What is the scope of a non-assignability provision in a commercial lease? How specific must the non-assignability language be to cover collateral assignments for security as well as absolute present assignments of possession and use? If the lease clause expressly states only that the tenant will not assign or sublease its interest in the lease without prior notice to and approval of the landlord, this may not be sufficient to prevent the tenant, without complying with such notice and consent requirements, from assigning, mortgaging, or pledging its leasehold interest as collateral to a third party who provides financing to the tenant. This article will discuss this issue and analyze the case law -- which is not extensive -- on this topic, as well as change in ownership or control of a tenant entity as a violation of the non-assignment clause.
The Stone v. Simmons Case
In Stone v. Simmons, No. 91-CH-125 (2nd Dist.1999), disposition aff’d, 301 Ill. App. 3d 1103 (1999), the Illinois appellate court issued an opinion upholding the trial court’s ruling that the tenant’s collateral assignment of its interest in the lease to Continental Bank (“Continental”), as security for a loan of $6 million did not constitute a violation of the clause in the lease prohibiting assignment without the landlord’s prior consent. The plaintiff alleged that the collateral assignment of the lease to Continental breached the anti-assignment clause in the lease stating that “Tenant shall not assign this Lease without prior notice or written consent of Lessor.”
While acknowledging that this was a case of first impression in Illinois, the appellate court affirmed the holding of the trial court that Continental’s security interest in the lease was in fact a collateral assignment, and that the assignment did not provide Continental with possession of the property unless and until a default occurred under the loan. The appellate court also noted that the language in the non-assignability provision of the lease did not specifically prohibit collateral assignments without the landlord’s written permission, concluding that collateral assignments are “different in kind” from present assignments. The court further noted that the plaintiff could have prevented the disputed collateral assignment of the lease by drafting the assignment-of-lease provision to specifically cover such an event.
Change in Ownership or Control of Tenant Entity
With the advent of securitized and conduit financing and the use of bankruptcy-remote borrowing entities, it has become more common for non-assignment clauses in leases to contain a “change of ownership or control” provision, i.e., a prohibition against certain “direct or indirect” changes in the equity ownership, control or management structure of the tenant (usually a limited partnership or limited liability company). This language usually provides that if certain principal individuals or entities at any time own less than a specified percentage of the management, ownership, membership, general partnership, or voting interests of the tenant entity, or if the tenant entity sells, conveys, or assigns more than a specified percentage of such interests, a default will have occurred under the lease. The parties of course generally heavily negotiate such assignment restrictions.
Anti-assignment lease provisions that prohibit or limit the change in ownership or control of the tenant have been enforced by the courts, including a sale of stock, subsequent equity mergers, and transfers by operation of law. For example, in In re Washington Capital Aviation & Leasing, 156 B.R. 167 (Bankr. E.D. Va. 1993), the Virginia bankruptcy court held that language in the lease requiring the lessee-debtor’s principal to control the lessee-debtor prevented a sale of stock in the debtor-lessee as a method of transferring its interest in the lease. See also Parks v. CAI Wireless Systems, Inc., 85 F. Supp. 2d 549, 555 (D. Md. 2000) (stating that “under appropriate circumstances a corporate merger can result in the violation of an anti-assignment provision contained in a contract”); The Citizens Bank & Trust Co. of Maryland v. The Barlow Corp., 295 Md. 472, 485 (1983) (holding that merger of corporate tenant under commercial lease into another corporation violated non-assignment clause that expressly excluded assignments by operation of law); PPG Indus., Inc. v. Guardian Indus. Corp., 597 F.2d 1090, 1095 (6th Cir.1979) (“If the parties had intended an exception in the event of a merger, it would have been a simple matter to have so provided in the agreement”); Nicolas M. Salgo Assocs. v. Continental Ill. Properties, 532 F.Supp. 279, 283 (D.D.C.1981) (holding that “A transfer is no less a transfer because it takes place by operation of law rather than by a particular act of the parties” (citation and internal quotation marks omitted)).
Lessons for Landlords (and Lenders)
The holding of the appellate court in Stone v. Simmons, supra, should not be seen as shocking or misguided. The law (although certainly not extensive) in other jurisdictions, and in scholarly journals and treatises, generally supports the court’s analysis and ruling. For example, in Friedman on Leases, § 7.3.3 (Express Restrictions—Construction of Express Restrictions—General) (Updated July 2016), the author states that:
Restrictions against assignment, subletting, and mortgaging are restraints on alienation and for this reason are construed against the restriction. A covenant against one form of alienation does not preclude another form. A covenant against assignment does not prevent subletting. Nor does it prevent pledging or mortgaging the lease, though the enforcement of the pledge or mortgage may vest title to the lease in a third person with the same effect as if it had been assigned.
Currently almost all forms of commercial leases--which generally are prepared by and for landlords—forbid the tenant to assign, sublet, mortgage, or otherwise encumber the lease. The following is a sample lease provision that prohibits assignments (including collateral assignments) by the tenant without the landlord’s consent:
____. Prohibitions. Tenant for itself, its successors and assigns, expressly covenants that it shall not by operation of law or otherwise assign, sublet, hypothecate, pledge, encumber or mortgage this Lease, or any part thereof, or permit the Premises to be used by others without the prior written consent of Landlord in each instance. For purposes of this Article _____, “assignment” shall be considered to include a change in the majority ownership or control of Tenant if Tenant is a partnership, limited liability company, or privately held corporation. Any attempt by Tenant to assign, sublet, hypothecate, pledge, encumber or mortgage this Lease shall be null and void. The consent by Landlord to any assignment, subletting, hypothecation, pledge, encumbrance, mortgage, or use of the Premises by others, shall not constitute a waiver of Landlord’s right to withhold its consent to any other or further assignment, subletting, hypothecation, pledge, encumbrance, mortgage, or use of the Premises by others. Without the prior written consent of Landlord, this Lease and the interest therein of any assignee of Tenant herein shall not pass by operation of law or otherwise, and shall not be subject to garnishment of sale under execution in any suit or proceeding which may be brought against or by Tenant or any assignee of Tenant. The absolute and unconditional prohibitions contained in this Article _____ and Tenant’s agreement thereto are material inducements to Landlord to enter into this Lease with Tenant.
The best approach is to address these issues during the negotiation of a commercial lease, and carefully draft the non-assignability provision to specifically cover a collateral assignment of the lease, as well as certain changes in ownership or control, and exempt only specifically negotiated and specified matters such as estate-planning transfers and certain “one-time only” transfers. In addition, the provision should expressly provide that any purported violation of the provision will automatically be void and invalid.
Assignment clauses are lease provisions that are often not given appropriate consideration by tenants in lease negotiations. Likewise, landlords’ standard anti-assignment clauses may not cover some transfer scenarios that could result in a less creditworthy replacement tenant assuming the lease.
A tenant’s primary concern in negotiating a lease assignment clause is flexibility. The need for flexibility is heightened in long-term leases. If facing economic hardship, a tenant may want the ability to downsize or to obtain help in paying the rent either via subletting a portion of the space or a wholesale assignment of the lease. Likewise, if a tenant’s business is growing, the tenant may need to assign the lease or sublet the premises in order to find a larger, more suitable premises for the tenant’s needs.
In the case of an assignment of a lease or a subletting of a space, a landlord wants to be sure that an entity with sufficient net worth is liable under the lease for the payment of rent and the performance of the other lease obligations. Additionally, a landlord will want to prevent a tenant from competing with the landlord for the leasing of space within the building, shopping center or property (as applicable). Often a landlord will prohibit assignments and subleases with other current tenants of the property or with a prospective tenant with whom the landlord is negotiating for the lease of space at the property.
There are a number of issues that should be considered when drafting and negotiating the assignment provision of a lease.
Landlords should make sure that their anti-assignment provisions are sufficiently broad and capture various types of assignment, subletting and third-party occupancy arrangements, as well as changes of control and other entity-level transfers. Although anti-assignment clauses usually restrict the assignment of the lease and the sublease of the premises, a comprehensive anti-assignment clause should also restrict (1) the sublease or all or any portion of the premises, (2) a shared occupancy agreement or license to use the space by a third party, and (3) sub-subleases of the premises or any portion of the premises. “Transfer” should also be defined broadly to cover a transfer of the equity interests of (and/or the power to control) the tenant entity (or any parent entity if the tenant entity is a subsidiary). A tenant should negotiate for language providing that the landlord will not unreasonably withhold, condition or delay its consent to a proposed assignment or sublease.
- In light of broad anti-assignment provisions, as discussed above, a tenant should develop a list of transfers that constitute “permitted transfers” and that do not require any landlord consent. When negotiating these provisions on behalf of a tenant, it is crucial to understand the tenant’s business and its unique needs. For example, is it likely that, during the term of the lease, the tenant entity will be purchased by another company? If so, the tenant will want to exclude a sale of all or substantially all of its assets or stock from the definition of “transfer” and clarify that such an event will not require the landlord’s consent. Often, a landlord will require a net-worth test in this situation to ensure that the successor entity has a net worth following the transfer at least equal to that of the original tenant immediately prior to the transfer.
- Many landlords’ form leases include language that, in the event of an assignment or sublease, the landlord is entitled to 100 percent of any profits realized by the tenant from any sublease or assignment. As discussed above, a tenant will want to be sure that any profit-sharing requirement does not apply to a preapproved or otherwise permitted transfer. Additionally, the tenant should push for a 50/50 sharing of any sublease or assignment profits.
- A landlord will want to ensure that the original named tenant remains liable under the lease following any assignment, even if the assignment is approved by landlord. If a landlord is willing to consider releasing the original tenant from liability, the landlord will typically want to defer that determination until the tenant actually makes a transfer request. Once the landlord has the proposed assignee’s financial information, the landlord is in a better position to make a decision as to whether the original tenant should be released from liability under the lease. The release of liability language can be added to the form of consent executed by the parties in connection with the transfer.
- An overly restrictive permitted-use clause in a lease can thwart even the most tenant-friendly assignment clause. If the permitted use of the premises under the lease is limited to operating under a specific trade name, the tenant’s ability to assign the lease or sublet the space is severely limited. Tenants should be sure that the use clause of their lease is broad enough to allow the lease to be assigned or sublet to a different named operator, or even for a different type of use.