Rules and Scenarios with Leasing and Subleasing


Aaron Hall: I’m Aaron Hall, business attorney in Minneapolis.

Steve Freeman: I’m sitting with Steve Katkov of JUX. When it comes to, let’s say, the small business owner they’re looking for 1200 square feet. Let’s say that their rent is going to be $2000 per month. What would be an average amount that they would expect to give to the landlord to hold, and how long will they hold it? Until the end of the term? Or is there a time period that that security deposit could be applied towards rent?

Steve Katkov: The landlord would turn that question to you and say, “What—“. Before I answer that, what is the tenant’s leasing experience? Has this tenant been a successful [leases] in previous businesses or in previous locations? So let’s assume, hypothetically, that this is a new business. This is a true start-up with no leasing experience. The landlord’s answer to that question is going to be very different than if it was a major corporation who’s operating 80 or a hundred locations under leases. In our scenario, it is most likely that the landlord is going to ask for a security deposit equal to the first and the last month’s rent. And if it’s a term of a year, chances are the landlord’s going to bargain to keep the security deposit until the lease is either renewed or terminated at the end of the term. It’s a guarantee of performance. So another way to eliminate it—Because Steve, for some small businesses, first and last month’s rent, especially if you’re in a start-up, that’s a big nut to crack right off the bat where cash is king. I want to hold it and use it in business operations to acquire inventory, for instance, or hire an employee, and be able to cash flow my payroll. It is a significant issue for small businesses. One alternative to what might be considered a large security deposit, or difficult security deposit terms, is to offer a personal guarantee from the owner of the business. Now if our tenant is organized as a corporation or a limited liability company, then the obligations under the lease fall to that entity. The tenant could say, in response to a request for either a large security deposit or one that the landlord wants to hold for the term of the lease, is to say, “What if I gave you a security deposit equal to one month’s rent? You hold that until the end of the term guaranteeing my performance not only of base rent but that additional rent. Common area maintenance charges are a great example. But instead, I’ll also give you a personal guarantee of the obligations of my company.” And often, landlords will accept that assuming the guarantee has some substance.

Steve Freeman: So that brings up an important point. If the small business owner is an LLC as an example, which is probably the cheapest way for them to go and maybe in their situation, a smart way to go. And they go and lease a property but they give a personal guarantee. Fast forward 18 months, they’re not doing so well. They realized that they need to get out of the space at the very least, or they need to file bankruptcy. Now if the company files bankruptcy but they’ve signed a personal guarantee, what happens to them at that point between them and the landlord?

Steve Katkov: A guarantee in broad terms, whether it’s in a landlord-tenant context or a lending context, where the LLC borrows money from a large banking institution with that one’s a personal guarantee, is really a contract of indemnity. In other words, the guarantor is promising to indemnify or make whole the landlord from defaults of the underlying obligor, the party that’s really contracted for performance. So if an entity were to file bankruptcy, the entity’s obligations under the lease agreement would be terminated by the bankruptcy action, but not so with the guarantee. Guarantee’s are generally better thought of as continuing promises of performance. And sometimes—And you’ll see documents that instead of saying “Guarantee” at the top, they’ll actually say “Continuing Guarantee”. The point trying to drive home to the guarantor is that your obligation continues regardless of what fate befalls the party who’s actually obligated on the primary obligation. Tenant would be the primary obligation of the company.

Steve Freeman: Okay. So to put it in layman’s terms, what that means is—Going back to our small business person. They lease the property for 5 years, as an example, I set a 5-year lease. 18 months into it they realized, “This isn’t going to work. I’m going to have to file bankruptcy and I have too many creditors after me.” And they informed the landlord of that. And the landlord can then say to them, “I feel really bad for you but you owe me 3 and a half years of rent, regardless of what happens with the corporation.”

Steve Katkov: Right. So the only recourse for the guarantor, our tenant, our client, is to also seek the protection of the bankruptcy court by filing either Chapter 13 which is an individual plan of reorganization, or a Chapter 7 which is the liquidation. Or lastly, negotiate a buy-out if you will of the guarantee. But the—Here’s the key point. That tenant, guarantor, our client, must get a written release of the guarantee.

Steve Freeman: But if we’re representing the tenant in this scenario, we would try to get them to not sign a personal guarantee if there was any way around it. Would that be a good assumption?

Steve Katkov: It is. It’s always our first step forward in negotiating on behalf of tenants with the landlord, is to let the landlord know that our initial offer and terms will not include a personal guarantee. It’s one thing if the business goes belly up, and the owner’s done everything they can to make it a success. It’s another thing if the owner does everything they can in good faith to make the business a go, and has to file personal bankruptcy. But you will find, and our tenants, and our clients will find that the idea of a personal guarantee will always be floated by commercial landlords, particularly with tenants who have little or no leasing experience.

Steve Freeman: So here’s an idea. If you were going to go into commercial space, again small owner, could you go in with the understanding between you and the owner that the first 24 months, there would be a personal guarantee and a renewal of the lease? And then after those 24 months, go in and renew the lease, not have a personal guarantee but have it against the corporation instead?

Steve Katkov: Our response would be to negotiate from the outset that what we would consider a success factor. In other words, if our tenant is successful, then we expect the tenant to benefit by the release of the security deposit and/or release of the guarantee. Now that’s the best way to make this happen. And at JUX, we think this way. We think, what if in two years the tenant’s super successful and maybe not only needs to renew the lease, but God forbid, expand? So that should be part of the discussion, too, rather than only look at risk management as preventing negative consequences for the owner. We first look and assume success. And if the landlord wants a security deposit and a guarantee to assure performance, then the discussion should be around the timing at which point the landlord can assume that our client is a good bet.

Steve Freeman: So Steve, let’s say that the tenant in your scenario, they’ve done really well. They need to expand and there’s not space where they are currently. But they’re only halfway through their lease. What obligations do they have? And what can they do? What are their options at that point to find new space and get out of their current lease?

Steve Katkov: And this we spoke earlier, Steve, cash flow for small business is always critical, and particularly for start-ups. So imagine a scenario where the tenant didn’t plan for success and has outgrown its space. Could it possibly cash flow two leases? The existing lease—because again, it is an enforceable agreement against the tenant, and the tenant may have signed a personal guarantee. So the stakes are high—As well as go find a larger space maybe next door or across the street. Most small businesses can’t afford to cash flow two locations, or two don’t make sense. So one vehicle, is to get the landlord’s agreement to sublease the property. In this context, the tenant then becomes almost like a landlord. And that’s why we call it a sublease. It’s secondary to the lease agreement between landlord and tenant. Again, an important drafting point going into the relationship, rather than looking at it as I’m going to fail and might have to leave and close shop, and subleasing, or to make good on my promise under the lease agreement. Let’s think about it in terms of, I’m going to have success, and I need to expand, and I can’t. An important negotiating point is to get the landlord’s agreement on subleasing. Generally, a tenant has no right at common law to sublease. States vary on that issue. And it smacks against our old world property concept that the tenant has a really established significant real property interest, even though it’s just a lease hold interest, just the tenant. But it’s this contract law that’s coming in and saying, “Well that’s not a benefit of the bargain.” It might have been in old days, but this is modern world. And unless the document allows for subleasing, the tenant should presume he can’t do it. So negotiate for it upfront. And then the discussion will be around whether the landlord can be unreasonable in who you present as the new tenant.

Steve Freeman: So in that scenario, the landlord would have the right to approve or disapprove anyone who might do the sublease, if he even allows it.

Steve Katkov: Correct. And we would always argue that tenants obtain the right to sublease, and to limit the landlord’s acceptance or rejection of a potential [sublease] to what is reasonable.

Steve Freeman: Let’s say that the tenant is able to find a subtenant. They sublease. The owner approves it. Now they’re released of liability, and they don’t have to worry about that lease anymore. Is that correct?

Steve Katkov: Not necessarily. The primary obligation still resides with the first relationship: landlord-tenant. The tenant, unless they get specific release from the landlord, also remains liable for the performance under the lease whether his tenant performs or not. Ultimately, we would encourage tenants in that scenario, if they anticipate issues with their landlord, to obtain release from the lease particularly when our tenant has worked to present a very qualified replacement tenant. Landlords, on the other hand, like subleasing because now they have two actors to go after in the event of non-performance: the tenant, and the subtenant.

Steve Freeman: Really, we’re talking about the shifting of risk. So if the tenant, the first tenant, the original tenant, is able to get out of and be released from the obligations of that lease, that’s great for them. Not so good for the current landlord. But in the scenario would be better if they did it that way.

Steve Katkov: It would be better for our tenant, less complicated for all the parties nonetheless. And in a small leasing scenario of a thousand, 1200 square feet, the issue of landlord making tenant improvements, which he intends to recapture from the lease payments, is less intense than if it was a 70000 square foot lease in which the landlord invested 50, 70, or even a hundred thousand dollars to improve on behalf of the tenant. And that’s where we really see issues with subleasing come into play. Because part of the landlord’s out of pocket expenses could be significant tenant improvements. Generally, that won’t be a large number in a 1200 square foot. And landlord’s are much more amenable to not only a full lease—a release of the tenant’s obligations under the lease. But they certainly are amenable to subleasing.

Steve Freeman: Let’s say that rather than move, the tenant has done so well that now they found a buyer. A buyer’s come out of the woodwork and offered them a sum that they just can’t believe someone would buy this building for, not building but the business. What would take place? What needs to take place? Now I understand that there should be some kind of an assignment. And how does that impact the relationship between the current tenant and owner of the business, and the landlord?

Steve Katkov: In rough terms, we like to think of subleasing as not relieving the obligations of the primary tenant from performance under the lease. Whereas with assignment, we are presuming and hoping that it includes a release of those obligations. So if the question is, does the landlord, by law, have to allow assignment? The answer is no. That is a matter of contract law. So it’s a matter of what your lease states. So in addition to the other protections that we bring for our tenants and thinking about success, is we also have to think about whether or not this lease should be assignable. And we would argue that it should always be assignable. Landlords generally don’t want that. And again, different issue if it’s 70000 square feet and the landlord has put significant tenant improvements in place. Because they’ve had to do a credit analysis, if you think about it, it’s almost an under riding process that a lender might go through in managing risk. What’s my outlay? When am I going to get my money back? When I get it back, how much have I made of money? And last but not the least, what is the risk that I’m not going to get it back? So assignment in a small lease context presents less of a challenge to a landlord than in a large leasing context. We would argue that it should be in the lease, for the occasion that the client receives a non-solicited offer that’s just too good to be true. And part of selling the business and moving on, is not only acquiring the value from the buyer, but also a release of existing or current obligations. You want to leave that behind, too. And an assignment provision in the lease is necessary for the tenant who sells the business, to get rid of the lease obligations. Now typically, landlords will say, “Okay. I’ll agree to assignment, but I get to review the quality of the new tenant or the buyer of your business.”

Steve Freeman: So are you saying, in this scenario, that the landlord could actually keep the sale from taking place?

Steve Katkov: It depends whether or not the lease is an asset of the business. It is in the strictest terms. But is it a valuable asset? And in some business contexts, a long term lease, while it might be a burden in some situations, can be an advantage in a business sale. Because going back to our previous discussion about location location location, a buyer of the business, once the business in that location, if that location is available only on a short term basis, then the lease is not as great an asset as it can be. And that’s where the rubber meets the road, because tenants, particularly in start-ups, are nervous about long term commitments. And the other hand, if they think about success rather than failure, and location is critical to their business and its growth, you would argue for a long term lease. So in the sale of a business, which is something we do for clients as well, we have a schedule of assets. And a lease is not seen as an asset. It’s usually on the schedule with liabilities because it requires the buyer or the current tenant to pay money. So it ends up on a schedule of liability. But I will tell you as a practical matter, businesses that are flourishing in a particular location have, as an arrow in their quiver, a long term lease in place.

Steve Freeman: And the drawback for potential new buyer of that—just so that people understand the importance of the location, the current location—if that buyer looks at that short term lease and thinks to themselves, “I’m going to have to move this business if I can’t renew the lease, and that could cost me thousands of dollars. And I may not be able to copy the location that I’ve got nor the traffic that’s currently coming in to this particular business.” So it is a big deal.

Steve Katkov: It is. And also—Not to look at the dark side of business in America, but let’s be frank. A business owner with a very successful tenant who learns of a sale, and the tenant has only a matter of months left on a lease, you might suspect that the landlord would be highly motivated. That when negotiating with the buyer of the business, the lease terms are much more [owneresque], that base rents’ going to go up, and common area maintenance provisions are going to be expanded. They may still be pro-rata, but maybe he’ll try to negotiate to include some items that the current tenant and seller of the business wouldn’t allow.

Steve Freeman: So in this scenario, someone approaches you to buy the business, you don’t go running to the landlord. You run to the attorney first.

Steve Katkov: You run to Steve. Yes. And again, to make the—We agree, and it’s self serving and I understand that, but I really believe that sitting down with knowledgeable business lawyers, and I tie those two together, require lawyers that have done something other than practice law. And at JUX, we have a lot of those.

Steve Freeman: And this scenario, if you’ve had a good attorney that did your divorce, they may not be the best person to do your lease.

Steve Katkov: Yes. Or your CPA.