COVID-19 - Lease Downsizing Strategies
May 22, 2020
Under its dire first page headline An Ecosystem Under Threat in Manhattan, The New York Times recently reported that many large firms are deciding whether they will ever return to their office towers with all of their pre-COVID-19 workers. They are wondering whether health concerns created by the COVID-19 pandemic might make the dense Manhattan environment less attractive for their employees and not viable for their newly adapting business models. Some employees might continue to work from home, either full or part time, or some might be relocated to suburban offices nearer their homes, so they do not have to commute via public transit.
Any commercial tenant considering whether to reduce its urban footprint will weigh these complex business concerns. As part of the process in evaluating its options, commercial tenants should include in their decision matrix the legal question of how feasible it will be to actually shed their excess space and, perhaps, limit future liability for that unneeded space. To make those important legal determinations it will be necessary to first carefully analyze the relevant provisions in the tenant’s lease.
Termination or Partial Surrender Options. Not many tenants will be fortunate enough to have previously negotiated an option that by its terms entitles the tenant to terminate or surrender its lease in whole or in part. If it exists in the lease, such option usually requires payment to the landlord of a fee, which is typically calculated as a certain allocable multiple of the monthly rental amount plus the landlord's unamortized costs for brokerage commissions, leasehold improvements, and free rent concession. Although such an option provides tenants with a clear ability to exit, it is not likely that the window of time to exercise the option and the size of the premises that may be involved will line up perfectly with the tenant’s business determination of its COVID-19 related needs and accelerated time frame.
Ability to Assign or Sublet. Absent express provisions for early termination or surrender options, the lease may still contain other key provisions which allow downsizing flexibility, even during this pandemic and its aftermath. In legal terms, this means either assigning the lease in its entirety or subletting the space, in whole or in part. Among key questions which the tenant and its lawyer must determine are:
- Under New York law, unless the lease has a provision stipulating that the landlord will be reasonable in withholding its consent to an assignment or sublet, a landlord may arbitrarily withhold its consent, and thereby can either (i) entirely prevent a tenant from employing this exit strategy or (ii) extract material lease modifications or monetary charges in exchange for granting its consent. In some leases, this landlord power may be more subtly addressed, whereby although a landlord will have agreed to not unreasonably withhold its consent to an assignment or sublet if enumerated conditions are satisfied, the lease then further stipulates that whether those conditions have been satisfied is determined by the landlord in its sole discretion. Even if the landlord is required to be reasonable, a tenant should review whether it has an effective available remedy if the landlord breaches that obligation. In many leases, tenants often agree to limit their rights for a landlord unreasonably withholding its consent solely to the right to seek specific performance in court, and typically a potential assignee or subtenant will have had to move on to another transaction rather than wait for a judicial determination.
- Even if the lease requires the landlord to be reasonable, other lease terms can make any transaction unmarketable, such as a requirement for a minimum rent under a sublease, or a prohibition on different business uses of the space than the particular use then being utilized by the existing tenant.
- Conversely, some lease terms can greatly facilitate the disposition process by, for example, requiring that only a term sheet rather than the fully signed document be presented to the landlord for its consent, specifying a short time period in which the landlord must respond (and, perhaps, even including a provision in which the landlord’s consent would be deemed approved if the landlord fails to respond), and limiting the carve-outs from the reasonableness requirement, such as allowing subletting to occupants of the building.
Lingering Liabilities. Any tenant would want to receive a full release from future liability under the lease upon the consummation of the assignment or subletting, but this is rarely found in the terms of the lease, and is very unlikely to be granted by the landlord as part of the transaction. After an assignment the assignor tenant will therefore (most likely) continue to also remain liable under the lease, as will its guarantor. This lingering liability after an assignment can present future problems if the assignee defaults under the lease because of financial difficulties. The assignor tenant would still be obligated to pay rent to the landlord, and the indemnity given by the assignee to tenant against such liabilities may not be worth much. There then may be no mechanism for the assignor tenant to mitigate its continuing obligation to pay rent by regaining possession of the space and finding another party to take over the lease (unless, upon review of the lease, there was negotiated an agreement with the landlord that would allow the assignor tenant to do so). Moreover, under New York law, a landlord is not required to seek another tenant for the space or otherwise mitigate its damages (unless the lease expressly provided otherwise). Accordingly, a landlord might allow the space to stay vacant and accrue a monthly damage claim against an assignor tenant. In contrast, in the case of a default under a sublease, the tenant still may have the ability to terminate the sublease, cure the default and re-sublet the space to a better credit subtenant (unless provisions of the lease make that impossible as a practical matter).
Recapture Exit. One scenario in which the commercial tenant wishing to assign or sublet may receive substantive relief from liability occurs when the landlord is required to be reasonable in consenting to a proposed transaction, but wants, or needs, to have control of the space. In this situation, and if the lease has a recapture clause, the landlord may take an assignment or sublet for itself or may terminate the lease in whole or part, depending on the specifics of the situation and the lease terms. If the landlord exercises its recapture option, it would be almost as if there was a free termination option, although it would give tenant a release from rent only to the extent of the then market rent. While a final result of a landlord recapture would be a beneficial outcome for a tenant in shedding its space, the fact that the landlord has a recapture right could hamper the tenant’s marketing efforts. Potential prospects may be hesitant to pursue a sublease or assignment if they know that the time and costs they incur in negotiating a transaction ultimately could prove to be pointless if the landlord exercises its recapture option. As such, it would be helpful if the lease required the landlord to either exercise or waive its recapture option before the commercial tenant begins to market its space.
Surrender Exit. Outside of the parameters of the lease, a landlord might be willing to accept a surrender of the premises from a tenant under the right circumstances. Before approaching its landlord, though, a tenant should be familiar with its available rights and strategies for downsizing under the lease, as that information may help to facilitate a better deal with the landlord. For example, if the rent under the lease was below market, then upon an assignment or subletting, the lease may permit the tenant to retain one half of any profits. That may give the commercial tenant some bargaining power in its surrender negotiations and even enable it to leverage a payment from the landlord.
As we re-enter society following the lifting of restrictions imposed by stay at home orders, each commercial tenant will begin considering how to address its respective office space needs while its business model and its employee working arrangements adapt to our post-COVID economy. In doing so, it is imperative that each commercial tenant reviews and familiarizes itself with the governing provisions of its lease in order to properly assess and maximize its available downsizing strategies.