Publications

Tenant Defaults Under Commercial Leases:

Considerations in the Present Market

© 1992

by Jay B. Itkowitz, Esq. & Barry Gottlieb, Esq.

I. INTRODUCTION.

A. It is hardly a secret that the New York State commercial real estate market is severely depressed. This condition is the result of many factors, chief among them being the present depressed condition of the New York State economy, and the glut of both office and retail commercial space in many locations in the state.

The condition of the real estate market has obviously enhanced the bargaining power of commercial tenants in a variety of situations. It has affected relations between landlords and tenants at the outset of the relationship, midlease, and at the end of a lease, whether or not the lease contains a renewal option. Moreover, market conditions have affected the balance of power between landlord and tenant both where the tenant is financially distressed, and where the tenant is in sound financial health.

The altered balance of power has particular impact in connection with defaults in the payment of rent, which can occur:

a. immediately after execution of a lease,

b. after an initial period of reduced or free rent elapses,

c. anytime during the term of the lease, or

d. at the end of the term.

As the rules have changed so dramatically, the draftsperson must not blithely assume that a lease executed today will be followed tomorrow. The opposite is true. Both landlord and tenant should anticipate that the other party will default on some significant obligation(s) during the lease term. An attorney representing either party to a lease negotiation must take special care. An attorney representing a landlord must ensure that precious funds are not expended to build an installation for a new tenant, only to have the tenant disappear as soon as the free rent period ends. An attorney representing a tenant must protect it and its officers and primary shareholders from potential personal liabilities which may flow from a cessation of business and the startup of a new business. In short, draftspersons should anticipate that the default clauses will be utilized at some point during the lease term.

In these respects the default provisions and their practical application to an unhappy fact pattern may well be the most important lease clauses in tough times. Of course, the manner in which the default clauses intersect with other provisions of the lease can be critical.

II. SECURITY

A. One of the first issues to be addressed in a lease, and the first to be examined when a tenant default occurs, is the security clause(s). Security in and of itself is a hot issue these days. Landlords have always wanted it and demanded it, but nowadays tenants fight hard to reduce such requirements, if not eliminate them, because they are aware that from a landlord's perspective any rentpaying tenant is better than no tenant.

B. Where there is security, too often clauses pertaining to circumstances under which the landlord may utilize such security and demand its replenishment are vague and ambiguous. Vague and ambiguous security clauses are helpful to the tenant, because the lease is most often drafted by the landlord and any ambiguity is construed against the party who drafted the lease. Hence, a tenant should not necessarily seek to clarify lease provisions which do not provide for how and when the landlord may draw down on security -- unless, of course, the security is in the form of a letter of credit.

C. A key provision for a landlord is one providing for application of tenant security to rent arrears in the event of a tenant default in payment. It is a clause that is hard for a tenant professing good faith to argue against. Nevertheless, the tenant can seek to limit the circumstances under which the security can be applied towards an outstanding rental obligation.

1.) A provision providing for drawdown of security and application to arrears can be a temporary salve to a landlord with a cash flow problem. Particularly where the tenant appears headed for bankruptcy court, taking the security may be advisable, as otherwise the security will be frozen upon the tenant's filing a petition for bankruptcy or reorganization. L. Cherkis, Collier Real Estate Transactions and the Bankruptcy Code, § 3.04 (King, ed. 1990).

2.) However, leases which allow the landlord to apply the security toward arrears do not always contain a provision requiring the tenant to replenish the security within a specific period of time (some leases simply say "forthwith"), and many leases lack a provision deeming the obligation to replenish security to be an obligation to pay rent or additional rent (thus making it impossible to recover the security in a nonpayment proceeding). Accordingly, a landlord should be aware that taking the security to satisfy arrears may result in the landlord's loss of the security through the end of the term of the lease unless the lease specifically provides that a failure to replenish depleted security within a specified period shall be deemed a failure to pay additional rent under the lease. A sample lease clause requiring the tenant to replenish security within ten days of the landlord's demand and deeming the obligation to replenish security to be an obligation to pay additional rent is attached as Exhibit 1. Such a clause gives the landlord the option of forcing replenishment in a relatively inexpensive nonpayment summary proceeding. In the event the lease does not explicitly provide that replenishment of security within a specified period shall be deemed a failure to pay "additional rent" under the lease, a landlord would be relegated to seeking an injunction in Supreme Court in a declaratory judgment action to compel the tenant to replenish security. Such a course of action is cumbersome and expensive (not to mention uncertain in result) so that the practical effect of a lease's failure to require the replenishment of security in a specified period, and a lease's failure to deem a failure, to replenish to be a failure to pay additional rent, will be to leave the landlord without security after a drawdown.

D. Letters of credit. When security is in the form of a letter of credit, the tenant should seek specificity from the landlord in terms of when the landlord may draw down on the security. The practical reason is that the drawdown of a letter of credit compels the tenant to have to repay the bank for the funds drawn down on by the landlord. Accordingly, the tenant should seek as much notice as the landlord will give before the landlord is permitted to draw down on the letter of credit. Advance notice will allow the tenant to seek an injunction in court, if so advised, if the tenant is aggrieved by the actions of the landlord. The landlord, of course, prefers to give no notice or as little as possible before drawing down on the letter of credit. The replenishment issue or a letter of credit is identical to that discussed above in connection with cash security. After a drawdown, landlord wants the right to compel the replenishment of security and to have the failure to do so be deemed a failure to pay additional rent under the lease.

III. NON-PAYMENT OF RENT

The most frequent area of default in hard times is in the payment of the rent reserved under the lease. It is also the most pressing concern for a landlord faced with a default in the payment of rent. The landlord can, as noted above, apply the security to arrears, if necessary, to keep his cash flow going.

However, it the default continues, the landlord will be faced with a decision as to what type of legal proceeding to bring. The landlord has two theoretical options.

1. The first is to launch a summary proceeding. This is far and away the weapon of choice for a landlord, and with good reason. It is the cheapest and quickest method to bring the issue of nonpayment of rent to a head. Among the reasons it is cheaper and quicker are:

a.) A summary proceeding precludes discovery without leave of the court and a trial can be obtained much faster than in a plenary action; and,

b.) Most commercial leases contain a provision whereby the tenant waives his right to assert any counterclaims in any nonpayment proceeding commenced by the landlord. Such waivers are typically enforced in commercial leases. E.g., Earbert v. Little Luxuries, Inc., 99 A.D.2d.734 (1st Dept. 1984); Net Realty Holding Trust v. Cidis, NYLJ, December 7, 1990, p. 29, col 2 (App. T. 2d Dep't); Bomze v. Jaybee Photo Suppliers. Inc., 137 Misc.2d 957 (App. T. 1st Dep't 1983); Amazon Management Corp. v Paff, 166. Misc. 438. (App. T. 2nd Dep't 1938).

2. The second option is to commence a plenary action. While this course is theoretically possible, we can envision almost no set of circumstances where we would choose a plenary action over a summary proceeding in connection with a rent default. A few exceptions are discussed below.

A.) The Summary Proceeding. A good lease will allow the landlord to choose between two types of summary proceedings to bring in the event a tenant defaults in the payment of rent: (1) the right to commence a nonpayment proceeding as provided by statute, and (2) the right to terminate the lease for failure to pay rent in the event that the tenant is served with a notice to cure (notice of default) and fails to pay the amount required by the end of the cure period. Upon service of a termination notice pursuant to the lease, the landlord is entitled to commence a holdover proceeding on the ground that the lease is terminated. Of the two, the first is the most common remedy for nonpayment, particularly in an environment where tenants are not always easy to replace. However, there are times -- even in bad times -- when the landlord simply has had enough and wants to bring the landlord-tenant relationship to an end. Under such circumstances, a prerequisite to ending the relationship is the default provision providing for termination in the event of an uncured default in payment of rent and additional rent. The ability to threaten the tenant with a loss of its lease in the event of a failure to pay rent is a nuclear weapon where the tenant has a viable business and wishes to stay in possession. It is for this reason that landlords want such a clause and sophisticated tenants will resist such a clause, particularly where the market is going.

(1.) The nonpayment proceeding. Where the consideration is rent collection, the nonpayment proceeding, is the simplest most efficient procedure. As a creature of statute, the nonpayment is governed by the Real Property Actions and Proceedings Law ("RPAPL"). A requisite for commencing the proceeding is the demand for rent. RPAPL § 711(2). The demand may be oral or in writing. If in writing, it must be served in the same manner as a notice of petition and petition. The failure to serve a written rent demand in the manner as a petition and notice of petition pursuant to RPAPL §§ 711(2) and 735 is a common mistake for landlords to make. Even sophisticated landlords for some reason may be prone to think that mere service by certified mail is good enough. Perhaps that is because most lease notices may be served in such a manner. But the nonpayment proceeding is governed by statute, not leases, and the demand must be served in accordance with the statute or the proceeding will be defeated because the landlord will not be able to make out a prima facie case, which includes, as an essential element, that rent was properly demanded prior to the institution of the proceeding. RPAPL § 711(2).

(2.) The right to terminate. The termination clause provides a mechanism whereby the landlord may terminate the lease after a default by the tenant in paying rent, upon written notice to the tenant. Such termination clauses will be enforced by the courts. E.g., Grand Liberte Coop. v. Hilhaud, 126 Misc.2d 961 (App. T. 1st Dep't 1984); Nineteen N.Y. Properties. v. Apple Video Services, NYLJ, October 10, 1990, p 22, col. 1 (App T. 1st Dep't); T.W. Dress Corp. v. Kaufman, 143 A.D.2d 900 (2d Dep't 1988). However, the termination clause must be drafted as a conditional limitation upon the term of the lease, making clear that "upon the occurrence of an event the lease shall expire as if the lease by its terms had been limited to that time. 2 J. Rasch, New York Landlord & Tenant, Sec. 23:31 (3d ed. 1988).

(3.) At least one appellate case giving full force and effect to such a conditional limitation--Grand Liberte--noted that the use of such a conditional limitation to terminate a lease allowed a landlord to use a holdover rather than a non-payment proceeding to recover possession, thus depriving the tenant of the right to retain his lease by depositing the amount of the final judgment for arrears into court prior to the issuance of the warrant of eviction, pursuant to RPAPL Sec. 751(l). But the Appellate Term in Grand Liberte indicated that the aforesaid argument against the propriety of such conditional limitations was vitiated by the availability of "Yellowstone" injunctions to toll the running of a cure period (and thereby delay the termination of a lease for non-payment of rent). And subsequent cases have held that a Yellowstone injunction is generally not available to a tenant whose leasehold is threatened by the exercise of a conditional limitation based on the non-payment of rent. E.g., Rainbow Travel, Inc. v. Omabuild N.V., 139, Misc.2d 279 (Sup. Ct. NY. Co. 1988). The First Department has shown no inclination to either disallow the type of conditional limitation in question as void as against public policy (because it deprives the tenant of the "cure" provision available in nonpayment proceedings pursuant to RPAPL Sec. 751[l]), or make Yellowstone injunctions available in this context. However, it is unclear whether any of the other departments will at some future time rule that conditional limitations of the type under discussion are void as against public policy because of the unavailability of both the right to cure under RPAPL Sec. 751(1) and the right to a Yellowstone injunction, or whether any other department will hold that Yellowstone injunctions are available in this context. At Sec 23:34, Rasch sets out a good example of an effective conditional limitation allowing a landlord to terminate a lease for nonpayment of rent. Another example is attached as Exhibit 2.

B. The plenary action.

1. In a situation where a tenant in possession defaults in the payment of rent, the summary proceeding is the preferred remedy. As indicated above, it is quicker and cheaper than a plenary action. Some might ask, however, what if the landlord only wants to get money and not possession? Our answer is to proceed with a summary nonpayment proceeding. The reason is that a landlord can get everything it wants in the quicker cheaper forum; namely, where the tenant appears and defends, you can get a money judgment along with a possessory judgment. The money judgment obtained in the summary proceeding is as valid and enforceable as one obtained in a plenary action. The difference is that one is more easily obtained than the other. The point to remember is that the landlord does not have to execute on a warrant if the landlord ultimately decides not to dispossess the tenant. On the other hand, the judgment of possession gives the landlord the sword of Damocles to hold over the head of the tenant and, in fact, even a reluctant landlord may decide to dispossess after an extended period of nonpayment.

2. An instance where a landlord might favor a plenary action over a summary proceeding might be where the landlord has a solid personal guarantor it can go after to enforce the financial terms of the lease, or a solvent assignor of the lease, provided that the consent to the assignment did not release the assignor from the leasehold obligation. In such rare instances, the landlord can often proceed against such guarantor or assignor without proceeding against the tenant. A much more common instance where a landlord would proceed against a guarantor and/or assignor would be after the landlord has proceeded against and dispossess the tenant. In such instance, the landlord seeks to make itself whole from such persons, or at least cut its losses.

3. Action against related entities and/or individuals. A problem commonly encountered by commercial landlords arises where the tenant entity is a subsidiary or affiliate of another entity, and the tenant is effectively insolvent but the parent or affiliate is not. In such a situation, in an action to recover arrears and damages under the lease, the landlord may try to recover against the parent or affiliate, on the theory that the tenant was completely dominated and controlled by the parent or affiliate; or that the tenant was a mere agent of the parent or affiliate; or that the parent or affiliate was the "alter ego" of the tenant. Most of the law in this area has been developed by the federal courts, but New York State courts have sometimes been willing to hold corporations liable for the acts or omissions of separate but related entities in various contexts not relating to commercial leasehold obligations. E.g., Berkey v. Third Ave. Railway Co., 244 N.Y. 6O2 (1927); Int'l Aircraft Trading Co. v. Manuf. Trust Co., 297 N.Y. 285 (1948); Robinson v. Chase Maintenance Corp., 20 Misc.2d 90 (Sup. Ct. N.Y. Co. 1959); Musman v. Modern Deb, Inc., 50 A.D.2d 761 (1st Dept. 1975); A.W. Fuir Co., Inc. V. Ataka & Co., Ltd., 71 A.D.2d 370 (1st Dep't 1979); The Chase Manhattan Bank (N.A.) v. 264 Water Street Associates et al., 174 A.D.2d 504 (1st Dep't 1991).

If a landlord attempts to hold a separate but related entity liable for the leasehold obligations of a tenant, some or all of the following factors are likely to be deemed relevant by the courts:

a. the extent to which the ownership of the tenant is the same or substantially the same as that of the related entity;

b. the degree to which the tenant is financed by a related entity, the method of financing, and the extent to which the related entity determines the financial affairs of the tenant;

c. the extent to which the tenant and the related entity have common directors, officers, and employees;

d. the extent to which the tenant and the related entity keep separate books and accounts;

e. the extent to which the related entity determines the policies and decisions of the tenant;

f. the kind of business operated by each entity; and

g. the extent to which the trade or public regards the tenant and the related entity as one.

IV. RENT ACCELERATION

1. Some commercial leases allow the landlord to accelerate the tenant's obligation to pay all rents reserved under the lease upon the tenant's default in paying rent, so that all payments of rent due under the lease are immediately due and owing. Exercising such an acceleration option generally gets the tenant's attention, and shows the tenant that the landlord "means business"; if the tenant thereafter wishes to pay all arrears and become current, the landlord can always accept the tendered payment and agree to rescind its exercise of the acceleration option. However, an acceleration may also have the effect of pushing a financially troubled tenant further toward bankruptcy. Acceleration clauses are also useful where a viable tenant has abandoned the premises. In such cases, the landlord accelerates the rent obligation and goes after all the rent that would be due in a plenary action. In the absence of such a clause, a landlord may not sue on such rental obligations until they accrue, month by month. A sample lease provision giving the landlord the right to accelerate all rents reserved to him under the lease in the event of nonpayment of rent is attached as Exhibit 3.

V. LANDLORD'S DUTY TO MITIGATE DAMAGES

1. Traditionally, New York courts have declined to impose upon commercial landlords the duty to mitigate damages where a tenant has vacated and stopped paying rent. E.g., Mitche1 & Titus Assoc. v. Mesh Realty Corp., NYLJ, April 19, 1990, p.23, col. 3 (App. Div. 1st Dep't); Syndicate Building Corp. v. Lorber, 128 A.D.2d 381 (1st Dep't 1987).

EXHIBIT 1

If landlord applies or retains any part of the security so deposited, Tenant, within ten (10) days of Landlord's demand, shall pay to Landlord as additional rent the amount so applied or retained so that Landlord shall have the full deposit on hand at all times during the Term.

EXHIBIT 2

If the Tenant shall default in making any payment of any minimum rent or additional rent where the same becomes due and payable, and if the Landlord shall serve five (5) days' written notice of such default upon the Tenant, and if the Tenant shall fail to cure said default within five (5) days of the Landlord's service of the aforesaid notice of default upon the Tenant, then the Landlord may serve three (3) days' written notice of cancellation of this lease upon Tenant, and upon the expiration of said three(3) days, this lease and the terms thereunder shall end and expire as fully and completely as if the expiration of said three day period were the day herein definitely fixed for the end and expiration of this lease and the term thereof, and the Tenant shall then quit and surrender the demised premises to the Landlord, but the Tenant shall remain liable as hereinafter provided.

EXHIBIT 3

If Tenant shall default in the payment when due of minimum rent or additional rent, Landlord may elect to declare all Rent payable under this Lease by Tenant to Landlord due and payable, and, if Landlord shall make such election, such Rent shall be due and payable with five (5) days after Landlord's notice, to Tenant of such election.

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