I: The Beginnings of Revolution:
The last two decades have seen the beginnings of a common law revolution respecting the right of a commercial landlord to control subletting and assigning of the leasehold estate. Over a dozen cases have addressed the issue, and many of them - identifying an "emerging trend," have refused to enforce lease provisions giving a landlord discretion to withhold consent to proposed sublets and assignments except when, in the judgment of the court, the landlord has acted "reasonably."
The Appendix to this paper of many of the recent cases, together with some comments as to where they fit on the spectrum of analytic approaches that the paper describes. The paper also cites seven recent cases which have adhered to the traditional view, which most likely is still the technical majority. The "holdout" decisions, particularly a recent Indiana case, leave some doubt as to whether we have witnessed a true revolution, as opposed to mere guerilla warfare. Nevertheless, the willingness of courts in so many states to depart from established precedent is a reasonably good indicator that lawyers in other states will be faced with challenges to existing precedent favoring the landlord. Even if the new cases do not presage a new majority rule, they constitute a force with which all landlord's lawyers must reckon.
Prior to this sudden assault, of course, the established law had been that the landlord could restrict subletting and assignment as it wished, so long as a clear provision in the lease gave the landlord that option. Commercial landlords had come to expect control over subletting and assignments as their due. In certain circumstances, there can be no doubt, landlords overreached their privilege. There were such abusive provisions as those stating that the tenant's mere request for permission to sublet or assign automatically gave the landlord the right to terminate the lease. There were cases in which the landlord refused a reasonable substitute tenant and then, when the original tenant ultimately abandoned, sued the tenant for the term rent without making reasonable efforts to relet.
Perhaps some of the cases in this new "revolution" were responses to such abusive practices, but there really is little that suggests this. Rather, it has appeared that judges at appellate courts around the country have adopted the view that a landlord who agrees to accept a given tenant at a given rent for a set period has no legitimate right to deny a transfer of the leasehold to another tenant unless the new tenant presents significant new risks to the landlord's business.
Landlords, of course, see things differently. First, landlords are uncomfortable with judges and juries, who do not have their dollars invested in the rental property, "second guessing" the reasonableness of their decision on the acceptability of a given tenant. Second, in cases involving a rising market in leaseholds, landlords see a distinct difference in a tenant's renting a premises to conduct a business and a tenant's using a leasehold estate as a speculative commodity. The landlords' view is that if the leasehold estate has a "bonus value," and the tenant does not desire to stay, the value should belong to the landlord. In both situations, landlords do not see their positions as either "overreaching" or "unreasonable."
Assuming that landlord's views on the issues have not changed, the question is what should a lawyer representing such landlords do when confronted with the "new wave" of pro-tenant decisions on this issue. Is there any room for the landlord to achieve its goals in the face of the apparent lack of symphathy for the landlord's position in the various court decisions?
As to jurisdictions in which there are existing decisions, the answer depends partly on the theoretical basis the the court has used for its conclusions. As to jurisdictions in which the final cases have not yet been decided, lawyers representing landlords would do well to bring to the attention of the court those arguments that "go with the flow" -that acknowledge that there is a new approach to lease interpretation at work, and then seek to achieve the landlord's objectives within the parameters of the new thinking.
II. Working With the Existing Cases:
Virtually all of the existing cases have dealt with clauses that stated that the tenant could not sublet or assign without the landlord's prior written consent. Stating that the established rule had been that the landlord could withhold consent "arbitrarily," or without good reason, the courts conclude that leases should be interpreted more rationally in the modern world. Thus, they hold that the landlord cannot withhold consent without good reason.
Who can argue with this? Few lawyers really expect courts to acknowledge that their clients can take actions economically harmful to others for arbitrary reasons.
The problem, then, is not that landlords should have the right to control subleases or assignments for "bad" reasons. Commercial leases are all about making money, and when landlords make decisions that maximize their own economic return, those decisions are not "bad." If the parties have agreed that the landlord shall have such discretion, then the landlord's right to decide is part of a bargained for exchange. The question posed by the new cases, however, is whether landlords should be permitted to draft lease provisions that give them the express right to make judgments as to future occupants when courts, on the basis of general equities, and not bargained for exchange, would make a different judgment.
It is not yet clear landlords can achieve these goals under the new case law, but the picture is brightening up a bit. One important consideration is whether the basis for the court's decision is concern about restraints on alienation or merely (or primarily) concern about fairness in contract provisions and practice. Another is the whether the jurisdiction has adopted a somewhat obscure provision of the Second Restatement on Property.
A. The Restraint on Alienation Cases:
The common law doctrine restricting restraints on alienation of real estate is a device that courts have used on a number of occasions to avoid direct confrontation with the principle of freedom of contract. When the court has concluded that a particular provision of a real estate instrument operated in a way the court disliked, but the provision nevertheless was clearly written, the court's options were limited. A number of courts found that a broad interpretation of the free alienability concept provided doctrinal support for reviewing the reasonableness of harsh contract provisions, at least in real estate agreements.
A lengthy analysis of this doctrine is neither necessary nor appropriate here. But it is appropriate to call attention to the last great movement in the common law courts striking down express provisions in real estate instruments - the "due on sale clause" cases of the mid-80's. Although this started as a consumer movement, the issues soon became broader, and a number of courts concluded that due on sale clauses in commercial mortgages, on balance, "unreasonably restrained" the alienability of the mortgaged property when the mortgagee attempted to increase the economic return on the mortgage as a condition of consenting to transfer.
One would have expected, on the basis of the due on sale clause cases, to see the same kind of analysis applied in the assignment of lease cases. If anything, the concerns about alienability are much more applicable here. And, indeed, a few courts, most notably California in Kendall v. Earnest Pestana and Co., 709 P2d 837 (Cal 1985), did base a portion of their holdings against assignment and subletting restraints on the alienability principle. As one approach to evaluating the assignment clause, Kendall resorted to the "balancing test" used by the California courts in the due on sale issue. The quantum of restraint arising from the provision is balanced against the quantum of justification for its use identified by the court.
The focus of the balancing test as applied in Kendall is the degree to which the alienability of a property interest is restrained at the time the restraint is imposed - in the case of the assignment or sublease clause - at the time the landlord refuses to consent. Thus the entire issue is the justification for the landlord's behaviour, not the bargain of the parties.
As a consequence, in jurisdictions that rely upon the restraint on alienation doctrine as a basis for attacking the lease assignment clause, landlords should be prepared to defend their decision not to consent on the basis of facts existing at the time the issue arises. The contract language is unlikely to do them a lot of good. As litigation proceeds in the lower courts, and through the second set of appeals to "flesh out" the doctrines in these cases, landlords should take pains to justify their decisions by demonstrating the economic issues at stake.
At the eleventh hour in Kendall, the Pillsbury, Madison and Sutro firm was able to divert the tide of the "balancing test" and preserve some discretion for the landlord. It induced the court to provide a rather ambiguous footnote that suggests that the court would approve in some circumstances arrangements that would preserve the "bonus value" in a lease assignment for the landlord:
"Amicus . . . request that we make clear that, "whatever principle governs in the absence of express lease provisions, nothing bars the parties to commercial lease transactions from making their own arrangements respecting the allocation of appreciated rentals if there is a transfer of the leassehold." This principle we affirm; we merely hold that the clause in the instant lease established no such arrangement." 709 P2d at 848, note 17
This, of course, is a major victory for landlords, but the footnote is difficult to interpret and apply. It was clear, for instance, that the basis for the landlord's refusal to approve an transfer in the Kendall case itself was to secure for the landlord the increased value of the leasehold at time of assignment. It is also quite likely that, at the time of contracting, the parties anticipated that the landlord had this right based upon existing case law. What additional contract language would the court have required to interpret the Kendall language as an "arrangement for allocation of appreciated rentals?
In any event, it is important to note that footnote 17, which apparently authorizes some contract arrangements that would restrain alienation that courts otherwise find undesirable, is inconsistent with the basic restraint on alienation doctrine. The alienability policy normally is not a rule that the parties can "contract around." Because of the perceived injury to the public interest resulting from restraints on alienation, parties cannot waive in advance their protection from such conduct. Generally, courts that view controls on lease assignment as restraints on alienability do not approve the landlord's retaining the "bonus value" precisely because they view the "estate" transferred as carrying with it the potential for increased value over time that ownership of a real estate interest traditionally includes.
Whatever Kendall says about division of the "bonus value," the overall thrust of the opinion is that landlords will always have courts looking over their shoulders at the time they evaluate the acceptability of prospective transferees of leasehold estates. The only escape is to press the courts in these jurisdictions, as was done in Kendall, to define those areas in which a landlord's judgment will be given deference. Landlords deserve the right to define and limit their risks, and a few courts have made efforts to indicate factors which the landlords can take into account. But no amount of judicial precedent will provide complete protection to a landlord who wishes to limit in advance the exposure to tenants that the landlord finds undesirable. It is impossible for a landlord to anticipate at time of contracting all of the issues that are likely to affect its judgment years later as to the acceptability of a new tenant.
B. The Restatement of Property:
In addition to the common law restraint on alienation doctrine, Kendall also cited, apparently with approval, the Restatement of Property, Second, Section 15(2), which specifically provides that a landlord cannot withhold consent unreasonably to a proposed assignment or subletting. Other cases embraced this approach more directly, resting their entire holding on the provisions of the Restatement, sometimes with very little additional analysis.
Although the Restatement language arguably is an application of the doctrine against restraints on alienation, it also appears to implement a doctrine of "commercial reasonableness." Like Kendall, it departs from rigid "restraint" analysis when it specifically provides that the parties can agree by contract to give the landlord absolute discretion - so long as such a provision is "freely negotiated."
"A restraint on alienation without the consent of the landlord of a tenant's interest in leased property is valid, but the landlord's consent to an alienation by the tenant cannot be withheld unreasonably, unless a freely negotiated provision in the lease gives the landlord an absolute right to withhold consent." (emphasis added)
The logical next question for the transactions lawyer is what constitutes a "freely negotiated" provision. One answer, albeit an uncomfortable one in many contexts, is that a provision is "freely negotiated" only when a party may avoid the provision for a reasonable price in terms of other contract concessions. If a landlord offerred a tenant a lease with a consent provision that provided for reasonable landlord's discretion at one rental, and another that provided for absolute discretion at another, lower, rental, and the tenant selected the latter, then it would appear that a "free negotiation" had occurred.
This is not a satisfactory answer for a number of reasons. First, landlords usually would prefer not to sacrifice their discretion at any price. Second, lease negotiations are far more complex than the model suggests, and it would be difficult in many cases to identify what quid went with what quo. Finally, it is unlikely, in the modern world, that the landlord would get what it wanted anyway. The tenant likely would still be able to insist on reasonable behaviour by the landlord for the reasons discussed below.
Other interpretations of "freely negotiated" are perhaps obvious. The parties could separately initial the provision on assignability, or the assignability provision could be placed in larger letters at the begining or the end of the lease. The problem with these devices is that they might suggest that the assignability provision is not part of the overall bargain for the lease, or that other provisions not treated specially are not "freely negotiated" - which certainly is not the case.
Perhaps a preferable approach would be to cover assignability in a separate document. This would certainly call attention to the provision, but might again suggest that it not part of the overall lease. Such a problem could be cured, however, by language on this document indicating that it is indeed part and parcel of the overall bargain of the parties.
Most of the above suggestions, however, indicate that the assignment provision is "clearly disclosed," but do not necessarily indicate that it is "freely negotiated." Is it enough that the tenant clearly know and acknowledge that transferability is restrained? Official Comment i to the Restatement Section states that a provision giving the landlord absolute discretion "is not freely negotiated where [the tenant] has no significant bargaining power in relation to the terms of the lease." This language does not expressly require that the tenant be able to reject (for a price) the provision giving the landlord discretion. In fact, however, it may be even worse for the landlord. It requires evidence in every case that the tenant has significant bargaining power with respect to the whole lease. Even a negotiated agreement with respect to the transferrability of the lease may not be enough. In short, the Restatement appears to leave the question of whether a provision is "freely negotiated" to the judgment of the court at the time the provision is challenged, and thus to deprive the parties of predictability of result at the time of contracting. Full disclosure does not provide certainty of enforceability. None of the cases adopting the Restatement approach discuss this official comment at all, but the adoption of the principle Restatement section most likely would also incorporate this interpretive comment as well.
B. The "Good Faith and Fair Dealing" Cases:
Since the due on sale clause cases were decided, courts in many jurisdictions have taken a decidedly more activist view generally with respect to certain commercial relationships. They have developed the doctrine that a party given a choice of actions under a commercial contract must choose the action that is most consistent with an implied duty of "good faith and fair dealing." A number of the assignability cases have relied upon this thinking in analyzing the problem. The analysis here seems to be that parties to a contract have a right to assume that the other party will exercise its contract rights in a commercially reasonable manner - hence - the implied covenant flows from the reasonable expectations of the parties.
A recent example of this type of reasoning is the important Maryland Court of Appeals case of Julian v. Christopher, 575 A.2d 735 (Md. 1990), which holds that, on the basis of this implied duty, the landlord cannot suggest in the contract that it might consent to assignments and subleases when offered, and then unreasonably refuse to consent when the time comes. Like many other cases, Julian concludes that the landlord cannot refuse to consent in order to secure the "bonus value" for itself.
As the above analysis suggests, Julian establishes a clear and easy answer for transaction lawyers seeking to implement the landlord's goals described above - simply prohibit subleasing and assigning altogether. Then the tenant is not given any basis for believing that the landlord might consent.
Unfortunately, Julian compounds the Restatement confusion when it requires that provisions restricting assignment, or giving the landlord absolute discretion, must be "freely negotiated." As indicated above, it is difficult to know how this concept should be implemented. Under the Julian rationale, however, it does appear that a better case can be made that a fully disclosed contract provision, even one which the landlord was unwilling to change, meets the "freely negotiated" test. This is because the notion underlying the "good faith and fair dealing" test implemented in Julian is that a tenant not be misled into believing it is getting something that is not there.
Lawyers should be cautious not to overread Julian. The basic thrust is for fair play. If the landlord is really embarking on a course of business in which it anticipates that there will be a number of assignments and sublets, it probably should provide for them by contract in advance, and not pretend that they are forbidden. If a landlord who uses a lease with an absolute prohibition on lease transfers later proceeds to negotiate each time a tenant asks for the right to transfer, then it is likely that the courts will conclude that the landlord has implicitly agreed that it will be reasonable in deciding whether to waive the prohibition, despite the absolute language of the lease.
On the other hand, Julian may provide the best hope for those landlords who conclude that they can limit their risk on lease transfer by providing explicitly the circumstances under which they will or will not consent to a lease transfer. It, along with Kendall, would seem to validate a clause that gives to the landlord the right to increase the rentals to market or to obtain some other economic benefit as a condition for consent. Although it is clear that courts tend to view such demands as "unreasonable" when made at the time consent is requested, both cases validate their use in the original contract.
III. Jurisdictions To Which the Revolution Has Yet To Spread:
The notion that a party to a contract implicitly agrees to be reasonable in exercising contract options is likely to be attractive to many courts. It represents an opportunity to avoid unexpectedly harsh results and does not require courts to strain to find some other language in a contract implicitly restricting conduct deemed undesirable. Thus, lawyers in jurisdictions that have not incorporated this doctrine into their interpretation of commercial real estate instruments should anticipate that they may see it before too long.
As this paper has attempted to show, in the lease assignment area, and in many other areas as well, it is likely that the "good faith and fair dealing" rationale may be less frightening to landlords than a number of other approaches a court might take to implement judicial hostility to the assignability clause or other standard commercial practices. The virtue of the "good faith and fair dealing" approach for the landlord, is that it permits the parties to clearly allocate consequences in advance. Thus, to the extent that they can foresee problems with lease transfer or issues of wealth allocation resulting from the creation of "bonus value" a landlord and tenant can negotiate for provisions in the lease addressing those situations.
Of course, under the old regime, the landlord felt more protected against the unexpected - it could simply state that the tenant had to ask prior consent to a transfer and then wait and see what circumstances existed when the tenant requested permission. In fact, however, despite the language of the cases, landlords never had the unrestricted power to behave unreasonably. Courts have a number of other tools - manipulation of language, discretion over equitable relief and defenses, and control over damage determinations, to name only a few - that have always been available to curtail overreaching.
Thus, by confessing that "good faith and fair dealing" should be the law, at least in the area of commercial lease assignments and subletting, landlords likely aren't losing too much. It is still critical, however, to establish that "freely negotiated" in this context means nothing more than "fully disclosed." Any new litigation in an any state should focus attention on this issue.
In addition, lawyers should work with courts to carve out those areas in which landlords are entitled to limit their risk or preserve economic advantage in advance. As Julian indicates, courts are in fact cognizant that parties in the marketplace rely upon the predictability of the contract arrangements, and, to the extent consistent with fairness, courts may be willing, when asked by amicus groups for landlords or others, to provide clarity as to what contract controls over assignment and subletting will be enforced. An industry guideline from a national landlord's organization might even provide a basis for "trade practice" understandings that would be helpful, assuming counsel are satisfied that antitrust problems could be avoided. Conceivably a court could review and comment on such guidelines.
A recent Indiana decision is an important setback to the application of the "good faith and fair dealing" rationale. In First Federal Savings Bank v. Key Markets, 559 N.E.2d 600 (Ind. 1990), the Indiana Supreme Court reversed a lower appeals court decision adopting the "new" rule and upheld the right of a landlord to bargain for the right to refuse to consent to an assignment or sublet without justifying the "reasonableness" of the decision to a court. Importantly, the court acknowledged that the implied covenant of good faith and fair dealing did inhere in every Indiana lease, but that the covenant did not restrict a landlord from exercising a right that the parties had clearly conferred upon the landlord. Rather, the court concludes, parties have a duty to act "reasonably" with respect to aspects of the bargain that have not already been fully anticipated and addressed.
Undoubtedly, there will still be Indiana cases in which landlords will be denied the fruits of truly inequitable conduct, even when the lease nominally supports the landlord's behavior. Courts will not condone abuse in the exercise of a landlord's reserved right; but then, they never really did. Lawyers should not argue for absolute discretion, as this carries with it an opportunity for abuse. The argument should be for reasonable predictability and control over risk.
IV. If You Can't Lick 'Em, Lobby.
Another available approach in every jurisdiction, of course, is legislative. This was the ultimate resolution of the due on sale clause controversy. It is also the ultimate resolution of the problems that Kendall created in California. Cal. Civ. Code 1995.220, adopted in 1989, gives to landlords the clarity that Kendall did not. A lease may totally restrain assignments or subletting. It may provide that the landlord can get the "bonus value" if assigning or subletting occurs. If the lease does provide, however, that the lease can be assigned or sublet only with consent or only upon satisfaction of certain conditions, the landlord must be reasonable in determining whether to give consent. In a judicial challenge of the landlord's decision, the tenant has the burden of proof.
I. Restraint on Alienation Rationale:
Kendall v. Ernest Pestana, Inc., 709 P.2d 837 (Cal 1985) (discussed in text - follows both good faith and fair dealing rationale and restraint on alienation approach)
Funk v. Funk, 633 P.2d 586 (Idaho 1981) (restraint on alienation rationale - dissent notes that validity of an absolute prohibition is also in doubt under that rationale)
II. Restatement Approach:
Tucson Medical Center v. Zoslow, 712 P.2d 459 (Ariz App 1985) (expressly adopts Restatement as the law)
Basnett v. Vista Village Mobile Home Park, 699 P.2d 1343 (Colo. App. 1985) (expressly adopts Restatement as the law) rev'd on other grounds 731 P.2d 700 (Colo. 1987); but see, Bert Bidwell v. LaSalle & Schiffer, 797 P.2d 811 (Colo. App. 1991) (points to existence of Colorado landlord's duty to mitigate damages as supporting conclusion that a landlord could not arbitrarily refuse to accept a substitute tenant proferred by a financially failing prior tenant.)
Warmack v. Merchants National Bank of Fort Smith, 612 S.W.2d 733 (Ark 1981) (expressly adopts Restatement as the law)
Hendrickson v. Freericks, 620 P.2d 205 (Alaska 1980) (dicta) (cites Restatement with apparent approval)
III. Good Faith and Fair Dealing (sometimes described as Commercial Reasonableness)
Homa-Goff Interiors, Inc. v. Cowden, 350 So.2d 1035 (Ala 1977) (applies "good faith and fair dealing" rationale, although not by that name - does not discuss whether an absolute prohibition would be valid).
Gamble v. New Orleans Housing Mart, Inc., 154 So.2d 625 (La App 1963) (an early "good faith and fair dealing" rationale case - acknowledges validity of an absolute prohibition)
Boss Barbara v. Newbill, 638 P.2d 1084 (N.M. 1982)
Fernandez v. Vasquez, 397 So.2d 1171 (Fla 1981)
Comini v. Union Oil, 562 P.2d 175 (Or 1977) (not a lease case - assignment of an oil distributorship)
Newman v. Hinky Dinky Omaha-Lincoln, Inc., 427 N.W.2d 50 (Neb. 1988) (good faith and fair dealing rationale; expressly refuses to base its opinion on restraint on alienation doctrine or the Restatement, leaving these questions "for another day")
Julian v. Christopher, 575 A.2d 735 (Md. 1990) (discussed in text)
Jack Frost Sales v. Harris Trust & Sav. Bank, 433 N.E.2d 941 (Ill App 1982) (purports to follow Arrington v. Walter E. Heller International Corp, 333 N.E.2d 50 (Ill App 1975) - which is frequently cited as a pioneering case on this issue, but which involved a lease that provided expressly that consent would not be unreasonably withheld)
Shaker Building Co. v. Federal Lime & Stone Co., 277 N.E.2d 584 (Ohio 1971) (early case based primarily on interpretation of parties' intent - not on any implied duty); but see F&L Center v. Cunningham Drug Stores, 482 N.E.2d 1296 (Ohio App 1984) (readopting the traditional rule)
21 Marchants Row Corp. v. Merchant s Row, 587 N.E. 2d 788 (Mass. 1992)
First Federal Savings Bank v. Key Markets, 559 N.E.2d 600 (Ind. 1990)
Vaswani v. Wohletz, 396 S.E.2d 393 (Ga. 1990)
Snortland v. Larson, 364 N.W.2d 67 (N.D. 1985)
Danpar Assocs. v. Somersville Mills Sales Room, Inc., 438 A.2d 708 (Conn 1980)
B&R Oil Co. v. Ray's Mobile Homes, Inc., 422 A.2d 1267 (Vt. 1980)
Mann Theatres v. Mid-Island Shopping Plaza Co., 464 N.Y.S.2d 793 (NY App 1983)
Iseby v. Crews, 284 S.E.2d 534 (N.C. App 1981)