Subtenants Should Carefully Consider Legal Issues of Sublease Arrangements

by Pepper Hamilton LLP

Depending on the situation, sometimes leasing space from another tenant is a good business decision in terms of price, location and size. While a sublease arrangement makes sense from a business perspective, a subtenant should consider the legal issues involved with a sublease arrangement before moving forward.

A subtenant needs to understand that any rights it has to lease the subleased space from its sublandlord derive from and will be subject to what is commonly referred to as the master lease, which is the lease agreement between the sublandlord (as tenant) and its landlord. Given this fact, a careful review of the master lease is necessary. The sublease agreement may need to address certain items provided for in the master lease that do not reflect the sublandlord and subtenant’s agreement. Moreover, since the sublease will be subject to the master lease, the subtenant will need to understand the legal ramifications of the master lease terminating or expiring before the term provided for in the sublease.

The following is an illustrative list of issues a subtenant should consider before entering into a sublease agreement:

  1. Verify that the master lease provides the tenant/sublandlord the necessary rights to lease the space purported to be subleased under the sublease agreement.

  2. Verify that the term of the sublease agreement matches up with the term under the master lease (i.e., the term under the sublease should not be longer than the term under the master lease).

  3. Ensure that the sublease agreement properly provides for the exact terms and conditions of the master lease that will apply to the sublease agreement. Typically, the sublease agreement will provide that the sublease agreement is subject to all of the terms and conditions set forth in the master lease as if the sublandlord were the landlord under the master lease and the subtenant were the tenant under the master lease. Accordingly, to the extent there are provisions in the master lease that do not reflect the business deal between the subtenant and the tenant/sublandlord, it will be important to specifically exclude these provisions from the sublease or modify these provisions in the sublease, as applicable. For example:

    (a) Does the tenant have obligations to make certain repairs to the space it leases under the master lease? If so, do these obligations reflect the business deal between the tenant/sublandlord and the subtenant under the sublease arrangement?

    (b) Is the tenant responsible for a pro rata share of certain expenses under the master lease? If these costs are to be passed on to the subtenant under the sublease, it will be important to clearly identify the subtenant’s applicable share thereof, as appropriate.

    (c) What are the tenant’s obligations under the master lease to restore the premises following the expiration/termination of the master lease? The restoration obligations under the master lease may not necessarily reflect the business deal between the tenant/sublandlord and the subtenant. For example, the tenant/sublandlord may have the obligation to remove certain alterations made to the subleased premises arising prior to the subtenant leasing this space, whereas the expectation between the tenant/sublandlord and the subtenant is that the subtenant deliver the space back to the tenant/sublandlord in the condition existing when the sublease arrangement commenced.

    (d) What are the tenant’s insurance obligations under the master lease? It may be appropriate to adjust the insurance amounts imposed on the tenant under the master lease if the subleased space is less than the space being leased under the master lease. Also, coordination with the subtenant’s insurer will be important to confirm that the subtenant is able to comply with the insurance requirements imposed.

  4. Determine whether the master landlord’s consent is required for the sublease arrangement. If consent is required, the parties should be seeking the master landlord’s consent as early in the process as possible, so as to avoid spending too much time and money on an arrangement that the master landlord will not approve. Moreover, the consent is usually evidenced by a tri-party agreement between the master landlord, the tenant/sublandlord and the subtenant. Ideally, the consent to sublease agreement is signed at the same time the sublease agreement is signed. Many times, however, the master landlord will require a signed copy of the sublease agreement in connection with their review and approval of the arrangement. In this case, it will be important for the sublease agreement to provide: (a) that the sublease agreement is conditioned upon receipt of the master landlord’s consent, and (b) an outside date by which the consent must be obtained, and if not obtained within this time period, that the sublease agreement will automatically terminate.

  5. Determine if consent is required under the master lease or sublease for any alterations or improvements to the subleased space. If so, and these alterations are required for the subtenant to be able to use the subleased space as contemplated, the subtenant should obtain approval for these plans from the master landlord and the sublandlord at the same time that the subtenant enters into the sublease to eliminate any risk that these plans will not be consented to by the parties. Oftentimes, the consent for such improvements may need to be addressed in both the sublease and the consent to the sublease agreement.

  6. Consider obtaining from the master landlord an estoppel certificate providing for basic information such as: (a) certifying that the master lease attached to the estoppel certificate is a true, correct and complete copy of the same; (b) that the tenant/sublandlord is not in default of any of the terms of the master lease; and (c) whether there are any mortgages or deeds of trust affecting the property. Oftentimes, these items can be provided for in the consent to sublease agreement.

  7. Consider entering into an attornment agreement with the master landlord to protect the subtenant’s rights to the subleased premises. Since the subtenant’s rights under the sublease agreement derive from the master lease, if the master lease terminates or expires, then the subtenant will no longer have any rights to lease the subleased space. A subtenant can avoid this issue by entering into an attornment agreement with the master landlord and tenant/sublandlord to allow the subtenant to continue to lease the subleased space. This agreement will need to be obtained at the same time the sublease agreement is signed, otherwise the master landlord will have no obligation to recognize the sublease. An attornment agreement can be structured in many ways, but generally takes two forms:

    (a) If the tenant under the master lease agreement (subtenant’s landlord) defaults thereunder, the subtenant receives notice of the default and is provided with the opportunity to cure. If the subtenant cures the tenant’s default, the subtenant steps into the shoes of the tenant and essentially takes over the master lease, thereby taking over the master lease agreement and “attorning” to the master landlord. The attornment agreement would also provide that in this scenario: (i) as between the master landlord and the tenant, the rights and obligations under the master lease from such date forward would terminate, and (ii) as between the tenant/sublandlord, the rights and obligations under the sublease from such date forward would terminate. However, if the subtenant is not leasing all of the space leased to the tenant/sublandlord under the master lease, or if the rent under the master lease is much higher than what the subtenant is paying under the lease, this structure may not make sense.

    (b) Rather than taking over the tenant’s master lease, the attornment agreement could provide that the master landlord will step into the shoes of the tenant/sublandlord under the sublease agreement, thereby creating a direct relationship between the master landlord and the subtenant under the sublease agreement.

  8. Determine whether a subordination, non-disturbance and attornment agreement (SNDA) is in place. While the attornment agreement described above will protect a subtenant from any default by the tenant/sublandlord under the master lease, an SNDA protects the subtenant if the master landlord defaults under the master lease so that the master landlord’s lender forecloses on the property. A subtenant should first determine whether the tenant was able to negotiate an SNDA with the master landlord’s lender, and if so, review this SNDA to determine whether it will apply to its sublease arrangement. If the existing SNDA will not benefit the subtenant or there is no SNDA in place, the subtenant should request that the master landlord’s lender execute an SNDA in its favor.

The items highlighted above are just a few examples of how a sublease and master lease are related and the complicated and often opposing goals of the parties to a sublease transaction. Accordingly, it is important to carefully review and negotiate these documents.

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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