Navigating Commercial Lease Assignment Provisions: Tenants Beware

by Pepper Hamilton LLP
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Landlords use lease assignment provisions to maintain control over the quality, composition, and financial capability of their tenants. However, assignment provisions can have a chilling effect on a corporate tenant’s business operations and ownership structure. In this article, we explore the various pitfalls that corporate tenants should avoid when negotiating and drafting assignment provisions in commercial leases.

Most assignment provisions in commercial leases restrict two types of circumstances. The first is the proposed assignment of a lease to an unrelated third party or to an affiliate company of a corporate tenant. The second is the deemed assignment of the lease by operation of a change in control or ownership of a corporate tenant.

As a general rule, in the absence of a specific provision in a commercial lease restricting assignment, a tenant is free to assign its lease to a third party without notifying the landlord or obtaining the landlord’s prior approval. However, most modern commercial leases contain assignment provisions that either prohibit or restrict the circumstances under which a tenant may make an assignment of its lease. Provisions that restrict assignments require tenants to obtain the landlord’s prior consent to an assignment of the lease. Courts in New York State have consistently held that if an assignment is conditioned upon the landlord’s prior consent, the landlord may arbitrarily withhold its consent to the assignment unless the lease states to the contrary.1 To prevent a landlord from arbitrarily withholding its consent to a lease assignment, a tenant should negotiate and include a provision that states that the landlord shall not “unreasonably withhold, condition, or delay its consent” to a proposed assignment.

Even in those instances where a commercial lease assignment provision prohibits the landlord from unreasonably withholding its consent to a proposed assignment, the landlord’s consent will generally still be conditioned upon the satisfaction of certain conditions. These conditions typically include, but are not limited to, information regarding the proposed assignee and its use of the premises, copies of the proposed assignee’s financial statements, the payment of additional rent or security if the landlord approves the assignment, execution of an assignment and assumption agreement by the proposed assignee, and payment of the landlord’s attorney’s fees in connection with document review. Additionally, landlords often require that the assignor-tenant remit to the landlord all monies or assignment profits that the assignor-tenant receives from the assignee-tenant. The calculation and division of any such assignment profits is a matter of negotiation between the parties. However, the lease should provide that the assignor-tenant’s brokerage costs, expenses expended to ready the premises for the assignee-tenant’s occupancy, and its attorney’s fees be deducted from the amount of the assignment profits that the assignor-tenant is required to pay the landlord under the lease.

In addition to restricting assignments, commercial leases often contain recapture provisions whereby if a tenant requests the landlord’s consent to a proposed assignment of the lease, the landlord has the option of recapturing the leased premises and terminating the lease. If a tenant is not able to exclude the landlord’s recapture right, it is advisable to negotiate and include a specific provision in the lease giving the tenant the option to revoke and rescind its original request to assign the lease if the landlord exercises its recapture right thereby allowing the tenant to remain in possession of the premises and negating the effect of the landlord’s recapture election. This rescission right provides a tenant the flexibility to stop the recapture process depending upon the particular facts and circumstances and commercial exigencies of the tenant.

A well-drafted commercial lease assignment provision should expressly exclude transfers of the lease to an affiliate of the tenant from the restrictions of the assignment approval process. The definition of a tenant “affiliate” should be as broad as possible and include all entities related to the corporate tenant to provide maximum flexibility. Additionally, if the tenant contemplates transferring the lease to a specific entity in the future, it is advisable to incorporate this right into the text of the lease to avoid the assignment approval process and the landlord’s right of recapture.

With regard to change in control provisions, courts in many states including New York have consistently held that a transfer of a controlling shareholder’s ownership interest in a corporate tenant does not violate basic assignment provisions, which merely state that the lease may not be assigned without the landlord’s prior consent.2 The rationale behind these holdings is that a landlord entering into a lease with a corporate tenant should be aware that a corporation is an entity that exists separately from its stockholders and that a change in the ownership structure of a corporate tenant does not result in a change in the actual tenant entity that signed the lease. Consequently, if a landlord desires that a change in ownership or control of a corporate tenant be deemed a lease assignment, the lease must explicitly state so. Many commercial leases contain comprehensive anti-assignment provisions aimed at restricting changes in ownership and control of a corporate tenant. These provisions deem certain actions, such as the transfer of the corporate tenant’s stock, changes in the management or decision making of a corporate tenant or the sale of the corporate tenant’s assets to be assignments of the lease, which require the prior written consent of the landlord and trigger the landlord’s recapture rights.

If a corporate tenant effectuates a change of ownership or control of the tenant entity that is prohibited by the assignment provisions of the lease without obtaining the prior written consent of the landlord, the consequences can be devastating. Once the change of change of ownership or control of the tenant entity occurs and the tenant has failed to obtain the written consent of the landlord, the tenant may have committed an incurable default under the lease. If the lease contains a conditional limitation provision and the landlord discovers that a prohibited change of ownership or control of the tenant entity has occurred, the landlord can serve a notice to cure the default upon the tenant and if the default is not cured within the stated cure period, the landlord can simply terminate the lease. Depending upon the particular facts and circumstances, the corporate tenant may not be able to reverse the change of ownership or control of the tenant entity that has occurred in order to cure such default, which could then lead to the termination of the lease and forfeiture of the tenant’s entire leasehold estate. To avoid the draconian consequences of an incurable lease default, a corporate tenant should strive for clarity and precision in drafting change in control provisions.

By way of example, assume that Corporation X is a tenant under a commercial lease whose voting stock is owned 30 percent by Corporation A and 70 percent by Corporation B. Assume also that Corporation E owns 60 percent of the voting stock of Corporation B and that Corporation F owns 40 percent of the voting stock of Corporation B. If the lease contains an assignment provision that merely prohibits an assignment of the lease without the landlord’s prior written consent, then Corporation A and Corporation B may transfer and assign their respective shares in Corporation X to each other or to any third party without violating the terms of such assignment provision.

However, if the lease contains an assignment provision providing that any change in control of the tenant entity shall be deemed an assignment under the lease, then the transfer by Corporation B of 21 percent or more of its ownership interest in Corporation X to Corporation A or Corporation B’s transfer of 21 percent or more of its stock ownership in Corporation X to a third party would be deemed an assignment under the lease, if the term “control” is deemed to mean 51 percent or more of the voting stock of an entity.

Courts have generally held that lease assignment provisions that merely state that a change in control of the tenant entity shall be deemed an assignment only restrict transfers of stock ownership at the first level of ownership of a corporate tenant. Thus, in the foregoing example, a change of control of Corporation B would not be deemed an assignment under the lease. However, if a lease states that any “direct or indirect” change of control of a corporate tenant shall be deemed a prohibited assignment under the lease, then the transfer by Corporation E of 11 percent or more of its ownership interest in Corporation B to Corporation F or the transfer of 11 percent or more of its stock ownership in Corporation B to a third party would be deemed an assignment under the lease requiring the landlord’s prior consent. While New York courts have consistently held that a change in the indirect control of a corporate tenant will not be deemed a lease assignment unless the lease states so, it would behoove corporate tenants to negotiate and obtain a specific carve-out in the anti-assignment provisions stating that indirect changes in control of the tenant entity will not be deemed assignments under the lease, to avoid any confusion or applicability of anti-assignment provisions to these situations.

When drafting lease assignment provisions, tenants should clearly define the terms “control” and “change of control.” In doing so, a corporate tenant will help ensure that the correct determination is made in the future as to whether or not a proposed corporate reorganization or stock transfer will be deemed an assignment under the lease requiring the landlord’s prior written consent and/or triggering the landlord’s recapture rights. Further, the general criteria applicable to the granting of landlord’s consent in lease transfer situations should be tailored to exclude certain criteria that are inapplicable to change of control situations, such as the requirement that a corporate tenant pay an assignment fee or assignment profit to the landlord, an evaluation of the general reputation of the assignee, submission of the financial statements of the assignee, execution of an assignment and assumption agreement, and, if possible, the landlord’s recapture option.

In conclusion, in an ever-changing economic environment, commercial tenants may be forced to make certain decisions regarding their corporate structures and leases. In order to maintain the maximum flexibility and predictability, it is very important that special attention be paid to negotiating and including comprehensive language and exceptions to the anti-assignment provisions found in most modern commercial leases. The consequences of vague or incomplete lease assignment provisions for a corporate tenant could prove not only problematic, but in certain circumstances, a commercial and legal disaster.

Endnotes

1 See Kruger v. Page Management Co., 105 Misc. 2d 14 (N.Y. 1980).

2 See Rubenstein Bros. v. Ole of 34th Street, Inc., 101 Misc. 2d 563 (N.Y. Civ. Ct. 1979), citing: Ser-Bye Corp. v. C.P. & G. Markets, 78 Cal App 2d915; Burros Motor Co. v. Davis, 76 A2d 163; Alabama Vermiculite Corp v. Patterson, 124 F. Supp 441.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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