the sublet space; that is, if premium space within the Demised Premises is sublet, the rental rate shall reflect such premium), then, upon request of Tenant, Landlord agrees to execute and deliver to such sublessee an agreement confirming that, in the event this Lease is terminated for any reason, if such sublessee shall observe and perform all of the obligations of such sublessee to be performed pursuant to such sublease, then and in that event such sublease and the rights of the sublessee thereunder shall not be disturbed by Landlord but shall continue in full force and effect so long as such sublessee shall continue to observe and perform all of its obligations under such sublease. Such sublessee shall attorn to Landlord, including the payment to Landlord of minimum or base rent, percentage rent (if any) and additional rent equal to that provided for in such sublease. Such sublease shall require that sublessee shall in all events comply with all use and other restrictions applicable to the Shopping Center to the same extent that such apply to Tenant, but using the floor area of the subleased space (and not that of the Demised Premises) to determine applicability. Such sublease shall become a direct lease between Landlord and such sublessee and those parties will execute and deliver any further reasonable documents at such time to more fully effectuate the foregoing. If, by the terms of this paragraph, the lease with the sublessee becomes a direct lease between Landlord and the sublessee, Tenant (and Tenant’s Guarantor, if applicable) shall remain liable for performance of all obligations of sublessee and, upon request, Tenant (and Guarantor, if applicable) shall execute and deliver any reasonable documents from time to time to confirm such liability. Notwithstanding the foregoing, in the event of any such attornment, Landlord shall not be: (i) liable for any previous act or omission by Tenant under any such sublease; (ii) subject to any offset of rent that shall thereunto have accrued to any such sublessee against Tenant; (iii) bound by any previous prepayment of rent made by any such sublessee to Tenant for more than the current month; or (iv) liable to any such sublessee for any security deposit made by any such sublessee to Tenant unless Tenant pays such security deposit over to Landlord. The foregoing provisions of this Article shall apply only to those subleases that: (a) obligate the sublessee to pay base or minimum rent in an amount not less than a proportionate share of the Minimum Rent payable under this Lease (which proportionate share shall be based upon the square footage of the premises sublet by any sublessee as compared with the total square footage of the Demised Premises); and (b) obligate such sublessee to pay taxes, utilities and all other charges with respect to the premises covered by the sublease.

LEASE CLAUSE:

Lease Provision Requiring Landlord to Recognize Certain Subtenants - Negotiated Between Strong Landlord and Strong Tenant

Upon request of Tenant, Landlord agrees to execute and deliver to any sublessee of the Demised Premises or a portion thereof (provided such sublessee has a net worth of at least Twenty Five Million Dollars ($25,000,000.00) and operates at least fifteen (15) stores under a single trade name), an agreement confirming that, in the event this Lease is terminated for any reason, if such sublessee shall observe and perform all of the obligations of such sublessee to be performed pursuant to such sublease, then and in that event such sublease and the rights of the sublessee thereunder shall not be disturbed by Landlord but shall continue in full force and effect so long as such sublessee shall continue to observe and perform all of its obligations under such sublease. Tenant shall furnish Landlord with a copy of each sublease for which Landlord is seeking recognition. The sublessee under such sublease shall attorn to Landlord, including the payment to Landlord of minimum or base rent, percentage rent (if any) and additional rent equal to that provided for in such sublease. Such sublease shall become a direct lease between Landlord and such sublessee and those parties will execute and deliver any further reasonable documents at such time to more fully effectuate the foregoing. Notwithstanding the foregoing, in the event of any such attornment, Landlord shall not be: (i) liable for any previous act or omission by Tenant under any such sublease (unless a default of a continuing nature which is curable by Landlord); (ii) subject to any offset of rent that shall thereunto have accrued to any such sublessee against Tenant; (iii) bound by any previous prepayment of rent made by any such sublessee to Tenant for more than the current month; or (iv) liable to any such sublessee for any security deposit made by any such sublessee to Tenant unless Tenant pays such security deposit over to Landlord. The foregoing provisions of this Article shall apply only to those subleases: (a) that obligate the sublessee to pay base or minimum rent in an amount not less than a proportionate share of the Minimum Rent payable under this Lease (which proportionate share shall be based upon the square footage of the premises sublet by any sublessee as compared with the total square footage of the Demised Premises); (b) that obligate such sublessee to pay taxes, utilities and all other charges with respect to the premises covered by the sublease; (c) where the subleased premises contain a minimum of 10,000 square feet of floor area; (d) where the subleased premises have regular dimensions (e.g., generally rectangular in shape); (e) where the subleased premises are either to the far left or far right of the Demised Premises (looking from the parking area) and front on the parking area; (f) where Landlord is not bound by any payment of rent made by the subtenant to Tenant; (g) where Landlord is not be bound to any obligations on the part of the sublandlord under the sublease which obligations are in excess of, or in addition to, the obligations which the Landlord has under this Lease; (h) where the term of the sublease can be reduced, if needed, to a term no greater than the remaining term of this Lease; (i) where the Landlord has the benefit of the more favorable of the exculpatory and nonrecourse provisions afforded for the benefit of the sublessor under the sublease or of the Landlord under this Lease; (j) where subtenant’s use of its subleased premises is conformed to the uses permitted under this Lease.


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