When Remedies are Not Created Equal

One of the longest and most painful sections to wade through in a Lease is the landlord remedies section. You see, if a tenant doesn’t do what he’s supposed to do, including paying rent, maintaining the premises or carrying its insurance,  lots of terrible things will happen.  Reading the remedies is downright frightening.  Good thing debtors’ prison has been abolished in this country.  While people should certainly have recourse when the other party to a contract fails to perform as promised, it should be a two way street.  Problem is, most leases don’t even have a Tenant Remedies section and, even when the tenant does have remedies, they are watered down or largely illusory.

The basic premise for any contractual remedy is that each party is entitled to the benefit of its bargain should the other party fail to perform.  If the other party breaches, the non-defaulting party is entitled to be made whole. Thus, if a tenant signs a five year lease and defaults after three years, the landlord is entitled to the difference between what it didn’t receive from the tenant and what it does or can receive over the remaining two years from another tenant taking into account the costs of re-letting.  Further, if the tenant defaults in maintaining the premises thereby jeopardizing the value of the landlord’s asset, the landlord needs the right to evict the tenant and again sue for his resulting damages.  All of this makes sense and is fair.

As a wise man once said, however, “no matter how flat the pancake is, it still has two sides.”  Leases are not a one way agreement.  These documents also impose many important obligations, duties and responsibilities on the Landlord including building out the tenant premises,  funding certain improvement allowances, maintaining the property, providing utilities, security and elevator service, plowing the parking lot and insuring the property.  These form a critical part of the contract and are often a major inducement to the tenant in selecting a particular building or deal.  What  happens if the landlord fails to perform?

Just as the landlord wants to know that it has remedies that enable it to capture the benefit of its bargain should the tenant default, the tenant wants the same protections.  Typically a tenant wants to know that if the landlord doesn’t do what it is supposed to do, the tenant can step in and perform for the landlord and have a claim for the cost of curing landlord’s default.  Thus, if the landlord is responsible for maintaining the tenant’s air conditioning system and the landlord defaults, the tenant wants to be able to engage a subcontractor and get it fixed so it can get on with its business and enjoy the space as promised. If it costs $15,000 to fix the HVAC and the landlord refuses to reimburse the tenant, the tenant wants to be able to offset this cost against the rent.  In a fair world, the tenant should not have to keep paying full rent when the landlord owes it $15,000. However, the landlord rarely agrees to such self help or offset rights.  Instead, they insist that the tenant must bring legal action and obtain a judgment before exercising setoff or self help remedies.  Only then can they seek recourse.  The problem, of course, is that this legal process is lengthy and expensive and, in the interim, the tenant is not getting the benefit of its bargain.

Whereas landlords hold the ultimate hammers to compel tenant performance– the remedies of lease termination, eviction and rent acceleration– tenants are rarely if ever given similar hammers.  In fact, most leases and common law state that the tenant’s obligation to pay rent is an independent covenant and, therefore, he must continue to pay rent even if the landlord is not performing  its obligations.  Unless a tenant can prove that, as a result of the landlord’s breach, its space is uninhabitable, the tenant is really limited to a suit for damages and cannot terminate the lease for nonperformance by landlord.   However,  even then the tenant’s ability to be made whole can be illusory given the unique ownership structures of landlords and typical nonrecourse language in leases.

In today’s world, many landlords are single purpose entities who own nothing but one building.  These unique ownership structures became popular in the 1990s with the emergence of securitized debt and the need of lenders to isolate credit risk for a particular asset.  Thus, today a landlord that seemingly owns scores of assets may really own scores of affiliates, each of whom owns only a single asset.  Each landlord/building is a self contained unit and insulated from the liabilities of the others.

This single purpose entity structure is important because lease documents typically state that the Tenant is limited in its recourse to the Landlord’s interest in the building or, even worse, it’s equity in the building.  As a result, if the Building is in trouble, the underlying mortgage debt is greater than the asset value or the Landlord has no cash to satisfy its obligations, the Tenant may be left without a viable remedy and may even be required to continue to pay rent. That doesn’t seem fair.

Clearly some tenants are able to secure meaningful lease remedies that protect them depending on their negotiating leverage (i.e., lease termination rights, offset rights or even letters of credit to secure landlord obligations). The problem is that while the presumption in most leases is that the landlord should always be made whole and should have serious hammers to ensure tenants’ performance, the opposite is not true.  When we lived in a world with credit worthy landlords owning large portfolios of assets, tenants didn’t have to worry about recourse if they suffered damages.  However, with the advent of single purpose, bankruptcy remote entities, tenants have often lost the ability to protect themselves and guaranty the benefit of their bargain.  Tenant remedies have not adjusted to this newer paradigm and, in a world of increasing leverage and failed real estate projects, there is a real danger that tenants can be left out in the cold.  Perhaps it’s time to change the custom and start protecting the tenant too.

For more information contact Glenn Blumenfeld http://www.tactix.com/team.php#Glenn

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