Exit Strategies

The business dynamics created by the recession is a painful reminder to tenants of the need to strive for as much flexibility as possible in their leases. As a result, exit strategies cannot be neglected when entering into leases. Those companies that have built "flexibility" into their leases can now downsize or reconfigure in order to respond to changing needs. Let's look at some of the strategies employed by tenants and analyze how they affect tenant and building owner alike.

Perhaps the oldest exit strategies are found in assignment and subletting clauses, which allow tenants to reduce or eliminate costs. They may even create a profit if the fair rental exceeds the tenant's rent obligation and the tenant is entitled to all or a portion of that excess.

Owners usually want to obtain all the excess consideration that the tenant receives from an assignment or sublease. However, such a requirement provides the tenant no incentive to seek a profit. To the contrary, the tenant has an incentive to seek non-monetary concessions.

When the excess rent is divided between the tenant and the owner, it becomes important to define which components are subject to profit-sharing. Tenants want to limit the allocation to the rent component, while owners insist that all the consideration should be subject to sharing. One compromise excludes the transferee's payment for fixtures to the extent that the amount does not exceed the lesser of the then fair-market value of the fixtures or their depreciated value on the tenant's books.

Regardless of the excess profit-allocation formula used, tenants should seek first to deduct from the allocation their costs of implementing the transfer. Owners should not object because they are increasing profits without further financial risk when the original tenant remains liable together with the successor.

It should be no surprise that building owners seek an option to terminate the leasehold when a tenant seeks to substitute its occupancy. If a tenant desires to cease operating and vacate, it is not unreasonable for an owner to be given the opportunity to regain control of the property. However, the merit of that position weakens if the transfer involves multiple locations or arises in the context of a sale of an entire division, subsidiary or entire business.

If the owner obtains a right of recapture, the question arises whether he must exercise those rights in a vacuum or if the tenant must first broker the transfer. Arguably, a tenant's only obligation should be to notify the owner of his desire to transfer and give him a specified time period within which to decide to terminate the lease. Where an owner has a recapture right, a tenant may want to protect himself with a nullification right.

With requisite leverage, the indirect exit strategy contained in an assignment and sublet clause is eclipsed by the direct strategy of a kickout clause. Kickout rights are generally triggered by the passage of time. Thus, a tenant may negotiate a kickout, say, anytime after the third year. Kickouts may be one-time, multiple or continuous elections. Regardless of the number of opportunities to exercise a kickout, the owner needs sufficient time to respond. In exchange for permitting a tenant to terminate its lease, an owner will likely seek reimbursement for the unamortized value of the build-out costs, rent concessions and brokerage costs, and perhaps a reimbursement for the vacancy factor.

Owners must be wary of exercising capture rights if it will result in a rent loss. Hence, the owner might seek to have the departing tenant take responsibility for the differential between the rent in the old lease and the lower rent that will be paid by the succeeding tenant. Logically speaking, tenants should agree to this provision because it provides incentive to the owner to recapture the lease and to relieve the tenant of the obligations.

If a tenant willfully defaults, the owner looks to the remedies section of the lease. An owner's freedom of action will be limited if he has an obligation to mitigate his own damages. Even if the lease is silent regarding mitigation, state statutes or case law in at least 42 states and the District of Columbia sometimes obligate the owner to mitigate damages. Moreover, in jurisdictions where mitigation is required, courts are placing the burden on owners to prove that they used reasonable efforts to mitigate their damages.

Accordingly, building owners may discover that defaulting a tenant may not be the effective remedy they thought. A lease that lacks an acceleration provision making all future rental immediately due and payable is a remedy without teeth. In fact, it is likely that a jurisdiction that requires an owner to mitigate damages will not enforce an acceleration provision that is not equitable.

In all, exit strategies make sense for everyone because one never knows when one will need to find the door. 

Jeffrey H. Newman is a senior member of Sills Cummis Radin Tischman Epstein & Gross and chair of the real estate practice group.