By Tin-Fu (Tiffany) Tsai
When entering into a contract, it seems counterintuitive to picture how it will end. It is important to prepare for this possibility in the negotiation process. Every contract not carefully thought out is a litigation waiting to happen, and the current COVID-19 pandemic is just one of the many uncertainties complicating the deal. For example, it is not uncommon for a commercial lease to expand from a few years to decades. As a result, thinking beforehand about how a lease may end is crucial, because the terms of the lease may no longer match one's business strategy down the road.
The once the designated luxury shopping districts in New York City, Midtown East and the Upper East Side of Manhattan, have become war zones as many high-end brands are litigating against their landlords to exit their leases. Valentino, the Italian fashion brand, and Venus over Manhattan gallery, once known as the "Grand Central Terminal of the art world", are just a few of the well-known tenants that resorted to litigation. However, litigation is not the only way to end a lease. Although an exit strategy should be customized for any lease, this article hopes to provide an overview of alternatives for tenants to consider prior either to entering into commercial leases and/or before resorting to litigation.
Repurpose the Premises
Though not an actual exit of a lease, repurposing the premises is a way for a tenant to align the lease with its current needs. While the overall demand for brick-and-mortar stores has decreased, there has been a growing need for warehouse space due to growth of e-commerce. Repurposing the premises may not be allowed when there is a narrowly defined use provision under the lease. For example, if a lease specifies that the premises can only be used as a store front, it will be a breach of the lease for other uses. Furthermore, a tenant should be mindful of the zoning law requirements to ensure compliance.
The lease assignment is when a tenant transfers the entire lease or a portion of it to a new tenant. Most jurisdictions favor free alienability and permit the tenant to assign if the lease is silent about assignments. If not specified, New York courts allow the landlord to withhold the consent unreasonably or even without any reason at all.
Generally, the lease articulates the logistics of the right of assignment where a landlord's consent is required. The financial qualification of the new tenant is a common requirement to show the reasonableness of a landlord's consent.
Another option that relieves a tenant's financial burden is to sublet the premises to a subtenant. Essentially, subletting a lease will not release the tenant's obligations since the tenant remains on the lease and is liable for the subtenant's default. Similar to lease assignments, consent from the landlord is usually required, which could be withheld unreasonably if not specified under the lease.
A termination right, which is usually granted to a tenant with more leverage power, enables a tenant to exit the lease early without paying for the remainder of the term. It is not free of charge, as the tenant needs to satisfy certain conditions first, such as a minimum lease period, a triggering event, a prior notice, and recoupment of unamortized costs. Certain unamortized costs include free rent, brokerage commissions, legal costs, and buildout costs. Further, the termination right often results in higher rent as compensation to the landlord for early termination. Despite still having strings attached, a tenant may find the termination right a worthy avenue in which to retain a level of flexibility in response to future changes.
A lease buyout literally enables a tenant to buy an early way out. Often an expensive option, the price for a lease buyout depends heavily on the rental market. In a soft market, a tenant may be able to walk away without emptying its pockets, as the landlord is more optimistic in re-letting the premises. Generally, the "break-up fee" would reflect the landlord's cost of re-letting, the estimated vacancy period, the unamortized costs, and the remaining lease term. A landlord's development plan of the premises also plays a crucial role in the dynamic of the buyout negotiation. If the buyout matches a landlord's plan at the time, such as one to repurpose the premises, it is more likely to be settled at a lower price.
Force Majeure and Similar Common Law Doctrines
In an extreme situation, such as the COVID-19 pandemic, a tenant may have other options to excuse its lease obligations. Force majeure, a clause that had not attracted much attention until recently, has become a focal point as a result of the global pandemic. If written in a contract, the force majeure clause exempts a party's contractual obligation when it is disturbed by a triggering event that is neither foreseeable nor within the party's control. That said, whether a tenant can assert the force majeure clause to its advantage depends on the specific contractual language, which is narrowly construed by New York courts. If a certain type of triggering event is not included in the clause, New York courts usually conclude that it is intentionally excluded by the parties. Often, even when the clause is in place, it benefits the landlord and not the tenant.
If no force majeure clause is available under a lease, a tenant can still resort to other common law principles to relieve its contractual obligations, such as impossibility and frustration of purpose. A tenant should look out for provisions that waive common law defenses before raising those defenses against the landlord. For the impossibility to apply, the party's performance will only be excused if it is rendered objectively impossible by an unforeseeable triggering event. For example, if a lease requires a tenant to operate continuously, such tenant may argue for impossibility due to government orders limiting the operation hours. Frustration of purpose applies when an unforeseeable triggering event frustrates the basis of the contract and makes it pointless. For example, when a lease ties rent payments to the tenant's profits, a reduction of business caused by governmental restrictions may warrant a frustration of purpose defense. Again, New York courts interpret these doctrines narrowly and the asserted party bears the burden of proof. Still, many tenants, such as Valentino, are using them with hopes of terminating the lease or to reduce the rent payments. It may be too early to predict how those lawsuits will play out, but it is safe to say that the COVID-19 pandemic is likely to change how the courts view the issues.
The Landlord's Default
If a landlord has promised to have a certain type or percentage of occupancy threshold in a lease, commonly known as the co-tenancy provision, a tenant may have a way out upon the landlord's violation of such provision. Often, a demonstration of economic harm is a prerequisite before a tenant can terminate its lease. An exclusive use provision can also be helpful for a tenant when its landlord leases other spaces on the premises to the tenant's competitors. In addition, a tenant has a right of quiet enjoyment, which guarantees an undisturbed possession of the premises, and he or she can invoke a constructive eviction claim and further exempts contractual obligations when the landlord violates such right. For example, if a tenant is denied access to the premises, tenants may have a claim of constructive eviction.
Tenants may want to break the leases, but not the relationships or their bank accounts. Amongst all the uncertainties that are outside of one's control, the best policy is to read the fine print and understand what options a tenant may have to excuse or to reduce its contractual obligations. While repurposing the premises, subletting, and lease assignment keep the current lease in place, there are restrictions associated with these arrangements. The termination right and the lease buyout could be useful when the former is built into the lease and the latter is applied under a landlord's market. In rare cases, the tenants are better off if the conditions are met under force majeure, other common law doctrines, and landlords' defaults. In sum, different alternatives come with different price tags. With a good road map, one can find peace of mind.