Month: August 2022

Co-tenancy clauses in leases can take many forms, but the most commonly used clause ties one tenant’s obligations under its lease to another tenant’s continued occupancy or to the general performance or makeup of the retail center, and once these clauses are triggered they usually grant the tenant with the right to terminate its lease, reduce its rent payments, or both. This article will focus on ongoing co-tenancy clauses that tie performance to the continued occupancy of another tenant, which is usually the anchor tenant at the applicable retail center.

Pitfalls of a Co-Tenancy Clause

A co-tenancy clause may seem like an innocuous lease provision that attracts those highly coveted national chains to your retail center. As with many optimistic developers, you may take the position that these clauses will never be triggered. The anchor tenant is locked into a fifteen year lease and has constructed millions of dollars’ worth of tenant improvements in its space so there is little or no risk with the tenant leaving. This mentality is dangerous and can lead to your retail center imploding. Imagine a scenario where all the national chains in your center have a co-tenancy provision directly or indirectly tied to a Target store. Nobody would expect Target to close up shop and leave, especially if the economy is good. However, the same could have been said of Kmart twenty years ago and look where Kmart is today. We do not know what the future holds for Target regardless of its strength today. Target may also be a party to a merger that obligates the new company to close stores due to antitrust concerns or synergies. Now imagine that Target does close. This closure triggers each of the national chains’ co-tenancy provisions, who slowly leave your center. The closure of the retail chains and Target reduces foot traffic and all of your independent stores’ sales drop so they can no longer pay the rent. Before you know it you are booking Kevin Smith’s next movie at your mall because you have no tenants and your mall is empty. This horrific scenario has occurred throughout the United States and is all the result of an indifferent or negligent treatment of co-tenancy provisions.

Limiting a Landlord’s Exposure

A landlord’s first response to any tenant requesting a co-tenancy clause should be to say no. If the tenant has sufficient leverage and is willing to walk without such a clause, a landlord should find ways to limit its exposure. First, a landlord should propose a rent reduction upon the co-tenancy triggering event, and the reduction should be limited to base rent. As an alternative the landlord could propose to convert the base rent provision to a percentage rent provision so that the landlord would not lose income if the retail center continues to perform. Even if the tenant demands that all rent abate once the co-tenancy provision is triggered, the overall impact on the retail center under a rent reduction approach will be minimized as the tenant will not have a termination right and will still attract customers to the center. The landlord will also not have a series of vacant premises. That makes attracting new tenants difficult. If the tenant still insists that it needs a termination right, the lease should obligate the tenant to exercise the right within a set period of time or the right expires so that the tenant’s option does not hang over the landlord’s head indefinitely.

Second, a landlord should have the right to find a replacement co-tenant if the original co-tenant leaves, particularly if the tenant has a termination right. For example, Banana Republic should be fine with either a Macy’s or a Nordstrom’s as both should have a sufficient draw to the retail center so Banana’s co-tenancy termination right should not be triggered if Macy’s leaves and Nordstrom’s takes the premises within one year after Macy’s leaves. The landlord may even want to list the permissible replacement co-tenants or types of co-tenants so that the tenant cannot subsequently claim that the replacement co-tenant is inadequate. The amount of time that a landlord should have to find the replacement tenant should increase with the size of the co-tenant’s premises as it is far more difficult to find a tenant for a 50,000 square foot store as it would be for a 10,000 square foot store. A landlord should also add language that gives the landlord with the flexibility to break up the co-tenant’s space and lease to two or three smaller tenants if no one tenant is willing to take all of the space, although many tenants will baulk at such a request. The lease should further state that the rent reduction or termination right expires immediately if a replacement co-tenant signs a lease even if the landlord is unable to find a replacement co-tenant within the time period specified in the lease.

Third, a landlord should add language that prevents the co-tenancy provision from triggering if the tenant’s gross sales exceed a specified amount. Alternatively, the landlord should require that the tenant demonstrate that the vacancy of the co-tenant lead to a decrease in revenue compared with prior years before it is triggered. The justification for a co-tenancy provision is that a tenant’s financial health is tied to the existence of the co-tenant so the tenant should not object to limiting the applicability of the co-tenancy clause to situations where the tenant’s financial health is, in fact, negatively impacted.

Fourth, the lease should exclude situations where the tenant is either currently in default under the lease or has gone dark. A tenant that has violated its lease or which is no longer operating in the premises should not have the right to object to another tenant vacating.

Fifth, the landlord should confirm that the co-tenancy clauses makes it clear that the tenant’s only remedy is termination or reduction in rent, as the case may be, and not damages. A landlord will want to avoid any litigation where the tenant claims that a landlord made certain representations as to the makeup of the retail center and the representation was violated upon the vacancy of the co-tenant.

Finally, a landlord should request concessions out of the tenant that requests a co-tenancy clause. It is only fair that the tenant agree to a go-dark prohibition, additional percentage rent requirement, a longer lease term, or other provision that benefits the landlord if the landlord is granting a co-tenancy clause. Such a clause puts most of the risk on the landlord when the economy declines so the landlord should be able to enjoy some of the perks of a good economy and the tenant should do all that it can to make sure that the retail center continues to perform.

Co-tenancy provisions can be helpful, and sometimes essential, for attracting many of the national retail chains, but a landlord should be careful when granting such a right, and should limit the clause’s scope as much as possible. A landlord should also always consider its overall exposure so that one closure does not lead to the chain reaction that bankrupt’s the landlord’s retail center.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.

The most commonly used co-tenancy clause ties one tenant’s obligations under its lease to another tenant’s continued occupancy or to the general performance or makeup of the retail center, and once these clauses are triggered they usually grant the tenant the right to terminate its lease, reduce its rent payments, or both. This article will focus on why a tenant would want a co-tenancy clause in its lease and how to make the landlord accept such a clause.

Benefits of a Co-Tenancy Clause

The ultimate objective of the typical tenant is to sell enough products or services in its store to make the leasing of its space an economic benefit to the tenant’s overall business. The driving force behind the success of a tenant’s business in a retail center is the customer traffic at the center, and a tenant’s business will suffer substantially if the retail center does not drive sufficient customer traffic. Such a driver could be a large anchor tenant like Target or Macy’s, or a small chain store with a substantial national presence or recognition. A tenant that ties its obligations under its lease to the presence of the anchor tenant or national retailer, or to the general performance of the mall, reduces its risk associated with downturns in the tenant mix or performance of the retail center. Such a term may make the difference between a tenant’s survival and its bankruptcy.

An additional concern with retail centers is that many of the big name tenants have the negotiating power to require a co-tenancy provision in their leases so most of these tenants will have the right to leave if an anchor or a key tenant closes its doors at the retail center. A smaller tenant with less clout does not want to be the only one without this right. If the tenant does not include such a provision in the lease, the tenant may find that it is leasing a space in a building with few tenants and no customers under a lease with a term that does not expire for several years. Such a scenario will cause the tenant to bleed cash until its proverbial death.

Making the Landlord Accept a Co-Tenancy Provision

For those retail centers with spaces that are highly competitive and lucrative a tenant will have little success in negotiating a co-tenancy provision, but such a provision may not be necessary as the mall itself is the driving force behind the customer numbers (e.g. the Mall of America). For other malls it will be a question of negotiating power and how badly the landlord wants you to lease its space. There are ways that a tenant can help the landlord to swallow the very large pill that is a co-tenancy provision. The first would be to give the landlord substantial opportunity to find a replacement tenant before the co-tenancy clause kicks in. A tenant that agrees to such a concession will want to limit the language so that the replacement tenant has the same reputation and draw that the prior tenant had or the co-tenancy provision will become worthless. A tenant that ties its lease obligations to a large anchor tenant will also want to guarantee that the replacement tenant has the same or similar square footage as size does often matter in the retail world.

A second negotiating point that a tenant could try is to eliminate the termination option present in many co-tenancy provisions and replace it with a base rent reduction. As stated above, the goal of the co-tenancy provision is to reduce the tenant’s risk associated with a poorly performing retail center. By removing the termination right, the landlord keeps its tenant, but the tenant does not have the burdensome monthly rent payment that it needs to meet if the retail center tanks. Such a clause may be more advantageous than a termination right to many smaller retail tenants as the tenant may not have the funds to build out a new space if the lease is terminated. If a tenant agrees to such a provision, the tenant should also consider whether it wants to limit its liability under common area maintenance charges. First, the tenant should attempt to limit the landlord’s ability to pass on certain costly expenses (e.g. capital improvements). Second, the tenant should attempt to eliminate the landlord’s ability to “gross up” other operating costs (clauses that permit the landlord to increase a tenant’s proportionate share of occupancy-dependent operating costs). Such limitations will reduce the tenant’s economic risk and monthly rent burden.

A third concession could be to limit the co-tenancy provision to situations where the tenant demonstrates that the tenant’s sales have actually fallen after the anchor tenant or national retailer vacated its space. This last concession will be burdensome for the tenant as some time will need to pass before the tenant will be able to demonstrate that its sales have fallen. Such a concession will also lead to issues with how sales will be calculated as our world is increasingly becoming online and as there may be anomalies in the tenant’s sales figures. The burden will also shift to the tenant to prove the drop in sales and the tenant can guarantee that the landlord will attempt to discredit the tenant’s figures. This last concession should be used sparingly.

Despite gallant efforts, many tenants will not be successful in adding a co-tenancy clause to their leases. An indirect method for accomplishing the same goal is to convert the base rent provision in the lease to a percentage rent provision so that the tenant’s rent burden is tied to the performance of the tenant in its space. Most landlords will not cap the tenant’s total monthly percentage rent amount to the same base rent amount that the landlord previously agreed to so a tenant may end up paying more in a good market. However, this should not be a concern for the tenant as the tenant will be earning more in such a market and will receive a beneficial concession in a down market.

A co-tenancy provision can definitely be a benefit to a retail tenant. A tenant should do what it can to include one in its lease. By reducing the risk to the landlord as described above, a tenant should be able to convince the landlord to accept such a clause.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.

Since we do not live in an ideal world where each and every tenant has a perfect credit history and pays all amounts that are due under its lease, landlords must fortify leases with certain security-enhancing measures that protect against the possibility of a tenant default. Such measures may also discourage a tenant from willfully defaulting under the lease. A savvy landlord will consider its exposure when entering into a lease and will determine each tenant’s credit-worthiness before determining which security measures to insert into the lease. There are many forms of security that a landlord can use. This article will discuss the mechanics and the general pros and cons of the following lease security enhancements: (i) security deposits, (ii) guaranties, (iii) security interests (liens), and (iv) standby letters of credit.

Damages to Consider When Calculating Sufficient Security

The first step in the process is for the landlord to determine its potential exposure upon a lease default, which is not merely limited to lost rent. The landlord may have granted the tenant a free rent period or an allowance, may have undertaken improvements to the premises, and will probably have incurred transaction costs in connection with the execution of the lease including leasing commissions and legal fees. All of these costs decrease the landlord’s bottom line and were likely incorporated into the calculations for determining the amount of base rent that the landlord was willing to accept. These amounts should be considered when determining what types of security measures the landlord will accept and whether the security is sufficient. The landlord’s lease should also make it clear that the unamortized amounts of these costs can be recouped if the tenant defaults and the lease is terminated earlier than the scheduled expiration of the term.

Security Deposits

Cash is king. The more cash that a landlord has on hand, the better off that landlord will be in connection with a tenant default. No other security method compares to a security deposit as the landlord does not need to seek remedies through a court proceeding, make a demand on the provider of a letter of credit, or hold a sale of the tenant’s personal property. The landlord can simply apply the cash to the amount that the landlord is owed under the lease. The issue with this form of security is that most tenants do not have substantial cash reserves that they can hold in an account. Most tenants will also balk at tying up a significant cash balance as it may hinder the growth of their business. A landlord will likely not be able to obtain a security balance exceeding the equivalent of a couple of months of rent obligations under the lease for these reasons and due to market standards. The approach that the landlord should take is to obtain as high of a security deposit that it can obtain, but fill the gaps with other forms of security.

Guaranties

A guaranty is an essential form of security from a landlord’s perspective in that it creates a situation where the owner of the tenant cannot walk away from a bad business. Absent a guaranty, the owner of a corporate tenant will not be personally liable for the debts of the tenant as the corporate structure of the tenant creates a liability shield between the tenant and the tenant’s owners. Due to this situation a prudent landlord will always obligate the principals of the tenant to sign a guaranty unless the tenant’s balance sheet is incredibly strong.

Actually enforcing a lease guaranty is not simple. The guarantor is unlikely to pay upon demand. Instead, the more likely scenario is that the landlord is forced to sue upon the guaranty and the guarantor will fight the landlord in court. The landlord would not see any cash until either a settlement is reached at a fraction of the amount that is due, or the issue is litigated to judgment, which could be difficult to collect upon. In either case the landlord has incurred legal fees that may exceed the amount that the tenant owes (although a landlord can reduce the latter exposure by including language in the guaranty that the landlord is entitled to legal fees and costs in connection with any enforcement action). Another possible nightmare for the landlord is that the guarantor no longer has assets that can be applied to the tenant’s debt. The tenant’s business and the guarantor’s financial health are likely tied to each other so a tenant that is defaulting is usually a good sign that both the tenant and the guarantor are on the verge of bankruptcy. Simply put, exercising rights under a guaranty is an uphill battle for the landlord and a landlord should not solely rely on this form of security.

One additional issue that a landlord should take into consideration when requiring a guaranty is whether to include the guarantor’s spouse on the guaranty. Minnesota is not a community property state so one spouse may not have any ownership interest in the assets of the other spouse. A landlord will not know how spousal assets are treated or how the assets are transferred between the spouses. A careful landlord will have both the owner of the tenant and the owner’s spouse sign the guaranty.

Security Interests in the Tenant’s Property

Of the lease security measures discussed in this article, the least used and the one that is least recommended by the authors is a security interest in the tenant’s property. Some landlords require that each tenant grant to the landlord a security interest (or a lien) in the tenant’s personal property that is located in the premises, such as inventory, equipment, and furniture. Tenants usually fight such clauses in the lease negotiation process. As such, security interest clauses in leases are uncommon. However, when in place and perfected, the security interest allows the landlord a mechanism to acquire ownership of the tenant’s personal property upon a default under the lease. The remedy process is complex and is rarely fully acted upon.

A security interest in a lease is only enforceable if the landlord takes the next step to “perfect” the security interest, and it is only collectible if other superior lien holders (such as the tenant’s lender) do not apply proceeds from the sale of the tenant’s assets to their debts. To perfect a security interest in tangible goods, the landlord must file a UCC-1 financing statement. For tenant entities formed in Minnesota, the UCC-1 must be filed with the Minnesota Secretary of State’s filing office. Many landlords ignore, or are unaware of, this crucial second step of perfecting the security interest by filing the UCC-1, which renders the grant of security interest meaningless. UCC filings lapse after five years unless the filing is properly and timely renewed.

There is a place in the lease where security interests are highly recommended. Landlords should add a provision in the security deposit section of the lease that grants to the landlord a security interest (or a lien) in the tenant’s security deposit. Since the deposit is cash that is delivered to the landlord, the security interest in the deposit is perfected simply by mere possession (no UCC filing is needed). The reason for obtaining a lien on the security deposit is in case the tenant files bankruptcy and the bankruptcy trustee demands the return of the security deposit as cash that should be a part of the bankrupt’s estate. In such a case the landlord can resist such a demand under the argument that there is a perfected lien on the security deposit that renders it as the landlord’s cash collateral. Thus the landlord ought to be deemed a secured creditor that is entitled to adequate protection of its collateral (which is the security deposit).

Standby Letters of Credit

A standby letter of credit (LOC), where the tenant’s bank agrees to deliver funds to the landlord if the tenant defaults under the lease, is a solid form of lease security due to something called the “independence principle”. This means that the letter of credit is an independent agreement and payment under it will be made if the tenant defaults under the lease even if the tenant files for bankruptcy. However, at least one court in California has held that the automatic stay from a tenant’s bankruptcy prevented the landlord from drawing on the LOC, and another held that the draw on the LOC creates a cash security deposit that is the property of the estate. Thus, the benefit afforded by the independence principle is no longer clear in at least one other state and could be eroded by other courts.

The key to a good standby LOC is to be very careful about the actual language on the face of the instrument. It must be clear that the landlord can draw on the LOC whenever there is a default. Avoid any further steps, such as statements that require the landlord to first give written notice and the opportunity to cure before drawing upon the LOC.

Ultimately, no form of security is perfect and all forms have certain benefits and costs. A diligent landlord will determine the financial strength of the tenant and fit the form of security for the applicable tenant.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.

The view of the tenant in connection with security measures required under a lease is quite different from that of the landlord. Many tenants are entrepreneurs and all tenants want to reduce or eliminate any liability associated with a failing business. The obligations under the tenant’s lease are one of the largest risks. A tenant will therefore want to minimize its exposure as much as possible, or even eliminate it altogether. Successfully reducing or eliminating the lease security measures is the best way to accomplish this goal.

Security Deposits

The most commonly used form of lease security is the security deposit. It is omnipresent and very familiar to tenants. Most landlords require one month’s rent along with an obligation that the tenant replenish any amount of the security deposit that is applied to a tenant default. The upside to a security deposit is that it may provide sufficient comfort to a landlord so that the landlord does not require another form of security so the exposure of the owner of the tenant will be capped. The downside is that the landlord controls the tenant’s money so the tenant will likely not see any of the security deposit if the relationship goes south, the return that the tenant will make on the security is minimal, and the tenant’s funds are tied up for the length of the lease. Of the types of security measures employed by landlords, security deposits are the most innocuous and should be favored by tenants.

Letters of Credit

Standby letters of credit (“LOC”) are a benefit to landlords as the landlord does not need to look to the tenant to be made whole. The landlord can simply draw on the LOC whenever the tenant defaults so the landlord is guaranteed a repayment source. LOCs are not, however, a benefit for tenants and should be avoided. A tenant will have to pay both an issuance fee and an annual fee for the entire term of the LOC (which costs can be substantial), and the tenant will lose the ability to control any dispute with the landlord as the letter of credit will provide that the lender must permit the landlord to draw on the letter of credit if specific preconditions are satisfied. There is very little upside for a letter of credit from a tenant’s perspective so a tenant should eliminate any language requiring one if possible.

If the landlord continues to insist on a letter of credit, a tenant may be able to mitigate its risk by carefully drafting the conditions that the landlord needs to satisfy in order to make a draw on the letter of credit. The standards should be objective and should give the tenant the ability to prevent a draw if the tenant disputes the landlord’s claim to damages. A tenant could also request that the LOC requirement be terminated after a couple of years so long as the tenant has not committed any event of default. It may be difficult to convince a landlord to accept such language. If all attempts at reducing its exposure fails and the landlord is still requesting a LOC, a tenant should consider whether it wants to enter into a lease with such a landlord.

Guaranties

An individual does not want to be personally liable for the debts of the individual’s business. That is why an individual will form an entity to cut off any such lability. Entering into a guaranty will essentially eliminate all of the benefits of creating a corporate liability shield. For many small tenants, the cumulative amounts owed for the remaining term of the lease are enough to force the individual in bankruptcy. Such a risk would make most individuals wary of entering into any new business venture as the individual could lose everything he or she owns. Due to the substantial personal risk associated with guaranties, a tenant must limit or eliminate any guaranty if possible. A tenant’s initial approach with the landlord should be to refuse any guaranty requirement. Most landlords will not accept this. The tenant’s second approach should be to require that the guaranty be capped at a set amount, and that the cap burn off over time so long as the tenant does not commit an event of default (e.g. 25% for each year of the term until the guaranty is terminated). As the landlord’s risk is reduced over time, the tenant’s risk should also be reduced.

Granting a Security Interest

An increasing number of landlords are asking their tenants to grant a security interest (i.e. a lien) in the tenant’s assets, particularly the assets located at the tenant’s premises. If a tenant does not anticipate needing a loan at any time during the term of the lease, granting such a security interest would not be that detrimental as the landlord would ultimately have the right to go after the tenant’s assets once it receives a judgment against the tenant following a tenant default. If a tenant does anticipate needing a loan, or if the tenant is unsure of its future financing needs, a tenant should avoid granting a security interest as most lenders will not accept being in a second position behind the landlord. A landlord holding a lien on the tenant’s property will likely preclude the tenant from obtaining any such loan. One possible compromise would be to include language in the security interest provision that states that the lien held by the landlord is subordinated to the lien of any future lender of the tenant together with language stating that the landlord must execute any document reasonably requested by the lender and that subordinates the landlord’s interest. The tenant should be successful in arguing that a landlord should want to assist the tenant in obtaining financing as such a line of credit will improve the financial health of the tenant.

Lease Remedy Provisions

If a tenant is unable to successfully negotiate the elimination of the security measures that are required by the landlord, or if the landlord is demanding security measures that the tenant does not want to give, a tenant could attempt to indirectly reduce its risk under a lease by drafting the landlord remedy provisions in a way that favor the tenant. Improved remedy provisions will reduce the tenant’s exposure upon a default so any security measures would also be limited to the amount of such damages. The most effective way to accomplish this is to eliminate any rent acceleration provision in the lease. Without such a clause the landlord’s damages would be limited to the rent and other costs due and owing as of the termination date of the lease. Any eviction of the tenant will effectively terminate the lease despite contrary language in the lease so a tenant’s exposure will be mixed as of that date. The difference could be owing a couple thousand dollars instead of owing a couple hundred thousand dollars. And, many landlords do not understand the ramifications of eliminating such a provision so such a reduction in damages can be a very useful tool of the tenant.

Incorporating to Minimize Risk

Regardless of the types of security measures that a landlord requires, a tenant needs to run its business through a corporation or a limited liability company, and must further maintain the necessary corporate formalities needed to preserve the liability shield created by a separate legal entity. If done properly, running a tenant’s business through a separate legal entity together with eliminating any personal guaranty will prevent the landlord from going after the personal assets of the tenant. A tenant should engage a good corporate attorney that can assist it with correctly establishing such an entity.

The ultimate goal of the tenant should be to be able to walk away from a failing business without having to declare bankruptcy in the process. There are many ways to accomplish this goal. A tenant should consider these risks when entering into a lease.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.

A tenant that faces a landlord bankruptcy is put into the precarious situation that it does not know what its fate is. If the bankruptcy trustee accepts the tenant’s lease, the tenant must continue to satisfy its obligations under the lease as if no bankruptcy has occurred. If the trustee determines that it is in the best interests of the debtor’s estate to reject the lease, the landlord will no longer have an obligation to perform under the lease and the tenant will be deprived of essential services, its leasehold interest, and potentially very expensive tenant improvements. This type of situation makes it difficult for a tenant to plan its future and may be financially ruinous for tenants without deep pockets. A tenant is put into the position where it must decide if it should risk defaulting on its lease and enter into a new lease so that it will have a place of business if the lease is rejected, or should it wait around until the bankruptcy court determines the fate of the existing lease and risk having to find a premises in a shortened timeframe. Neither scenario is desired.

Rejecting the Lease

Generally, the bankruptcy trustee handling the landlord’s bankruptcy has the option to either accept or reject the tenant’s lease, but the court will only accept the lease rejection if the trustee demonstrates that that the rejection of the lease reflects a proper business judgment. Absent such a showing, the debtor must accept the lease.

The amount of time in which this decision must be made depends on the type of bankruptcy that the landlord has filed. For Chapter 7 liquidation cases involving residential property, the bankruptcy trustee must accept the lease within 60 days (or longer if the court orders a longer period) or the lease will be deemed rejected, and the trustee will generally allow the lease to be rejected unless the trustee believes that there is value in the lease. Tenants under Chapter 7 cases will at least know their fate fairly soon.

Residential tenants in Chapter 11 reorganizations are not in a better position as the trustee has no obligation to reject the lease until the point at which the reorganization plan has been adopted. This process can take months or years. A tenant, however, does not need to wait idly by while the bankruptcy trustee decides its fate. A tenant can request that the trustee make a determination regarding the status of the tenant’s lease within a specific time period, and many bankruptcy courts will grant the tenant’s request.

There is no general deadline for rejecting a lease of commercial property and therefore there is nothing compelling the trustee to make any speedy decisions. Some courts, however, have granted a tenant’s motion that requests the court to adopt a specific timeframe.

Note, however, that the trustee’s right to accept or reject a lease only applies to leases entered into prior to the bankruptcy. The trustee has no right to reject leases that were entered into subsequent to the commencement of the bankruptcy, and the landlord must perform according to the terms of the lease. If the landlord fails to perform under such a scenario, the tenant will have a damage claim against the landlord that will be entitled to an administrative priority expense status in the bankruptcy, meaning that the tenant will likely receive the full amount of its claim.

Accepting the Lease

An assumption of a lease can only be done through a court order. Before the bankrupt landlord can assume an unexpired lease, the landlord must obtain court permission for the assumption, cure any pre-filing and post-filing default, compensate the tenant for any losses arising from the breach, and provide adequate assurance of future performance.

Rights and Obligations of a Tenant Prior to a Rejection

A landlord that has declared bankruptcy cannot be compelled to perform under a lease even if the lease has not yet been rejected or accepted in connection with the bankruptcy proceeding. The landlord is not even obligated to provide the basic essential services, repairs, and maintenance services. Conversely, the tenant in such a proceeding is obligated to continue to perform under the lease until the trustee and the bankruptcy court determines the status of the lease. The tenant is even obligated to perform if the landlord had breached the lease prior to the commencement of the bankruptcy, and language in the lease that would allow the tenant to avoid its obligations when such a default occurs will not be enforced by the bankruptcy court, nor will a clause that allows the tenant to declare an event of default under the lease if the landlord declares bankruptcy.

A tenant, however, is not without rights. A tenant can still enforce its statutorily protected rights against its landlord until the lease is rejected or accepted by the bankruptcy trustee, and the tenant has the right to offset many of the costs that it incurs in connection with providing these services against future rent payments. The tenant will also have a claim against the landlord’s bankruptcy estate if the tenant continues to perform under the lease and does not receive the corresponding benefits under the lease. The problem with the tenant’s claim is that it may only make a claim for the fair market value of the services and not for the value as set forth in the lease or for the costs the tenant actually incurs so the tenant may still not be made whole.

Rights and Obligations of the Tenant After Acceptance

Once the lease is accepted by the trustee, the landlord is once again obligated to perform under the lease, and any failure to perform will entitle the tenant to a claim against the bankruptcy estate that has priority over most other claims. A landlord must also cure prior defaults and compensate the tenant for losses that it suffered as a result of the defaults.

Rights and Obligations of the Tenant After Rejection

A tenant under a rejected lease has two options. First, it can treat the lease as terminated and assert a claim for damages against the landlord. This right, however, is limited to circumstances where the lease language would treat the landlord’s rejection of the lease as a default that allows the tenant to terminate the lease. Most leases will allow this.

Second, the tenant can remain in possession of its premises and retain some of its rights it has under the lease including the right to possession, although the tenant’s rights are fairly limited under this scenario. Some of the rights that the tenant may still be able to enforce are statutory rights granted to it, radius clauses contained in the lease, and certain use restrictions. The tenant will also have the right to offset most of the damages that it suffers as a result of the landlord’s defaults against future rent payments, but the types of damages applicable to this right are fairly limited (some of the damages that would be included are the basic landlord services normally provided under a lease like general repairs and maintenance).

Note also that a tenant may be dispossessed of its premises if the trustee sells or conveys the property where the tenant’s premises is located. The most common conveyance would be in connection with a conveyance to a secured creditor that held a mortgage lien against the property. The mortgage should be able to terminate the tenant’s leasehold interest under such a scenario if the mortgage predates the lease. The Bankruptcy Code also allows the trustee to sell the property to a third party free and clear of any interests in the property, which some bankruptcy courts have found to include any leasehold interests.

How to Protect Your Rights

Unfortunately, most tenant rights are subservient to the rights of the bankruptcy trustee, and there is not much that a tenant can do to preserve its leasehold interest if the trustee determines that it is against the business interests of the landlord. At a minimum a tenant should engage an aggressive and competent bankruptcy attorney that can work with the trustee and the court. The attorney may be able to preserve the tenant’s rights and negotiate a solution that works for all parties. As there is value in most tenant leases out there, an aggressive attorney can frustrate the court to the point that the court is more willing to work out a favorable settlement then to reject a lease outright.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.

The illusive purchase or leasing option contained in many a lease has probably caused more lawsuits than any other lease provision. Landlords like these provisions as they please their tenants, help to close deals, and may lead to money down the road. A landlord that is considering granting such a right should be wary of doing so as options are usually not worth the hassle or the potential liability. If a landlord does grant such a right, the landlord should always use special care in drafting the language that grants the option so as to avoid many of the potential pitfalls associated with these rights. Failure to do so will likely result in future headaches and perhaps litigation.

Types of Options

There are two general categories of options granted in leases: purchase options and leasing options. The former grants the tenant with the right to purchase the landlord’s property under certain conditions. The latter allows the tenant to lease additional space in the landlord’s building, usually adjacent to the tenant’s existing space. Within each of these categories, however, are numerous subcategories. The most common are straight purchase or leasing options that state that the tenant can either lease a specific space or purchase a specific parcel within a definite timeframe and at a specific price or rental rate. Assuming that the terms of the purchase or lease are included in the option language, few problems arise from such options as the landlord and tenant know their rights and obligations.

The more complicated and problematic options are rights of first refusal and rights of first offer. Rights of first refusal generally state that if the landlord receives a bona fide third party offer to rent a defined premises or to purchase a specific parcel, the landlord must present the same offer to the tenant for the tenant’s acceptance or rejection before entering into any agreement with the third party. Rights of first offer are similar except that the tenant is the one making the initial offer to the landlord once the landlord informs the tenant that it is willing to sell or lease, and the landlord must either accept or reject the tenant’s offer before it can market the property or premises to third parties. Rights of first offer and rights of first refusal are where most of the problems arise as they are frequently poorly drafted and ambiguous. Very often tenants believe that they have not been given the opportunity to exercise their rights and landlords believe that they have given their tenants an opportunity to exercise their rights and the tenants are simply impeding their deal.

Drafting the Option

First and foremost, a landlord should think twice before granting such an option, especially if the tenant is not giving additional consideration for such an option. These options may lead to strained relationships, disputes, and litigation, and very often interfere with a landlord’s ability to sell its property or lease out space. The benefits for such options very rarely outweigh the costs unless they are granted to an anchor tenant or other tenants that have the ability to draw other tenants to a property.

Second, the option language must be specific and unambiguous. Minnesota courts will not enforce options that do not include the most significant terms (e.g. an option that fails to state what the future rental rate or purchase price will be, or fails to specify the manner in which such terms will be determined with any certainty). The language should include the most significant monetary terms, set forth a precise timeframe and the manner in which the option can be exercised, and should include any limitations in exercising the option (e.g. precluding a tenant from exercising an option if it defaults under the lease terms).

Rights of first offer and rights of first refusal have additional issues that need to be addressed. Most lawsuits that arise out of rights of first offer are from situations where the landlord rejects the tenant’s offer and then subsequently accepts a bona fide third party offer that includes terms more favorable to the third party than what the tenant had presented to the landlord, which leaves the tenant believing that the landlord circumvented the tenant’s rights. Landlords that face a tenant with a right of first refusal have a similar problem when a landlord presents a third party offer that the tenant rejects, but the landlord subsequently changes the deal with the third party. The tenant usually insists that the landlord has an obligation to present such an offer to it before the landlord accepts the offer provided by the third party, and the landlord’s position is usually that the tenant was given its chance and now the option has expired.

Language in the lease that grants the option rarely addresses what the landlord’s obligation is to its tenant when the terms that the landlord has agreed to with the third party do not match what the tenant was offered, and the lease rarely helps the landlord avoid the dispute that subsequently arises. To avoid this scenario the lease should expressly set forth the limited scenarios when the landlord is obligated to present the third party offer to their tenant. The landlord should set out a precise and specific method for presenting offers and rejecting them, and should further state that the landlord has no obligation to present any additional offers to its tenant once the tenant rejects an offer despite any changes in the terms unless the monetary terms vary by more than ten percent of what the landlord originally presented to the tenant. Such language may seem harsh to the tenant, but at least the rights of the parties will be unambiguous.

Tenants and tenants’ brokers should also be wary of tricks that a landlord may attempt. Tenants that have been granted rights of first refusal should always require that the option language expressly limit offers that trigger the option to those coming from unrelated third parties. Absent such language, nothing would prevent a devious landlord from presenting an offer received from a related third party (usually under common ownership) that contains unfavorable terms in an attempt to eliminate any rights that the tenant may have. A tenant would face a situation where it either has to accept a below market purchase price or above market rental rate or risk losing its option.

Presenting an Offer

An additional problem area for landlords is when they present third party offers to their tenants. A landlord that presents an offer to a tenant will often not present all of the material terms due to laziness, oversight, or simply because the terms have not yet been worked out. Such a mistake can often be fatal as the tenant was not given a true offer and therefore will not lose its option if it rejects the offer. This can be a difficult situation for landlords as a landlord will rarely work out all of the intricate details of a deal before it is ready to present the offer to the tenant as it does not want to invest the time and money on negotiating with a third party if it will be forced to deal with its tenant in the future. Regardless, a landlord should bite the bullet and finalize all material terms before presenting the offer to the tenant. Even if the landlord is not obligated to do so under the lease, an upset tenant may derail a deal and prove difficult to work with over the remaining term of the lease, and the landlord may find itself facing a costly lawsuit brought by a tenant claiming that it was not presented all of the necessary terms.

This article addresses only some of the many problems that a landlord faces when it has granted an option. The truth is that even the most masterfully drafted lease language can still lead to problems. A landlord should seriously consider engaging a real estate lawyer before granting such an option, while drafting the lease language, and while entertaining offers to lease or purchase. A dollar spent today could prevent spending ten dollars in the future.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.

A well written lease should have a comprehensive and aggressive remedies section in favor of the landlord. The landlord’s rights should include the right to collect both past due and future rents, the right to re-enter the premises and relet it to another tenant, the right to terminate the lease, and the right to collect all damages incurred in connection with the tenant’s default. These rights will put the landlord in a position to recoup its losses and be made whole in the event that the tenant does not live up to its obligations under the lease…if the landlord can exercise its rights. There is a difference between the legal rights granted to the landlord in a legal document, and the practical rights that the landlord will actually have if a dispute arises or if a tenant defaults. The former is worthless if the latter does not exist.

Cost of Litigation

The first, and usually the largest, hurdle to overcome in a dispute with a tenant is the cost of the litigation. The old adage that the only ones who truly win in a legal dispute are the lawyers is true when it comes to lease disputes as the legal costs that the landlord incurs can greatly outweigh the damages that the landlord will receive. If a landlord is lucky, it has included language in its lease that states that the prevailing party can collect its legal fees from the other party. This right, however, is also a double-edged sword as a landlord may lose its case and end up with not only having to pay damages to its tenant, but also both the landlord’s and the tenant’s legal fees. This is a risky proposition.

Let’s consider the actual costs. A landlord’s out of pocket costs for a simple eviction start at $1,000, but this action can easily cost more than $100,000 if the tenant disputes the eviction, brings defenses, makes procedural objections, or delays the trial. Similarly, an action to recover damages will likely cost more than $2,000 just to file the complaint before the lawyer even steps foot into a courtroom or receives any response from the tenant. A landlord would likely pay more than $50,000 for a simple trial. A crafty tenant’s lawyer could cause the landlord to bleed cash and delay an action so that the landlord is compelled to reach an unfavorable settlement with its tenant even if the tenant is to blame.

The Insolvent Tenant

Prevailing in a lawsuit against a tenant is not the end of the landlord’s problems. Even assuming that the landlord evicts its tenant and wins a lawsuit against its tenant, the landlord must still collect on its judgment. Many tenants are shirking their obligations under their leases due to the simple fact that they have no money. If the landlord comes after the tenant, it will simply declare bankruptcy to avoid its obligations to its landlord. A landlord could try going after the guarantors as well, but chances are that they, too, are bankrupt, and the landlord may need to commence another legal action against the guarantors if the landlord has not included the guarantors in the original lawsuit.

Solutions

If the landlord is confident that it will prevail in any litigation brought against the tenant, the lease contains provisions that not only allow the landlord to recoup unpaid rent and damages, but also legal costs, and the tenant has deep pockets, the landlord should by all means commence a lawsuit and seek its damages. For the majority of the landlords in the world, however, this will not be the case. Such landlords should consider negotiating with their defaulting tenants. Although it may be painful, a landlord may have to swallow its pride and simply allow the tenant to vacate its premises. A landlord that offers a tenant a deal that relieves that tenant with most or all of its future obligations under the lease may be the best scenario for all parties as the landlord will be able to lease up the space and avoid mounting legal fees.

The best scenario for landlords is to protect themselves when negotiating the lease. Cash is always king so any security deposit that a landlord can obtain will benefit the landlord greatly, but tenants in today’s market are not willing to pay a security deposit equal to more than a month or two in rent so the security deposit alone will not provide the level of security that most landlords want. Another alternative is to require that the tenant provide a letter of credit, but even this form of security is not fool-proof as many landlords find that the bank that issued the letter of credit is not always willing to honor its obligations under the letter when the tenant’s finances go south. A lien on the tenant’s assets is another viable alternative if the tenant has assets and the tenant’s lender does not already have a lien on the assets. The best form of security is finding both tenants and guarantors with strong balance sheets, regularly checking the financial health of each, adding provisions in the lease that allow the landlord to declare an event of default if the tenant’s or the guarantor’s net worth is in jeopardy, and actually exercising its rights on the lease before other creditors are involved if, in fact, the tenant’s or the guarantor’s net worth deteriorates.

One additional comment should be made. When negotiating with its defaulting tenant, a landlord should be extremely cautious with how it treats the tenant and its property. A landlord can inadvertently accept a surrender of the tenant’s leasehold interest (thus relieving the tenant from any additional obligations), constructively evicting a tenant, or undertaking certain actions that would allow the tenant to bring a claim for damages. A landlord should seriously consider engaging an experienced leasing attorney for each of these steps so that it can avoid potentially harmful and unwanted consequence.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.