Canada: Preventing An Insecurity Complex: What To Do Before Your Landlord Goes Under

Copyright 2009, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Real Estate, April 2009

In economic downturns, talk in the commercial leasing industry inevitably turns to what to do with shaky tenants and how to best protect the position of the landlord. However, tenants and subtenants should not assume that the headaches are all on their landlord and sublandlord's side – tenants and subtenants are increasingly finding themselves left out in the cold, figuratively and literally, when their landlord or sublandlord face financial difficulties.

Securing Possession: Get That NDA!

When times were good, tenants would often negotiate for the provision of a non-disturbance agreement (NDA) from the landlord's lender, but would never actually press their landlord to obtain it. Unfortunately for the tenant, without an NDA and where a lender's security is in priority to the lease, the lender is not bound to the lease and can force out a tenant where the landlord has gone into default. Although tenants like to think this could never happen to them, at the end of 2008, there were an estimated US$107-billion worth of commercial properties in the U.S. alone – hotels, retail properties and office buildings – that were already in distress or on their way there. And lenders have a number of reasons for wanting to get rid of tenants – including redevelopment of the property or sale to a potential owner/user, getting rid of "problem" occupants or simply a belief that they could get a higher rent if they went to the market.

The prudent tenant will therefore push their landlord to obtain an NDA as soon as possible after the lease signing, if not concurrently. Before the NDA is executed, however, a tenant will want to carefully review it. Some NDAs only provide, for example, that the lender will not disturb the tenant's possession so long as the tenant is not in default. For the tenant, however, it will also be important to try to get the lender to agree to be bound by the terms of the lease for as long as the lender is in possession. Without such an obligation, tenants may find themselves unable to enforce collateral rights for which they have bargained.

For subtenants, this problem is magnified twofold. Not only do they need to worry about their head landlord going into default under its mortgage (and, hence, subtenants should also obtain lender NDAs), but they also need to worry about their sublandlord defaulting under the head lease. Subtenants should consider negotiating directly with head landlords for the right to stay in the space upon default by the sublandlord, and should be wary of agreeing to waive statutory rights that permit them to remain in occupancy in the event of the default or bankruptcy of the sublandlord.

Securing Inducements And Other Amounts: Letters Of Credit, Deposits And Set-Offs

With bankruptcies on the rise, tenants and subtenants also need to consider how they can secure payment of the allowance and inducement for which they bargained. One possible solution is to require landlords and sublandlords to deliver funds into escrow (to be held by lawyers) or letters of credit to secure the payment. The letter of credit or escrow agreement needs to be carefully worded to ensure that these funds would not be able to be seized in a bankruptcy or otherwise not honoured.

Tenants and subtenants should also try, as much as possible, to avoid security deposits. In the event of a landlord's or sublandlord's bankruptcy or insolvency, security deposits could vanish into the bankrupt's estate. On the other hand, where a lease specifies that a "deposit" is in fact prepaid rent, case law holds that these amounts are not part of a bankrupt's estate, and tenants and subtenants will continue to have the benefit of having paid same.

Finally, tenants and subtenants should pay more attention to those clauses that prohibit any rights of set-off. Failure to pay construction allowances and other inducements should permit the tenant or subtenant to set off amounts owing against rent coming due. Tenants and subtenants should also consider including self-help remedies if their landlord fails to construct or perform the landlord's work, or otherwise fails to maintain and repair, with a right of set-off if the landlord fails to reimburse the tenant or subtenant for the amounts it has incurred.

Securing Peace Of Mind: Doing Your Due Diligence

Of course, tenants and subtenants can ease their mind at the outset by increasing the level of due diligence they are doing at the offer to lease stage. Tenants and subtenants should no longer simply assume that landlords have sufficient financial backing. This should particularly be the case with subtenants, where excess space should be a flag to subtenants that perhaps the prospective sublandlord is not necessarily as stable as it may appear.

In order to forestall problems at a later date, tenants and subtenants are increasingly asking to see financial statements of prospective landlords and sublandlords, hoping to avoid those who might be at risk of defaulting. Careful tenants and subtenants should also request that their lawyer conduct a subsearch of title: results will indicate who the true owner of the property is, whether there is any existing security registered on title, and any other existing liens that may be registered (such as for delinquent taxes or construction payments). In the result, landlords and sublandlords who have a history of financial stability and prudent management may find themselves more in demand than over-leveraged property owners.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.