Canada: Subleasing: A Potentially Risky Proposition

Last Updated: March 12 2010

Article by Lloyd Cornett And David Himmel (Articling Student)

Many commercial tenants, hit hard by the economic downturn, especially those locked into long-term leases, are seeking to sublet a portion of their unused rented space to defray rent and operating costs.

From an occupant's perspective, subleases can be a financially attractive arrangement. Tenants interested in subletting their space are often highly motivated or even desperate, meaning the prospective subtenant should be able to negotiate a sublease at a deep discount from the rent payable under the tenant's head lease. For instance, at the end of July 2009, sublet space in the GTA was discounted on average by 27% compared to direct space.1 However, these favourable rent rates are tempered by the risks associated with being a subtenant; most notably, the fact that the subtenancy is dependent upon the continuing existence of the head lease and will be automatically terminated if the head lease is dissolved. A subtenant has several statutory rights that may enable it to maintain some aspects of its tenure in spite of the extinguishment of the head lease, but head landlords often require the waiver of those rights in exchange for consenting to the proposed sublease. It is important for a prospective subtenant, before taking advantage of a subleasing opportunity, to have a clear understanding of its rights, in order to fully appreciate the effect relinquishing those rights will have on the security of its sub-tenure.

Surrender of Head Lease

Section 17 of the Commercial Tenancies Act (the "Act") grants a subtenant just such a right. In the event of the surrender of the head lease by the tenant, this section provides that the head landlord becomes an assignee of the interest of the tenant in any valid underlease granted by the tenant. In other words, a subtenant's rights and obligations will not be disturbed when the head lease is surrendered, as section 17 transforms the head landlord into the direct landlord of the subtenant on the terms of the sublease. Section 17 does not apply, however, in instances where the head landlord exercises either a right of re-entry and termination or a contractual option to terminate, both of which will result in an automatic termination of the sublease.

Forfeiture of Head Lease

In the event of forfeiture or a right of re-entry being exercised by the head landlord under the head lease due to a default by the tenant, section 21 of the Act affords a subtenant the ability to maintain its subtenancy. In these circumstances, section 21 allows a subtenant to apply to Court for an order permitting it to retain its leased premises as a direct tenant of the head landlord, a similar outcome to the application of section 17. However, if such an order is granted, the Court has discretion to impose such terms as to the tenancy as the Court deems just, including the amount of rent payable, costs, expenses, and giving of security, though the term of the new lease cannot exceed the term granted to the subtenant under the sublease. In considering what terms to impose, the Courts have been concerned with not being unfairly prejudicial to the head landlord. This will often lead to the terms of the head lease, rather than the sublease, being imposed (including the higher rent amount normally payable under the head lease). Where the subtenant subleased from the tenant less than all of the space under the head lease, it should also be aware that the Court may require the subtenant to lease the whole premises. The combination of having to pay the higher rent and being required to lease all of the tenant's premises may render an order obtained under section 21 of little value to the subtenant.

Bankruptcy of Head Tenant

Section 39(2) of the Act provides that in the event of the bankruptcy or winding up of the head tenant, and provided the sublease was approved or consented to by the head landlord, the subtenant can elect, within three months of the bankruptcy filing or issuance of the winding up order, to take over the head lease on the same terms and conditions, except as to rent. If the subtenant elects to exercise such rights, it must also assume the entire term of the head lease, and the rent payable will become the greater of the rent due under the head lease and that due under the sublease. However, the subtenant is not required to pay any rent arrears. This arrangement allows the subtenant to "trump" the rights of the bankrupt tenant's trustee to affirm, assign or disclaim the lease within three months after the bankruptcy. Where a subtenant of a part of the leased premises exercises its rights under section 39(2), it is unclear whether (like section 21) the court can require the subtenant to assume the lease for all of the leased premises or only for the portion sublet.

Distress

Even if the head lease continues, a subtenant's inventory, furnishings, equipment and other personal property could be exposed to loss if the tenant fails to pay its rent. If rent for the leased premises is not paid by the tenant and the head landlord exercises its right of distress, (i.e. the right to seize assets on the premises and to sell them to satisfy the rent) the subtenant may use section 32 of the Act to protect its own assets from the distress, provided it has paid the sublease rent to the tenant. Many head landlords will want a prospective subtenant to waive its protection under section 32 prior to consenting to a sublease, because the head landlord's right of distress may be its only form of security.

Mitigating the Risks

Outside of the statutory protections described above, which the subtenant may be compelled by the head landlord to relinquish, there are several other means by which a subtenant can minimize the risks occasioned by the uncertainty inherent in a sublease. The subtenant can seek an agreement from the head landlord which would allow the subtenant continued occupation of its premises on the same terms and conditions as in the sublease in the event the head lease is terminated. However, this will rarely be available as the head landlord is unlikely to be interested in continuing to rent out a portion of its premises at the discounted rate that is probably in place under the sublease. In lieu of this, head landlords may be willing to agree to other accommodations, if asked. For example, a head landlord may agree to a provision whereby the subtenant will be permitted a reasonable period during which it may remain in occupancy of the subleased premises after the termination of the head lease. In addition (or alternatively), the head landlord may agree that written notice will be given to the subtenant of any default by the tenant under the head lease, and that the subtenant will have a right to cure such default. While not ideal, these two provisions would give the subtenant some time to either cure the default (or get the tenant to do so), negotiate a new lease directly with the landlord or find other premises. Another option would be for the subtenant to make arrangements with the tenant and the head landlord to have the sublease rent paid directly to the head landlord, eliminating the risk that the subtenant's funds could be diverted and not passed upstream to the head landlord, while also establishing goodwill between the subtenant and the head landlord. Finally, the subtenant should request, as a condition of the sublease transaction, that the tenant post financial security to be resorted to by the subtenant if the head lease is terminated due to a tenant default or bankruptcy. While such security would offer no protection against the loss of the sublease, if the security was for a sufficiently large amount it might afford protection against the costs and losses which the subtenant would be exposed to if it was forced to suddenly relocate to new premises.

A prospective subtenant should be sure to perform the necessary due diligence before entering into a sublease arrangement. Such due diligence should include analyzing all the agreement that make up the head lease, (i.e. the head lease, any amendments to it, estoppels certificates, etc.) ensuring that the tenant has sufficient financial strength to perform its obligations under the head lease and ensuring that a non-disturbance agreement has been granted to the tenant by the head landlord's mortgagee, so that if the head landlord defaults under its mortgage the tenant's lease will be protected from termination by the mortgagee, thereby avoiding a consequent termination of the sublease.

In considering the financial opportunity to obtain leased premises at a reduced cost, which a sublease may offer, a prospective subtenant should keep in mind the legal and practical risks inherent in the complex, tri-party relationship which a sublease entails. While there are statutory protections which can mitigate such risks to some degree, those protections may have to be foregone in order to obtain the consent of the head landlord to the sublease. There may be other ways to partially reduce these risks, but a sublease will inevitably always represent a riskier proposition than a direct lease.

Footnote

1 Colliers International GTA Sublease Report, July 2009.

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.

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