Leasing Basics – Assignments, Subleasing, and Transfers, Part 2, Defining and Conditioning a Tenant’s Right to Transfer

This is Part 2 of the basic series on assignments, subleasing and other transfers. Part 1 covered the difference between assignments, subleases and other transfers, and provided a short summary of California law. This post covers how transfers are defined and conditioned from the perspectives of a landlord and a tenant, how AIR forms cover these issues, and a few thoughts on how to prioritize negotiation.  

Why Are Transfer Provisions so Critical?

If you are a landlord, these provisions are your way of ensuring that you maintain control over your property. As covered in Part 1, if a lease is silent on transfers, the tenant has the right to freely sublease, assign or transfer its interest in the lease. And, to the extent a lease does restrict transfers, a court will read those restrictions narrowly and in favor of permitting transfers. For this reason, landlords need to clearly restrict all possible transfers and then carveout specific exceptions for the types of transfers they are willing to accept.        

If you are a tenant, these provisions are just as critical. I don’t know who said it first, but a general rule in business, especially in the business of real estate, is to always know what your exit plan is. If you are a tenant, your exit plan is the transfer. Tenants often need to expand, downsize, move, close or sell their businesses during the term of a lease, and there is a chance you will too. When you sign a lease for 5 - 10 years and commit to paying hundreds of thousands, and often millions, of dollars in rent and other expenses, you have to take the time to get these provisions right.

Negotiate Accordingly to Your Business Plan and Manage Risk

Before discussing the issues a landlord and tenant often negotiate, I need to add a sort of disclaimer that applies to this post and every post to follow: I may list a lot of issues but not all of them will be important for a specific transaction. Many landlord forms do not cover all the landlord issues identified here, and many tenants will not convince their landlords to make changes to cover all the tenant issues identified. And that is OK. An easy way to kill a deal, or at least waste a lot of money on attorneys, is for either party to make an issue out of everything regardless of how small the impact or likelihood.

                              Mind Tools Risk Impact/Probability Chart

                             Mind Tools Risk Impact/Probability Chart

Anytime you are working through a lease, or any other agreement for that matter, remember to (1) negotiate according to your business plan, that is, know what issues are important based on your specific business, what it is doing now and what it may be doing in 5-10 years, and (2) think about other issues from a risk management perspective, that is, prioritize issues based on what might happen, how often it might happen, and what the impact will be. This chart from Mind Tools is a good reminder. 

I’ll add to this by saying that generally you should also factor in the size of the deal and its relative importance, to you and to the other party you are negotiating with. You start with the high impact, high probability issues, and as the size or importance of the deal grows, you generally move down the scale. A lease of 1,000 square feet for 3 years cannot be negotiated the same way as a lease of 20,000 square feet for 10 years. And it goes both ways – if you are a tenant don’t ask for low priority things that don’t matter, and if you are a landlord and your tenant asks for low priority things that don’t matter, don’t be afraid to say yes to keep thinks moving.  

AIR Commercial Real Estate Association Leasing Forms

For each of these posts, I’ll briefly compare the issues identified with how those issues are covered in the AIR Commercial Real Estate Association leasing forms widely used in California. There are primarily three types of AIR forms, an office lease, a shopping center lease, and an industrial/commercial lease, and these forms come in variations – single tenant or multi-tenant, and net or gross. My comparisons will mostly be based on the multi-tenant net versions of the office, shopping center, and industrial/commercial leases. 

The comparisons are not meant to bless or condemn the AIR forms, but since the goal of this site is to be a resource, and many of you use AIR forms, this is an easy way to flag potential issues you may want to consider as a landlord or tenant. Remember, because the AIR forms are designed to cover as many transactions as possible, they are by nature generic and will often need to be revised by the parties to fit the transaction, sometimes slightly, sometimes so much that it's easier to start with another form.

A Landlord's and Tenant's Fundamental Perspective 

Let’s start with the fundamentals from a landlord’s and tenant’s perspective. If you add your own hotbutton issues to this list and keep it in mind when reading through the transfer provisions in a lease, the rest will largely be common sense.     

Landlord:

  • Control. Wants to control its property and vet and approve any new party or entity in the same way it did with the original tenant. In short, a landlord doesn't want someone in its building or center it would not have originally leased to.
     
  • Risk. Wants to minimize changes to the extent possible. The landlord got comfortable with and underwrote a specific set of facts that made up the deal – the principals or management of tenant, the tenant’s business, the guarantors, the tenant’s assets, etc. Whenever possible, a landlord will be looking to minimize, approve, or at least have notice of any changes to those facts because they may increase the landlord's risk.
     
  • Value. Wants to recover increases in value, avoid any disruption of cash flow, and ensure the space stays marketable and the tenant mix appropriate (which is always important but can be critical for a retail property).

Tenant:

  • Freedom. Wants to ensure restrictions on transfers will not unreasonably constrain internal operations –for example, entity structuring, routine transfers among affiliates, subleasing or sharing space with affiliates. 
     
  • Exit. Wants reasonable assignment and transfer rights as an exit – for example, the right to assign the lease to a third party or to sell its business.
     
  • Growth/Contraction. Wants to be able to sublease to expand or contract space as needed.
     
  • Third Parties. May need the right to encumber, pledge or assign the lease in connection with financing, franchise agreements, or partnership agreements (remember to negotiate according to your business plan).   

How a Landlord and Tenant Define Transfers 

Landlords Broadly Define – A landlord should define transfers broadly to cover every possible transfer and then carveout specific exceptions for transfers that are permitted or permitted subject to the landlord’s consent. Accordingly, restrictions on transfers should be written to apply to everything – not only to assignments and subleases – but also licenses, space sharing and occupancy agreements, encumbrances, pledges, and transfers of the ownership, control, or assets of the tenant, all whether voluntary, involuntary or by operation of law (see Part 1 for why this is important).

Tenants Carveout Exceptions – A tenant will generally accept the landlord’s broad definition of transfers but will want to carveout exceptions for “permitted transfers”. Typically these include (1) changes in ownership or control resulting from internal organizational changes and restructuring, (2) assignments or subleases to affiliates, and (3) sharing space with affiliates, clients, customers, and contractors. A tenant may also negotiate a relaxed standard for the sale of its business (especially for larger companies acquired as a going concern where the specific management or personnel of tenant is not material to the landlord).


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AIR Form Comparison:  For the landlord, while the AIR forms broadly define transfers, they could be broader still and include (1) involuntary transfers (courts distinguish between transfers “by operation of law” which are covered by the AIR forms vs. “involuntary” which are not), and (2) licenses or other space sharing or occupancy agreements. If maintaining current ownership is important, the change of control provisions could also be broader and include involuntary or voluntary transfers, and the transfer, pledge or encumbrance of ownership interests in the tenant (think death, bankruptcy, and mezzanine debt).

For a tenant, none of the typical carveouts for permitted transfers are included in the AIR forms, other than a reference to allowing vendors to use “a deminimis” portion of the premises, for what that’s worth. A tenant also needs to determine whether the restrictions on transferring voting interest or assets are acceptable. Is a restriction on transferring 25% of the voting interest or reducing the tenant’s net worth by 25% acceptable? Often these thresholds are revised up to 50% as a matter of course. But there’s more to consider: What’s “voting control”? For an LLC or LLP, does this include transfers where the manager/GP maintain control? For a corporation, is this the board or shareholders? If the board, a tenant with regular changes in the board would violate this provision repeatedly without even thinking about it. And what about transfers of assets? At minimum this should exclude transfers made in the ordinary course of business; however, for particular tenants, the provision may need to be deleted altogether.


How a Tenant's Right to Transfer is Conditioned 

With few exceptions, every lease form will require that a tenant obtain the landlord’s consent before transferring the lease (other than for the permitted transfers noted above).

The landlord's consent will generally be conditioned in two ways: First, there will be an express standard saying the landlord's consent will be reasonable or that the landlord's consent will be in its sole discretion. (And remember from Part 1, in California, if the lease is silent on the standard, then the landlord's consent must be reasonable). Second, there will be a list of conditions or grounds for denial that the parties agree will give the landlord a reasonable basis for denying a transfer.

What Standard Should Apply to a Landlord's Consent?  –  Reasonable or Sole Discretion? 

If a lease requires a landlord's consent, should that consent be reasonable or in the landlord’s sole discretion, and does it matter? Many practitioners, and I'm among them, believe the landlord's consent should always be reasonable. There are a couple reasons for this:

First, in California, most landlords want to preserve their remedy under Civil Code 1951.4 to keep a lease in place after a tenant's default, and the landlord only has that remedy if the conditions to transfers are reasonable. (See Part 1 for more detail)

Second, when the parties list out conditions to a transfer, they are really already moving beyond the "sole discretion" standard and agreeing that if those conditions are met a transfer will go through. I know I know, the lease will never say that, but that is clearly the implication, and unless a landlord has a very good reason, if a tenant doesn't hit any of the triggers for denial, it's implied that the transfer will be approved. 

Third, and most importantly, a sole discretion standard doesn't have much benefit. Although using a sole discretion standard means you don't have to be reasonable, it doesn't get you out of your obligation to act in good faith, which is a standard read into all contracts by courts in California and the majority of other states. And the line between the standards that apply when someone is supposed to act reasonably versus "just" in good faith is murky. Simply put, a sole discretion standard gives the landlord a little protection from a court second-guessing its decisions, but not much.

Most tenants request that the landlord agree to act reasonably (this avoids the hassle of potentially litigating the extent to which the landlord's sole discretion allows it to act unreasonably), and most landlords readily agree to the tenant's request.  


AIR Form Comparison: The AIR forms require a landlord’s consent but are silent on the standard that applies, so the landlord’s consent must be reasonable under the Civil Code.


Grounds for Denial – Should a Lease List These Out?

In addition to requiring that a landlord consent to any transfer, most commercial leases these days also include a negotiated list of grounds for denial, or sometimes conditions to approval, that apply to any transfer proposed by a tenant. More often than not, these are written as grounds for denial, e.g., if X is true, then the landlord can reasonably withhold its consent. I'll say "grounds for denial" to be consistent, but note that these could also be written as conditions to approval, e.g., if X, Y and Z are true, then landlord will not unreasonably withhold its consent.

Should a lease list out the grounds for which a landlord may reasonably deny a proposed transfer? For most leases, the answer is yes. It’s not required. (And as noted below, the AIR forms don’t list these out.) Simply stating that the landlord's consent is required gives the landlord the right to withhold its consent if there is a reasonable (read justifiable or legitimate) basis for doing so. However, listing out grounds for denial, which the parties agree are reasonable, shifts the burden of proof to the tenant and makes it harder for the tenant to later argue that any of these grounds are no longer reasonable. For this reason, most landlord forms do include a list.

For a tenant, it's less important that a list be included, but on balance, it’s still preferable. The reason for this is that, although the list is not exclusive, in the same way that it’s harder for a tenant to challenge a denied transfer based on a listed ground for denial, it is also harder for a landlord to deny a transfer based on a ground not listed. If a lease simply requires a landlord's reasonable consent, a landlord has a lot of leeway to make up arguments for why a transfer is not reasonable. But if a lease lists out specific grounds, it’s implied that if none of these triggers are hit, a landlord will consent to the transfer. Putting in the list also gives the tenant a chance to negotiate these points with the landlord upfront, while the tenant still has leverage.    


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AIR For Comparison: The AIR forms do not include a list of grounds for denial. The only express condition, other than the landlord’s consent, is that the tenant not be in default.


That's it for Part 2. To keep the posts from getting too long and to make it easier to find posts in the future, I'll be splitting these up. Part 3 will follow this post and cover the various grounds for denial that are most frequently seen in a lease. As you'll see, the list is surprising long.