By Sheldon A. Halpern and Mark C. Hulbert

At this point in the real estate cycle, many geographical areas are experiencing a large increase in subleasing activity. Retailers with surplus space on their hands are striving to reduce overhead after sales growth has failed to meet ambitious projections made during rosier economic times.

One threshold consideration in any prospective sublease is, of course, the satisfaction of any required approval of the master landlord. Even if this issue is taken care of, documenting a sublease deal can be a complicated process. It is easy to make the mistake of cutting corners to save time or transaction costs. The easiest approach is to incorporate by reference the provisions of the master lease, but such an approach can result in unforeseen difficulties if due care and attention is not paid to the specific items that are being incorporated.

Incorporating certain sections of the master lease should be avoided altogether. For example, the specification of the premises, the parties, the term (which should never be longer than the remaining master lease term) and the rent (particularly any percentage rent element) should always be spelled out in detail.

Any sections of the master lease that are being incorporated into the sublease should be closely reviewed. The following sections, however, warrant particular attention:

Payments by Subtenant
Sublandlords and subtenants should pay special attention to incorporated provisions governing payments by the subtenant (rent, CAM, taxes, etc.). It must be clear whether the payment is to be made to the sublandlord or directly to the master landlord. Note that if the payment is going to the sublandlord first, the sublandlord must ensure that it gets the payment early enough to timely pay the master landlord.

CAM Costs
Watch out for references to “Tenant’s Pro Rata Share”, which, in the case of a sublease of less than the entire premises, will be wrong. (As a general matter, a subtenant leasing less than the whole of the sublandlord’s premises should ensure that it only assumes obligations with respect to the subleased premises, not the entire premises covered by the sublandlord’s lease with the master landlord.)

Services and Operations
The sub-landlord should not unintentionally assume, with respect to its subtenant, the master landlord’s obligations with respect to services and operations (e.g., maintenance, cleaning, utilities, security, etc.). In these sections of the sublease, it is often appropriate that references to the “landlord” continue to refer solely to the master landlord and not to the sublandlord. Note, however, that if the master landlord will not be a signatory to the sublease, provisions in the sublease creating any affirmative obligations of the master landlord to the subtenant will probably be unenforceable against the master landlord (although the sublandlord could agree to use reasonable efforts to enforce the master landlord’s obligations).

Tenant Improvements
If the sub-landlord will be doing any tenant improvement work for the subtenant, this should be specifically spelled out in the sublease (and the sublandlord must obtain any necessary approval of the master landlord). The master landlord’s tenant improvement work obligations (or TI allowance payment obligations) should not be unintentionally incorporated into the sublease.

Casualty and Condemnation
Sub-landlords should be wary of incorporating casualty and condemnation provisions. The sublandlord would not typically want to assume any obligation to restore the premises.

Continuous Operation; Radius Clauses
Given the importance of these clauses to the master landlord, the sublandlord must ensure continued compliance. Any radius clause should be closely reviewed to ensure that the subtenant’s other stores within the radius do not violate the radius clause. The sublandlord should also consider whether it wishes to impose its own radius restrictions on the subtenant.

Exculpation
Many leases limit a landlord’s liability to its interest in the underlying real estate. Subtenants will probably want to avoid giving such broad exculpation to their sublandlords as the “interest in the underlying real estate” will, in most cases, be limited just to the value of the sublandlord’s leasehold interest.

Sublandlord’s Special Rights
Sub-landlord should be careful not to unintentionally incorporate special rights it has received from the master landlord. Certain rights may be clearly outside of the scope of most subleases (e.g., expansion rights and rights of first offer/refusal). Other rights may be included in provisions that the sublandlord was able to negotiate with the master landlord but which it may not wish to offer to a subtenant (e.g., early termination and offset rights).

Indemnification
These provisions are rarely drafted in such a manner that they would lend themselves to incorporation without significant thought and attention. The master landlord’s obligations (e.g., with respect to common areas), may be broader than would be appropriate for the sublandlord.

Insurance
Although the types of coverage referenced in insurance provisions may be appropriate for incorporation, care should be taken that the amounts are appropriate for the size and use of the subleased premises and the status of the subtenant entity. Note that specific rights granted to a larger sublandlord under the master lease (e.g., self insurance rights), may not be appropriate for a smaller subtenant. The master landlord should also be added as an additional insured.

SNDA’s
Both sub-landlords and subtenants should be wary about the incorporation of any provisions regarding subordination, non-disturbance and attornment. The sublandlord might end up having an obligation to obtain a SNDA from the master landlord’s lender (impractical, at best) and the subtenant may find itself without the protections it desires if it does not obtain a recognition agreement from the master landlord.

Notice Provisions
Care should be taken to ensure that notice provisions dovetail appropriately with the master lease. Sublease renewal notices, if applicable, should be given early enough to allow the sublandlord to provide timely notice to the master landlord regarding renewals of the master lease term. Similarly, the sublease should provide that any approval periods that sublandlord must observe allow adequate time for it to obtain the approval of the master landlord, if applicable. The sublandlord should ensure that notice and cure periods with respect to defaults are adjusted appropriately (e.g., the sublandlord should leave itself some time to fix a problem if subtenant fails to timely cure a problem that could constitute a default under the master lease).

Waivers
It is important to note that incorporation by reference of legal waivers may not be effective. For example, in a recent case in New York, a court held that general incorporation language in a sublease did not suffice to constitute a waiver of subtenant’s right to jury trial.

About the Authors: Sheldon A. Halpern is a partner and Mark C. Hulbert is an associate with Pircher, Nichols & Meeks, a Los Angeles-based real estate law firm with an additional office in Chicago.