Subleases: A Practical Perspective

by Colin J. Smith and John G. Lavoie, Watt, Tieder, Hoffar and Fitzgerald

During the last few years, sublease deals have been fairly infrequent for many real estate practitioners. However, market conditions have changed considerably over the last six to nine months. There are now a number of companies who find that they have leased more space than they currently need. With the "dot com crash" and the general economic slowdown has come a significant increase in the "sublease market," especially in certain Northern Virginia submarkets. Sublease transactions have become more prevalent and are likely to remain so for the immediate future.

This being the case, it has become more important than ever to understand the critical differences between sublease and "prime" lease transactions. While subleases can provide sublandlords and subtenants with flexible, cost-effective solutions to their space needs, they do involve certain inherent legal risks that should be fully understood before entering into such an agreement.

What is a sublease and how does it differ from a "prime" lease? A sublease is a transaction in which a tenant often grants an interest in its leased premises that is less in area or length of time than the interest granted to the tenant itself. The landlord is not necessarily a party to a sublease and, therefore, no contractual relationship exists between the landlord and the subtenant. The prime tenant/sublandlord remains primarily liable to the landlord for all prime lease obligations, even where the obligation has been "subleased" to a subtenant. Because the sublandlord's lease rights are defined by the terms of the prime lease, both parties to a sublease must concern themselves with the provisions of the prime lease.

Key Issues for Subtenants

Before entering into a sublease, a prospective subtenant should understand the following issues:

Prime Lease Termination: If the prime lease terminates, the sublease will automatically terminate as well. This is because a subtenant's rights to the leased premises are purely derivative of the sublandlord's rights. This is the fundamental deficiency of a sublease. The subtenant's nightmare scenario is one where the subtenant pays its rent obligation, and the sublandlord fails to forward the rent on to the landlord. Of course, when a financially weak sublandlord seeks to sublease a portion of its now unneeded space, the potential risk to a subtenant is great.

A prospective subtenant can address this fundamental problem by structuring the transaction as a lease assignment under certain circumstances, or by receiving a non-disturbance agreement from the landlord, if the landlord is willing. If the proposed transfer of lease rights by the tenant involves the entire leased premises for the entire lease term, the transfer can be handled as a lease assignment, rather than a sublease. Under a lease assignment, the assignee "steps into the shoes" of the tenant and becomes the new tenant under the lease. In this circumstance, the new space user has control over its own destiny by virtue of a direct contractual relationship with the landlord.

If the ideal circumstances required for a lease assignment do not exist, the new space user will have to accept a sublease and can achieve similar legal protections if the landlord will grant it a non-disturbance agreement. Under a non-disturbance agreement, the landlord agrees with the subtenant that should the prime lease be terminated due to a prime tenant default, the landlord will treat the sublease as a direct lease between the landlord and the subtenant. The granting of such a non-disturbance agreement is almost always at the sole discretion of the landlord. Whether a landlord will grant a non-disturbance agreement to a subtenant is generally dictated by the landlord's perception of current market conditions, the level of creditworthiness of the tenant and subtenant and/or the amount of rent to be paid by the subtenant under the sublease.

If the landlord will not grant a non-disturbance agreement, a subtenant may reduce its risk to some degree by negotiating for the right to pay its sublease rent directly to the landlord. This may be an important right of a subtenant which subleases all or most of the leased premises. Note, however, that under the terms of the prime lease, the landlord may have the right to refuse rent payments from any party other than the prime tenant. As an absolute minimum, the sublease should contain a specific covenant that the sublandlord will not cause any default under the prime lease, and that the Subtenant would obtain written notice if such event arises.

Incorporation of Prime Lease: Because sublease rights are derivative of the rights granted under the prime lease, well-drafted subleases should address to what extent the provisions of the prime lease are incorporated into the sublease. Some sublease documents provide that the subtenant take on all the obligations of the prime tenant under the prime lease. Prospective subtenants should understand what those obligations are and if they are unwilling to accept a particular obligation, the sublease should specifically say so. At a minimum, the acceptance of prime tenant obligations should be limited to those applicable to the portion of the premises being sublet and only as is consistent with the subleasing parties' business deal. The sublease should also incorporate responsibilities of the landlord under the prime lease as the obligation of the sublandlord. For obligations that must, by their nature, be performed directly by the landlord (such as the delivery of utilities and performance of building services), the sublease should specify that the sublandlord will take all necessary actions to enforce the landlord's obligations under the prime lease for the subtenant's benefit. The sublease should also specifically provide the subtenant with the benefits of landlord's waiver of subrogation rights under the prime lease with respect to property damage.

Landlord Consent: As the starting point for any prospective sublease transaction, the subtenant should be fully cognizant of what the prime lease says about the landlord's right to approve a sublease. Generally, the sublease document should provide that the sublease only becomes effective after the landlord's consent has been obtained. It is also important to understand early on whether the prime lease grants the landlord the right to "recapture" the space in the event of a proposed sublease. A prospective subtenant may want to evaluate the likelihood of such a landlord recapture before investing significant time and effort in this sublease process.

Key Issues for Sublandlords

Some important considerations for prospective sublandlords are as follows:

Primary Liability: Sublandlords must understand that they will remain primarily liable to the landlord for all lease obligations even if such obligations are "subleased" to a subtenant. Moreover, the sublandlord will remain as a "middleman" between the landlord and the subtenant, ensuring payment of the rent to the landlord and the provision of building services to the subtenant. Sublandlords must also understand that the landlord will review all actions or failures to act of the subtenant to be failures of the sublandlord. Thus, the sublandlord confronts a similar loss of control as noted with regard to subtenants. A sublandlord takes the risk that the subtenant will cause a default under the prime lease and generally the mechanisms for reducing the subtenant's risk will increase the sublandlord's risk. For example, under a lease assignment, the original tenant gives up its lease rights for good, but normally continues to remain responsible for lease obligations. Likewise, if a sublandlord agrees to allow a subtenant to pay its rent directly to the landlord, it may be more difficult for the sublandlord to protect against defaults due to nonpayment of rent. It is often in a sublandlord's interest to structure a transaction as a sublease, rather than a lease assignment, and to control rent payments to and all communications with the landlord. The prospective sublandlord should ensure that the sublease document contains a covenant by the subtenant not to cause any default under the prime lease.

Incorporation of Prime Lease: As noted with regard to subtenants, it is also critical for sublandlords that the sublease carefully incorporate the applicable terms of the prime lease as obligations of each party. Without language specifically incorporating the terms of the prime lease, the subtenant may not be bound to abide by such obligations. The sublandlord should also take care to avoid agreeing to perform a prime lease obligation that only the landlord can perform (such as the delivery of building services). Sublandlords have the same interest as subtenants in conditioning the commencement of the sublease on receipt of the landlord's consent.

Conclusion

A sublease can be a more complex transaction than a "regular" lease due to the interplay between the terms of the prime lease and the agreement of the sublease parties. This interplay of the two documents and the legal risks inherent in subleases should be understood by all parties. Sublandlords and subtenants operating in commercial leasing are well advised to consult with a qualified real estate broker and real estate attorney when structuring sublease transactions. Certain risks inherent in the process can be alleviated for both parties and significant economic benefits can result, provided that proper planning, documentation and organization are considered at the outset of any given transaction.

About the Authors

Colin J. Smith focuses his practice on commercial real estate transactions and real estate-related contracts.   Mr. Smith is a member of the Bar in Virginia, the District of Columbia, New York and Connecticut.

John G. Lavoie focuses his practice on real estate transactions with an emphasis on the acquisition and disposition of commercial real estate. Mr. Lavoie is a member of the Bar in Virginia, Maryland and the District of Columbia.

To learn more about WTH&F, please visit www.wthf.com.