Leasing Basics – Assignments, Subleases, and Transfers, Part 1, Introduction and California Law
/This is the first of a series on the "basics". It will take a while before there are enough posts for this website to be a usable resource, but that's the intent. So let's start with subleasing and assignments (and other transfers). Part 1 and will cover a general introduction as well as California law. Part 2 will cover drafting points from a landlord's and a tenant's perspective and then discuss how well those points are covered in the current AIR form leases.
What's the difference between an assignment and a sublease, and what other types of transfers might there be?
Assignments vs. Subleases
The difference between an assignment and a sublease is one of degree. Both involve transfers of a tenant's interest in a lease. If a tenant transfers its entire interest in the lease, then the tenant has made an assignment. The tenant as the "assignor" steps out of its tenant shoes, and a new tenant, the "assignee", takes its place. The lease then becomes a direct lease between the new tenant/assignee and the landlord.
With a sublease, the tenant stands in the middle, with no direct link between the landlord and sutenant.
If a tenant transfers less than its entire interest in the lease, then the tenant has subleased. The tenant as the "sublessor" remains in place, still liable to the landlord but now also acting as a landlord itself by leasing space to the new "subtenant" (or "sublessee" if you prefer). In that case, the landlord and the subtenant do not have a direct relationship with each other, and in fact, the default rule is that subtenant has no obligations or liability to the landlord because the tenant/sublessor acts as a middleman standing between the landlord and subtenant, with all rights and obligations relating to the space flowing through the tenant/sublessor.
The typical example of a sublease would be when a tenant leases a portion of its space or leases space for less than the entire term of the original lease with the landlord. But don't be fooled, even if a tenant leases its entire space for the entire term, if the tenant retains the right to take back the space following a default by the subtenant (called a right of reentry), then the parties have still entered into a sublease because the tenant has not truly relinquished all of its rights under the lease.
If you ever need to determine whether there is a sublease or an assignment, just ask this question: If the new tenant stops paying rent and the lease is terminated, who takes back the space? If it is the original tenant, then you have a sublease. If it is the landlord, then almost always you have an assignment.
Other Types of Transfers
Because there are more ways to transfer a tenant's interest in a lease than an assignment or sublease, most commercial leases provide that the restrictions on assignments and subleases apply to a list of other types of transfers as well. Generally these include a transfer of the ownership interest or a change in the control in the tenant, a license or other occupancy agreement, an encumbrance of the lease as collateral (e.g., in California, a deed of trust), and a reference to involuntary transfers or transfers by operation of law. These categories are discussed briefly below:
Transfers of Ownership or Control in Tenant. If a tenant wants to sell its business, it might do so by selling all of its assets, in which case the tenant would transfer all of its interest in its assets including the lease, which would be an assignment. But what if instead, the tenant structures the transaction as a sale of stock (or more likely nowadays, a sale of membership interest in an LLC)? There would be no transfer of the lease and therefore no assignment because the original tenant doesn't change, it just gets a new owner. For most landlord's though, unless the tenant is a large organization, a change of ownership has the same practical effect as an assignment of the lease. It's a type of backdoor assignment. The owners may be acting through the original tenant entity, but they are still new owners. The landlord is still dealing with someone that it didn't initially underwrite or enter into the lease with. The same is true even if the ownership interest in the tenant remains the same but there is a change of control, for example a new manager or general partner. To capture these events, many forms provide that a transfer of interest in the tenant or a change of control is a transfer restricted in the lease. (We'll talk a bit more specifically about what a landlord or tenant may want to include in a lease on this topic in part 2).
Licenses and Occupancy Agreements. As with assignments, there is also a backdoor type of sublease, and that is the license or occupancy agreement that gives another person/entity the right to use the tenant's space but perhaps not exclusively or for a fixed term. For example, if you are a tenant, instead of giving someone the right to use a portion of your space exclusively, you might just agree that they can share your space. Or,you might be approached by someone wanting to use your space to sell its goods (e.g., a concession stand) or hold a promotional event. Often from a landlord's perspective, especially if on an ongoing basis, these arrangements have the same practical effect of a sublease because there are new people using the tenant's space and almost always paying the tenant for that use.
Mortgage, Pledge or Encumbrance. A tenant might also encumber its interest in the lease with a deed of trust or otherwise pledge the lease as security for a loan or other obligation which gives the creditor the right to take over the tenant's interest in the lease if the tenant defaults. Here, although the tenant has not actually assigned the lease, it has promised to do so if it defaults on its obligation to the creditor.
Death or Bankruptcy. Finally, another type of assignment can occur when when the lease is transferred without the consent or involvement of the tenant. The two primary examples of this would be the transfer of a lease following the death of an individual tenant or tenant bankruptcy proceedings in which the bankruptcy trustee assigns the tenant's interest in the lease to a third party. In both cases the transfers are by operation of law and involuntary -- the tenant is not involved and does not consent. Some courts apply the terminology "by operation of law" to a transfer after death and "involuntary" to transfer in bankruptcy proceedings. Other courts find no difference. To be safe, a lease might restrict transfers "whether voluntary or involuntary, and whether effected by death, operation of law, or otherwise."
California Law on Transfers
The general rules:
PresenterMedia
You are free to agree on what you want. California law on transfers is fairly straightforward. The general rule is that unless illegal or unconscionable, whatever the parties agree on in the lease regarding transfers will be enforceable. A lease may prohibit transfers altogether or permit transfers subject to specified conditions, the most common condition being that a landlord consent to transfer before it is made.
If you are silent, rules will be implied. The only time standards are implied into a lease is when the lease is silent, in which case: (1) if the lease is silent on transfers altogether and neither prohibits nor permits them, then a tenant may freely transfer the lease; and (2) if the lease requires the landlord's consent, but does not specify the standard that applies to such consent, then the landlord's consent must be reasonable.
If you are unclear, what you say will be interpreted as narrowly as possible. If any restriction is particularly important to a landlord, the landlord needs to make that restriction crystal clear because courts are required to interpret any ambiguity in favor of transferability. In other words, if a lease does not expressly impose a condition on a transfer, a court will not read it in, and if a restriction is unclear, it will be interpreted as narrowly as possible.
All of these rules and the others noted below are found in Sections 1995.010-1995.340 of the California Civil Code. (Note that there is one exception to the general rules above, which is that if your lease was entered into on or before September 23, 1983, unlikely unless you have a ground lease or other long-term lease, and the lease requires the landlord's consent but is silent on the standard that applies, the landlords consent need not be reasonable. )
If you want a "transfer" to include a transfer of interest or control in the tenant, you have to say so in the lease.
A "transfer" as used in the Civil Code includes an "assignment, sublease, or other voluntary or involuntary transfer or encumbrance of all or part of a tenant's interest in the lease." Some commentators reason that this is such a broad definition, it covers a transfer in the tenant as well. But that's not the case. The key part part of the definition is the last part: "a tenant's interest in the lease." As we discussed above, a transfer of an interest in a tenant is not a transfer of a lease, and when you recall the rule about any ambiguities being interpreted in favor of transferability, it should be clear that if a landlord wants to prevent a tenant from making this type of transfer, then the landlord needs to specifically say so in the lease.
After a transfer, the original tenant remains liable under the lease.
If a tenant subleases, the tenant of course remains liable under the lease -- the tenant is still in possession, still paying rent, still the only party directly obligated to the landlord. (Remember, with a sublease there is no direct link between a subtenant and the landlord -- everything, including including liability flows through the tenant).
But even if the tenant makes a complete assignment of the lease, the default rule is that the tenant remains liable under the lease -- and not only for the initial term, but for any extension options that were granted before the assignment. If you are a tenant (or guarantor) this is something to carefully consider. Even though you are out of the picture and the new tenant has taken over the lease and is directly liable to the landlord, if the new tenant stops paying rent or otherwise defaults under the lease, the landlord can come come after you to collect.
There are two caveats: First, this is just a default rule. The parties are free to negotiate and generally do. For example, a lease might provide that if the new tenant/assignee meets certain conditions (e.g., same amount of money as the original tenant, same use, and operational experience) and performs for a period of time after the assignment, the original tenant and any guarantors will be released. Second, this rule only applies to the original lease as assigned. If the landlord and new tenant extend the term of the lease (beyond any extension options granted before the assignment) or materially change the terms of the lease, the original tenant is no longer on the hook.
A landlord may require that the tenant pay over bonus rent, but the requirement must apply only to rent and must be in the lease before the proposed transfer.
Bonus Rent!
Remember the general rule is that the lease may include any condition to a transfer so long as not illegal or unconscionable. This also applies to a provision requiring the tenant to pay the landlord all or a portion of any rent the tenant receives from the new tenant/subtenant in excess of what is required under the lease (often called "bonus rent").
The parties are free to make the payment of bonus rent a condition of a transfer, but it must be stated in the lease and can only apply to rent. Courts have held that requiring more than excess rent, for example, a portion of the proceeds of a sale of the tenant's business, would be unconscionable. Court's have also held that the obligation must be in the lease. For example, if a lease only requires the landlord's consent, the landlord cannot condition its consent on receiving bonus rent. Courts have found that to be unreasonable and a violation of the covenant of good faith and fair dealing.
One additional caveat: Although a provision requiring a tenant to share some or all of its bonus rent is generally enforceable, if the tenant goes through bankruptcy, the provision will be invalidated because the bankruptcy code (11 U.S.C. 365(f)) invalidates any provision that restricts or conditions tenants ability to realize the full economic value of its lease on assignment.
If any of the conditions to a transfer are unreasonable, or if the lease prohibits transfers altogether, the landlord loses its remedy under Civil Code §1951.4
Having just said repeatedly that a lease may include any condition to a transfer, I have to condition that by saying, but only if the landlord doesn't want to keep its remedy under Civil Code Section 1951.4.
Section 1951.4 of the California Civil Code gives the landlord the right to keep a lease in place after the tenant defaults and continue to enforce the landlord's rights under the lease and collect rent. It's essentially an anti-escape-hatch clause. If the tenant shuts down and abandons its space, the landlord can decide to hold the tenant to the lease and continue to recover rent as it becomes due. I'll cover this remedy in more detail in a future "basics" post on California remedies, but for now it is enough to say that for a landlord to have this remedy (which few landlords use in practice but most landlords want the option of using) the following must be true: (1) the lease must expressly say that the landlord has the remedy provided under Section 1951.4; and (2) there must be no unreasonable restrictions on transfers. Incidentally, this is why when a tenant asks that a lease be revised to say that the landlord will not unreasonably withhold its consent to a transfer, the response the landlord almost always gives is, "that's fine."
What happens when the parties don't follow the rules?
If a tenant or landlord is the bad actor, it can lose its lease and face contractual damages.
What happen if these rules are broken? What if a tenant ignores restrictions on transfers and makes a transfer anyway? What if a landlord refuses to consent to a transfer when all of the conditions in the lease have been satisfied? If the tenant is the bad actor, in addition to suing for breach of lease, the landlord may terminate the lease and sue for contractual damages. The same rule applies if the landlord is the bad actor. If the landlord refuses to permit a transfer when the conditions in the lease have been satisfied (or if there are no conditions) or unreasonably withholds its consent when the lease imposes a reasonable standard, then in addition to suing for breach of lease, the tenant may terminate the lease and sue for contractual damages.
Note that this remedy has more of a bite for a landlord that wrongfully refuses to consent to a transfer than for a tenant that wrongfully makes a transfer. In the tenant’s case, the landlord's damages would be fairly limited. However, in the landlord’s case, the damages could be substantial and include lost profits from the planned sale of the tenant’s business or the profitable sublease or assignment that the landlord wouldn't let go through.
If a transferee is the bad actor, it will lose its lease and face contractual damages along with the tenant.
The Civil Code also imposes significant liability on the third-party that accepts a wrongful transfer. Under Section 1995.330, the third party steps up next to the tenant and becomes jointly and severally liable with the tenant for any contract damages the landlord claims. That’s a good reason for any transferee to protect itself and require the landlord’s consent, or if consent not required, the landlord's acknowledgment of the transfer.
Further, the Civil Code expressly gives a landlord the right to terminate the lease or to terminate the transfer and keep the lease in place. In other words, if a transfer is wrongful, the landlord has the right to unwind the transaction, and then sue the tenant and the transferee for damages. (Note that some lease forms restate this remedy, saying that the landlord may void the transfer, but the Civil Code does not require that a lease to recite this remedy).
The rules above apply to any subsequent assignment.
And finally, a good way to wrap this up is to the say that under Civil Code Section 1995.340, unless the lease or landlord expressly state otherwise, all of the rules above apply to any subsequent assignment the new tenant may wish to make in the future.
That's it for part 1. In part 2, we'll cover points that a landlord and tenant may wish to address in the section of the lease covering transfers and how well AIR forms cover those issues.
Photo Credits:
Middleman image & California law by PRESENTERMEDIA
