November 6, 2020

PROCEED WITH CAUTION WHEN REJECTING A SUBTENANT’S PROPOSED SUBLEASE ASSIGNMENT

Our leasing team recently encountered a somewhat unique scenario in the commercial leasing arena involving an office sublease between affiliates and the potential pitfalls of a spinoff of the subtenant into its own independent entity. The tenant/sublandlord was particularly concerned about the prospect of one of its competitors acquiring the subtenant after the spinoff is completed. The tenant/sublandlord posed the question whether it could block the assignment of the sublease to its competitor. To answer this question, our leasing team researched and analyzed an interesting corner of leasing law involving the ins and outs of a landlord’s/sublandlord’s analysis when determining whether to approve or reject a lease/sublease assignment. We found that the ability to reject in this context is limited under applicable law, and therefore, we urge any party considering a rejection to proceed with caution.

We started our research looking at possible antitrust issues due to the potential for the sublandlord to be able to reject the assignment of the sublease to a competitor. Our research disclosed that, generally speaking, the risk of triggering antitrust liability through this type of rejection is minimal. As a preliminary matter, most (if not all) of the antitrust case law addressing this type of scenario (i.e., where a landlord disapproves of a lease assignment to a competitor) involves retail real estate. Because the corporate office location of competitors does not typically implicate anticompetitive practice and has no impact on the relevant market, it is very unlikely that a sublandlord’s rejection of a sublease assignment to a competitor presents antitrust risk.

That said, the rejection of a sublease assignment to a competitor does present other potential problems. A small handful of cases has dealt with this issue and, for the most part, the courts have held that a lease assignment that is otherwise acceptable but for the fact that the proposed assignee is a competitor of landlord must be approved. Courts assess these refusals to consent under a “commercial reasonableness” standard, but this standard is applied in a bit of a “landlord vacuum.” That is, the fact that a party assessing a proposed lease/sublease assignment may also have motivations or concerns associated with its primary business is irrelevant to the analysis; courts will only assess whether the rejecting party acted reasonably in its capacity as landlord/sublandlord. Some select language on this point from the case law as follows:

When a commercial lease provides that the landlord will not unreasonably withhold consent to its assignment, the landlord may refuse to consent to an assignment based only on consideration of objective factors, such as the financial responsibility of the [proposed assignee], the [proposed assignee’s] suitability for the particular building, the legality of the proposed use and the nature of the occupancy, i.e., office, factory, retail….Thus, subjective concerns and personal desires cannot play a role in a landlord’s decision to withhold its consent to an assignment of a lease. Logan & Logan, Inc. v. Audrey Lane Laufer, LLC, 824 N.Y.S.2d 650, 651 (2006).

When determining the reasonableness of a landlord’s refusal to consent to an assignment of a lease, the standard is that of a reasonable prudent man and, in applying that standard, the personal taste and convenience of the landlord should ordinarily not be considered….In determining whether a landlord’s refusal to consent was reasonable in a commercial context, only factors that relate to the landlord’s interest in preserving the leased property or in having the terms of prime lease performed should be considered….the landlord’s objection must relate to ownership and operation of leased property, not lessor’s general economic interest. Tenet HealthSystem Surgical, L.L.C. v. Jefferson Par. Hosp. Serv. Dist. No. 1, 426 F.3d 738, 743 (5th Cir. 2005).

So, for example, if a law firm subleases a portion of its office space to an insurance brokerage, and the insurance brokerage proposes an assignment of the sublease to a competing law firm, the sublandlord/law firm can only assess the assignment of the sublease through the sublandlord prism. This being the case, if the competing law firm is financially capable of performing under the sublease and is a suitable office tenant, the commercial reasonableness standard will almost certainly mandate that the sublandlord/law firm approve the assignment of the sublease, even if the prospect of bringing a new law firm into the office building presents a threat to the sublandlord/law firm’s more general economic interests.1

All said, from an antitrust perspective, concern is minimal. But, a landlord/sublandlord must be prepared to accept a lease/sublease assignment to a competitor, as refusing to do so could lead a court to find that such refusal is commercially unreasonable if the sole basis for the refusal is that the assignee is a competitor.

In addition to the “commercial reasonableness” issue, this scenario also presents some tricky issues on the confidentiality front. In our client’s situation, if the newly spun-off subtenant is to be acquired by a competitor of the client, the client would almost certainly need to see sensitive financial information of its competitor to assess (i) the proposed subtenant’s financials or (ii) whether the proposed subtenant/assignee is sufficiently capitalized such that sublandlord’s consent to the assignment is not required because the proposed subtenant falls into the “Permitted Transferee” category. In either scenario, concerns arise pertaining to the sharing of sensitive information with a competitor and also possible SEC Rule 10b-5 issues if the party acquiring the subtenant is publicly traded, such that the sublandlord would be made aware of the acquisition before the news is public.

To address these issues and protect the parties, the following protocol can be followed and memorialized in a written agreement:2

  1. In a situation in which SEC Rule 10b-5 does not apply, but there is nevertheless concern as to disclosure of sensitive information to a competitor, the parties should employ procedures to maintain the strictest possible confidentiality in light of the circumstances. These procedures may include, without limitation, the following:
    1. Permitting only a small group of employees in sublandlord’s real estate department to be privy to the sensitive information in assessing the proposed replacement subtenant;
    2. Ensuring that all sensitive information is destroyed or returned to the proposed subtenant after completion of the sublandlord’s review and assessment;
    3. Refraining from saving/storing sensitive information locally on any computer system/network/server/etc. of sublandlord;
    4. Prohibiting sublandlord from printing, photocopying, or otherwise replicating the sensitive information; and
    5. Conspicuously “watermarking” all sensitive information as “CONFIDENTIAL”.
  2. If sensitive information regarding the proposed replacement subtenant cannot be disclosed due to SEC Rule 10b-5 concerns prior to the closing of a merger/acquisition, then, after the closing, the new subtenant shall either:
    1. Provide the materials needed to assess the proposed subtenant, at which time sublandlord may still exercise its right to disapprove of the sublease assignment per the contract terms (in other words, the subtenant can roll the dice in hopes that sublandlord approves the assignment post-merger/acquisition); or
    2. If the prospective replacement subtenant believes that the assignment falls into the typical “Permitted Transfer” category due to sufficient capitalization, then, after the closing of the merger/acquisition, the subtenant shall tender the requisite materials to the sublandlord to confirm the “Permitted Transfer” categorization. If, upon receiving the post-closing disclosures, sublandlord determines that the capitalization thresholds for a “Permitted Transfer” were not met, then sublandlord can exercise its contract remedies due to the unpermitted transfer without consent.

In summary, landlords and sublandlords that are presented with a prospective assignment or sublease to a competitor must proceed carefully. Unwary parties can succumb to the hazards identified herein, which can lead to litigation and liability. But, those landlords that address these scenarios with knowledge of these potential pitfalls and employ these practices, will reap the benefits of greater insulation determines that the capitalization thresholds for a “Permitted Transfer” were not met, then sublandlord can exercise its contract remedies due to the unpermitted transfer without consent.

1 The authors recognize that lease exclusivity provisions, declarations, and/or covenants, conditions, and restrictions may give way to justified and lawful rejection of a lease/sublease assignment. But, in scenarios in which no such instruments/provisions are in play, acceptance may be the only safe option.

2 We use the identifiers “sublandlord” and “subtenant” in the following paragraphs, if only because the facts presented to our leasing team fell into the sublease context. That said, these analyses and recommendations apply equally in the context of a landlord assessing a proposed lease assignment or sublease to a competitor.

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Samuel J. Schumer is a partner in the Chicago office of Meltzer, Purtill & Stelle LLC and focuses his practice in the real estate and lending industries. Laura M. Carroll is a law clerk in the firm’s Chicago office and currently in her third year of law school at Loyola University Chicago. To receive more articles like this one delivered directly to your inbox, join MPS Law’s email list today.