Key Provisions in Restaurant Leases
June 17, 2012
Opening a restaurant is a labor of love and, even for the most business-savvy restaurateur, an extremely challenging enterprise that demands a great deal of planning, patience and persistence before one’s efforts start to bear fruit. It’s a marathon, not a sprint. A number of factors can contribute to the viability and success of a restaurant such as the location, the notoriety of the head chef or primary investor, the menu, and the quality of service, to name a few. However, before a restaurateur can focus on these factors in earnest, there is a more fundamental concern that warrants close scrutiny—the restaurant lease.
The restaurant lease governs the restaurant’s relationship with the landlord and with the premises that the restaurant will occupy. It will determine the term of years the restaurant is bound to operate in the premises, the type of food that the restaurant serves, whether it can sell liquor, what kind of signage it can post on the storefront, and, perhaps most importantly, whether the business owner can sell the restaurant, i.e. assign the lease, to a third-party in the event that the owner wants to leave the business for personal or financial reasons. A typical restaurant lease will address each of these considerations in addition to several others that affect the restaurant’s operation and business prospects. This article highlights key provisions that a restaurateur must be mindful of and discusses how to avoid common pitfalls while negotiating for language that maximizes flexibility and risk management for the business owners.
Length of Term, The Use Clause, & Liquor Licenses
Getting a restaurant up and running requires a significant up-front commitment of resources so it naturally follows that the longer the restaurant stays in operation, the better chance the investors stand in seeing a return. Thus, when negotiating the length of term of the lease, business owners should consider financial projections and always aim for a longer term than what would be the minimum number of years to start seeing a return on investment. In addition, the lease should also grant the restaurant an option to renew for another identical term of years. A longer term plus an option to renew accomplishes two things. First, it provides the restaurant with flexibility in choosing whether to continue operating out of the space, and second, it makes the lease a more salable asset in the event the restaurateur wishes to sell the restaurant and assign the lease to a third-party.[1]
For the same reasons, the lease should likewise provide for the broadest possible use clause. For instance, the restaurateur may initially want to open a French bistro only to realize that the surrounding area would be better served by a pizza-arcade serving a younger demographic. Or, in the event that the business is sold, the prospective buyer, i.e. the would-be lease assignee, may want to operate an Asian fusion restaurant. In either case, the lease should ideally allow the tenant to proceed without interference from the landlord or, as is often the case, competing tenants. If a party objects to a change in use and litigation ensues, the court will look to see whether the use clause only allows for the operation of a French bistro,[2] or, where the assignment clause allows landlord to reasonably withhold consent, the court will look to see whether landlord’s refusal to allow an Asian fusion restaurant is grounded in pragmatic business considerations.[3]
Most restaurateurs will want a liquor license issued by the New York State Liquor Authority as it can be very lucrative to offer patrons beer, wine and cocktails. Thus, the use clause should generally not prohibit or preclude the tenant from serving alcoholic beverages. However, the process of obtaining a liquor license can often be onerous and protracted. In New York, a liquor license can sometimes take as long as six to eight months to process and before filing for a liquor license, the applicant is required by law to meet with the appropriate community board organization and receive its blessing. In short, procuring a liquor license is a complex process and should be undertaken with the advice of knowledgeable counsel. But what if the restaurateur’s liquor license application is nevertheless rejected? Circumstances may require the restaurant to enter into a lease before it has its liquor license. But not having a liquor license cuts off a major stream of revenue for the business and threatens to sink it entirely in its infancy. In this scenario, the tenant will want to have the option to cancel the lease in the event that its application for a liquor license is rejected. This may require the tenant to part with its security deposit in order to be let out of the lease, [4] but it is a small price to pay where the alternative is being locked into a long-term lease while your business struggles to stay afloat. Therefore, tenants who negotiate for a cancellation clause in the event that their liquor license application is rejected, hedge against a very probable and potentially costly risk.
Assignment Clauses & Collateral Reassignments
As discussed in the previous section, the ideal lease from the restaurant’s perspective is one that does not bar or hinder the tenant’s ability to assign the lease to a third-party. But it is more often that assignment clauses will contain language that simply prohibits landlord from “unreasonably withholding consent”. This is naturally a fact-sensitive standard and what constitutes a reasonable basis to withhold consent can range from a prospective assignee’s failure to comply with landlord’s request of financial bona fides,[5] to business realities that will affect the potential success of the prospective assignee.[6] What will not pass muster under this standard is a landlord withholding consent based on subjective beliefs or personal desires.[7] For the landlord’s part, it will want to prevent tenants from circumventing consent provisions altogether through the use of stock transfers by having the lease deem transfers of 51% or more of the tenant-entity’s controlling shares to a third-party as an assignment.[8]
Assuming landlord grants consent to assign the lease and the restaurateur sells the business, what is the relationship between the seller-assignor and the landlord? An assignment of lease leaves intact the privity of contract between landlord and tenant but terminates the privity of estate.[9] In plain English, this means 1) that the tenant-assignor still remains liable on the express covenants in the lease (e.g., the covenant to pay rent) even though the landlord may consent to the assignment and accept rent from the buyer-assignee and, even if the assignee assumes the obligations of the assigned lease, and 2) that the seller-assignor no longer has an “estate in land” that is leased to another person, i.e. the assignment terminates the privity in estate, which is the interest in real property that one needs to maintain a summary proceeding to evict a lessee and take possession of a property.[10]
Take, for example, our hypothetical French Bistro, Che Pepe. After growing the bistro’s reputation, Pepe decides to sell the business and retire to an island where he will live off the proceeds from the sale. He finds a willing buyer to purchase Che Pepe for $1,000,000, of which $100,000 is a down payment, the remainder being secured by a promissory note that requires buyer to pay down the note in monthly installments. After the deal, buyer continues to operate the bistro as Che Pepe but the quality of food and service is just not the same. Che Pepe precipitously loses customers especially due to the increased competition in the neighborhood, and the buyer has trouble paying rent, let alone making the monthly installments to Pepe under the promissory note. Pepe now wants to swoop in, get the buyer out of the space, and save his beloved restaurant from certain demise. What can Pepe do? Unfortunately, the answer is not much. Assuming Pepe simply executed and delivered an assignment of lease in buyer’s favor, he destroyed the privity of estate and thus walked away from his possessory interest in the premises that is necessary to maintain an eviction proceeding.[11] Of course, the landlord will no doubt institute an eviction proceeding against the buyer, but Pepe will have no legal basis to stop the landlord from terminating the lease with Che Pepe and leasing the premises to a completely new business.[12] The best Pepe can do is sue the buyer for the balance remaining on the promissory note and hope that the landlord will be sympathetic to Pepe’s plight and consider letting the restaurant carry on under Pepe’s management.
Pepe could have avoided this mess if his attorney had counseled him to enter into a collateral reassignment. The goal of a collateral reassignment is to preserve the privity of estate between the seller-assignor and the landlord so that the seller can take back possession in the event that business for the buyer sours and jeopardizes the seller’s brand. In a collateral reassignment the seller assigns the lease to the buyer, who then reassigns the lease back to the seller as security pending full payment of the purchase price for the restaurant. Simultaneously, the seller-assignor and the buyer enter into a sublease agreement where the seller assumes the role of landlord and monthly rent may include the amounts owed under any promissory notes. Once the debt is discharged at the end of the sublease’s term, the interest in the lease reverts back to the buyer, i.e. to whom the initial assignment was made. If, however, the buyer fails to make payments during the sublease’s term, now the seller has legal standing to bring an eviction proceeding and take back the premises, i.e. the collateral reassignment from buyer to seller conferred privity of estate on the seller-assignor.[13]
From the business perspective, the sale of Che Pepe is really the sale of Pepe’s brand that he cultivated through his hard work, marketing and culinary prowess. A shrewd landlord will try to claim a piece of the sale price by arguing that the premium realized from the sale is really attributable to the appreciation in value of the real estate. Therefore, Pepe’s astute counsel should anticipate this tension during lease negotiations and make clear that landlord will have no claim to the purchase price of the restaurant. Failing that, tenant should maintain it is entitled to all the consideration from the trade name and/or fixtures.
Equipment, Fixtures & Signage
In building out a restaurant, the owners will want the maximum possible latitude in fitting the premises with the necessary equipment and fixtures, erecting signs on the building’s façade, and displaying its menu and decorative items. However, it is often the case that standard commercial leases will contain provisions that curtail this latitude and serve to frustrate the restaurateur’s business plan.
For example, many leases prohibit tenant from causing any liens to be placed against the property. But if the tenant needs to install a piece of costly equipment that requires it to enter into a financing agreement with a vendor, and the vendor will only sell the equipment if it can secure payment by placing a lien on the installed equipment, a landlord can construe this as a default under the lease and terminate the tenancy if tenant fails to discharge the lien, i.e. pay the outstanding balance.[14] Thus, tenants should head this issue off from the outset by negotiating for a carve-out that allows vendors to place liens on the premises in connection with tenant’s build-out of the premises.
Standard clauses that cover alterations and fixtures can also cause tenants significant problems towards the end of a lease’s term. For example, Article 3 of the Real Estate Board of New York’s Standard Form of Store Lease (“Standard Board Lease”) can impose costly obligations on the tenant if its counsel fails to have it stricken.[15] The import of Article 3 is that the landlord automatically takes title to all fixtures and installations that do not qualify as “trade fixtures”, but can also relinquish title to any fixtures upon 20 days notice to tenant before the lease’s termination, and require removal of the fixtures and restoration of the premises at tenant’s expense. For restaurants, removal of fixtures and installations can be a staggeringly expensive proposition and, more often than not, costlier than the price of the original installation. This fact, taken together with the possibility that landlord could impose such a burden upon just 20 days notice could leave the restaurant and its principals in an intractable position. Thus, tenant’s counsel should try and have the removal and restoration clause of Article 3 stricken in its entirety or, failing that, at least negotiate a clause that clearly identifies how the premises should be restored at the end of the term in order to avoid unpleasant surprises as the lease term winds down. In short, restaurants want the right to remove equipment and installations but do not want to give landlord the right to compel such removal.
The restaurant’s installations may also implicate a lease’s sprinkler clause which, in the Standard Board Lease, is Article 29.[16] If insurance requirements or government authorities require an enhancement or modification of the existing sprinkler system based on the restaurant’s equipment, Article 29 requires that the tenant bear the expense. Ideally, tenant’s counsel should negotiate a cost-sharing arrangement between landlord and tenant from the outset. Similarly, tenant’s counsel should also negotiate that fire insurance rate increases that may result from new regulatory laws or requirements imposed by insurance underwriters be shared between the restaurant and landlord to avoid burdensome chargeback clauses such as Article 6 of the Standard Board Lease.[17]
Finally, tenant’s counsel should negotiate liberal signage and display clauses that allow the restaurateur to make minor decorative and non-structural changes to the premises without obtaining landlord’s prior consent. This may include wall-hangings, art, and menu display. The lease should also address the specifications of the storefront signage, i.e. which façade of the building the sign will occupy, its dimensions and appearance, and how scaffolding, if at all erected for the purposes of repairs, should either leave signage unobstructed or provide for temporary signage at a visible height, e.g. second story signage.[18]
Right of Attornment
The final topic concerns the scenario where a lender, usually a bank, forecloses on a property and the property is auctioned off at a foreclosure sale. What will be the fate of our beloved Che Pepe? Typically, a lease will contain language that states that it is “subordinate” to underlying ground leases or mortgages.[19] This means that if landlord cannot meet its monthly mortgage payments and the bank forecloses on the building, then the rights of all tenants in the building and those with inferior interests, who are called “junior lienors”, will be extinguished and complete title to the premises will vest in the purchaser of the building at a judicial sale.[20] If tenant’s counsel fails, at the outset, to demand of the landlord a Subordination, Non-Disturbance, and Attornment Agreement (“SNDA”) between the bank and the restaurant, a purchaser of the property at a foreclosure sale can legally evict the tenants presiding there. Essentially, the SNDA preemptively obligates the bank to recognize the tenant’s lease notwithstanding a foreclosure action, i.e. the tenant attorns to the purchaser, and thereby preserves the leasehold so the restaurant can continue operating without interruption. Note that the SNDA is a separate agreement between the mortgagee-bank and the tenant, independent of the lease. Therefore, the lease’s subordination language should reference landlord’s obligation to obtain an SNDA from the bank(s) or lender(s) in favor of the tenant.[21]
Good Guy Guaranties
A “Good Guy Guaranty” (GG Guaranty) is shorthand to describe an agreement between the principal of a corporate tenant and the landlord that holds the principal, typically an individual, personally liable for the corporate tenant’s obligations under a lease until the tenant vacates and surrenders the premises. GG Guaranties became popular in the 1980s when commercial landlords, frustrated by tenants who operated rent-free while using technical defenses to forestall eviction proceedings, wanted to discourage such behavior using the specter of personal liability. Since that time, use of the GG Guaranty has evolved and now, the agreements can range from the basic Good Guy described above, to the very complex, where tenant must comply with a host of conditions before surrendering the premises and effectively terminating guarantor’s liability.
GG Guaranties are implicated when the corporate tenant defaults in its obligation to pay rent or some other covenant under the lease, and landlord seeks to enforce the terms of the lease against the guarantor. As long as the guaranty is in effect, the guarantor, in our example, Pepe, will have to answer for the tenant, Che Pepe’s defaults assuming it is a corporate entity. The only way Pepe can avoid personal liability is to surrender the premises at the natural expiration of the lease without having breached the lease, or terminate the lease sooner in accordance with the requirements of the GG Guaranty. Note that Che Pepe the entity will still be liable for future rent in the event of an early surrender. Pepe, on the other hand can avoid personal liability in the event of an early surrender if, at the time Che Pepe surrenders the premises, it complies with all the provisions in the GG Guaranty which will most likely implicate the lease. For example, if the GG Guaranty requires that the premises be surrendered in the condition as set forth in the lease, then reference must be made to the lease’s surrender provision. The surrender provision will most likely require tenant to remove all of its personal property in which case reference must be made to the alterations and fixtures provision of the lease to determine whether any installations qualify as trade fixtures that must be removed. If these conditions are not satisfied at the time of surrender, Pepe could be on the hook for, not only the cost of removal of the restaurant’s property, but also all future rent due and owing under the lease.
Nowadays, GG Guaranties will also contain advance notice provisions that require the tenant to provide anywhere between 60 to 180 days written notice to the landlord of the tenant’s intent to prematurely terminate the lease and surrender the premises. Failure to comply with this provision can likewise leave the guarantor on the hook for all future rent. Therefore, restaurateurs should always seek the advice of counsel before terminating a lease prematurely and surrendering the premises to avoid potential personal liability under GG Guaranties.
Conclusion
Needless to say, Pepe has his plate full with getting Che Pepe up and running. The decisions he makes in consultation with his attorney will be as critical to the success of his restaurant as are the decisions he will make in consort with his head-chef and fellow investors. In negotiating the lease terms for the restaurant, the core principles that should drive his decision-making are flexibility and cost reduction. Ideally, the lease should allow for the longest possible term with an option to renew, should not contain a restrictive use clause that would hamper his ability to serve liquor or change the business model of the restaurant, and should allow Pepe to assign the lease freely. It should also contain cost-sharing provisions in the event that sprinkler systems need upgrading or insurance rates increase due to circumstances beyond the tenant’s control. Finally, it should recognize the restaurant’s right to attorn to the lender or purchaser of the property after a foreclosure sale to avoid interruptions to its business in the event of a foreclosure. And, if Pepe feels that Che Pepe will need to terminate the lease prematurely and surrender the premises, he should pick up the phone and call his attorney.
[1] Popyork, LLC v. 80 Court St. Corp., 23 A.D.3d 538, 539 (2d Dep’t 2005) (plaintiff acquired prior tenant’s right to renew lease for six additional five-year terms for $550,000).
[2] Dennis & Jimmy’s Food Corp. v. Milton Co., 99 A.D.2d 477, 477 (2d Dep’t 1984) (restrictive use clause which permitted premises “to be used and occupied only for sale of delicatessen and groceries” precluded installation of video games).
[3] International Chefs Inc. v. Corporate Property Investors, 240 A.D.2d 369, 370 (2d. Dep’t 1997) (affirming Supreme Court’s denial of defendant-owner’s motion for summary judgment and finding that landlord’s refusal to allow an assignment had to comport with reasonableness as expressed in the lease which allowed landlord to consider nature of prospective assignee in relation to the other tenants in shopping center).
[4] Suey-Art Rest., Inc. v. 50th Taft Corp., 43 A.D.2d 541, 541 (1st Dep’t 1973) (affirming denial of summary judgment for lessee seeking return of security deposit and holding that whether restaurant exercised due diligence in pursuing liquor license was a fact question inappropriate for summary judgment).
[5] 200 Eighth Ave. Rest. Corp. v. Daytona Holding Corp., 2001 N.Y. Slip Op. 50023(U), 2001 WL 1602653, *1 (Sup. Ct. N.Y. Cty. 2001)
[6] Kenney v. Eddygate Park Associates, 34 A.D.3d 1017, 1018 (3d Dep’t 2006) (holding that landlord’s refusal to grant consent to a Korean restaurant as assignee of a lease in 1999 was reasonable and grounded in objective factors such as the neighborhood’s shifting demographic).
[7] Ontel Corp. v. Helasol Realty Corp., 130 A.D.2d 639, 640 (2d Dep’t 1987) (affirming trial court’s finding that landlord unreasonably withheld consent where it believed that prospective assignee’s representative should have contacted it to discuss assignee financials before tenant’s application to assign).
[8] Dennis’ Natural Mini-Meals, Inc. v. 91 Fifth Ave. Corp., 172 A.D.2d 331, 334 (1st Dep’t 1991) (holding that tenant’s transfer of all its stock to a third party did not constitute a breach of a nonassignment clause of the lease even where landlord’s consent to an assignment had previously been sought and refused because the lease did not address the effect of a stock transfer and landlord is charged with knowledge that corporate tenant is an artificial entity with a life distinct from the individuals who own it).
[9] South Bay Center, Inc. v. Butler, Herrick & Marshall, 43 Misc.2d 269, 270 (N.Y. Sup. Ct. Nassau Cty. 1964) citing Gillette Bros. v. Aristocrat Restaurant, 239 N.Y. 87, 90 (1924).
[10] Id.
[11] 39 East Rest. Corp. v. Caffe Adulis Ltd., Index No. 61682/02, 2002 WL 1880253, *2 (N.Y. Civ. Ct. N.Y. Cty. 2002) (finding that lessee who assigned its interest in the lease could not maintain a summary proceeding against the assignee under Real Property Actions & Proceedings Law § 721 because the assignment destroyed privity of estate and therefore, the necessary landlord and tenant relationship did not exist) citing Anjo Restaurant Corp. v. Sunrise Hotel Corp., 98 Misc.2d 597 (1979).
[12] Anjo Restaurant Corp. v. Sunrise Hotel Corp., 98 Misc.2d at 600.
[13] See Reb Michael, Inc. v. Southbridge Towers, Inc., 121 A.D.2d 962, 963-66 (1st Dep’t 1986) (recognizing plaintiff’s right as the prime tenant to bring a summary nonpayment proceeding against undertenant in light of an albeit imperfectly executed collateral assignment).
[14] See, e.g., Gyncor, Inc. v. Ironwood Realty Corp., 259 A.D.2d 363 (1st Dep’t 1999) (landlord served notice to cure on tenant for its default of encumbering the premises with a mechanic’s lien and thereafter terminated the lease); John A. Reisenbach Charter School v. Wolfson, 298 A.D.2d 224 (1st Dep’t 2002) (tenant sought Yellowstone injunction to toll cure period and litigate the issue of whether a lien constituted a default under the lease).
[15] Article 3 reads:
All fixtures and all paneling, partitions, railings and like installations, installed in the premises at any time, either by Tenant or by Owner on Tenant’s behalf, shall, upon installation, become the property of Owner and shall remain upon and be surrendered with the demised premises unless Owner, by notice to Tenant no later than twenty days prior to the date fixed as termination of the lease, elects to relinquish Owner’s rights thereto and to have them removed by Tenant, in which event, the same shall be removed from the premises by Tenant prior to the expiration of the lease, at Tenant’s expense. Nothing in this article shall be construed to give Owner title to, or to prevent Tenant’s removal of, trade fixtures, moveable office furniture and equipment, but upon removal of
same from the demised premises or upon removal of other installations as may be required by Owner, Tenant shall immediately and at its expense, repair and restore the demised premises to the condition existing prior to any such installations, and repair any damage to the demised premises or the building due to such removal. All property permitted or required to be removed by Tenant at the end of the term remaining in the demised premises after Tenant’s removal shall be deemed abandoned and may, at the election of Owner, either be retained as Owner’s property or may be removed from the demised premises by Owner at Tenant’s expense.
Standard Board Lease, Art. 3
[16] Article 29 reads:
Anything elsewhere in this lease to the contrary notwithstanding, if the New York Board of Fire Underwriters or the Insurance Services Office, or any bureau, department or official of the federal, state or city government, require or recommend the installation of a sprinkler system or that any changes, modifications, alterations, or additional sprinkler heads or other equipment be made or supplied in an existing sprinkler system by reason of Tenant’s business, or the location of partitions, trade fixtures, or other contents of the demised premises, or for any other reason, or if any such sprinkler system installations, changes, modifications, alterations, additional sprinkler heads or other such equipment, become necessary to prevent the imposition of a penalty or charge against the full allowance for a sprinkler system in the fire insurance rate set by any said Exchange or by any fire insurance company, Tenant shall, at Tenant’s expense, promptly make such sprinkler system installations, changes, modifications, alterations, and supply additional sprinkler heads or other equipment as required, whether the work involved shall be structural or non-structural in nature. Tenant shall pay to Owner as additional rent the sum of $ ____ on the first day of each month during the term of this lease, as Tenant’s portion of the contract price for sprinkler supervisory service.
Standard Board Lease, Art. 29.
[17] Imposing, as additional rent, the difference in higher fire insurance rates paid by landlord that arise from tenant’s violative use of the premises under relevant laws and regulatory bodies such as the New York Board of Fire Underwriters or the Insurance Services Office. Article 6, Standard Board Lease.
[18] 90 Washington Rest Associates, LLC v. JDM Washington Street, LLC, 91 A.D.3d 501, 501 (1st Dep’t 2012) (awarding plaintiff-restaurant summary judgment and holding that landlord violated the lease by erecting scaffolding for work that obstructed signage).
[19] See Article 7 of the Standard Board Lease:
This lease is subject and subordinate to all ground or underlying leases and to all mortgages which may now or hereafter affect such leases or the real property of which the demised premises are a part, and to all renewals, modifications, consolidations, replacements and extensions of any such underlying leases and mortgages. This clause shall be selfoperative and no further instrument of subordination shall be required by any ground or underlying lessor or by any mortgagee, affecting any lease or the real property of which the demised premises are a part. In confirmation of such subordination, Tenant shall from time to time execute promptly any certificate that Owner may request.
Standard Board Lease, Art. 29.
[20] 6820 Ridge Realty LLC v. Goldman, 263 A.D.2d 22, 26 (2d Dep’t 1999) (“The rationale for joinder of tenants and junior lienholders “derives from the underlying objective of foreclosure actions—to extinguish the rights of redemption of all those who have a subordinate interest in the property and to vest complete title in the purchaser at the judicial sale.”) (internal citations omitted).
[21] This is a typical example of a lease clause requiring landlord to obtain an SDNA:
SUBORDINATION AND ATTORNMENT; NON-DISTURBANCE
40.01 This Lease is and shall be subject and subordinate at all times to the lien of any first mortgage or first deed of trust now covering the Premises and to all renewals, modifications, consolidations, replacements and extensions thereof, and Tenant agrees to execute any documents reasonably required to effect or express such subordination. Notwithstanding anything contained in this Lease to the contrary, within forty-five (45) days from the date hereof, Landlord shall, at its sole cost and expense, obtain, deliver, and caused to be recorded a fully executed and notarized subordination and non-disturbance agreement in form annexed hereto (an “SNDA”) from all current mortgagees having a mortgage against the Premises and/or the Building (collectively, the “Mortgagee”). Additionally, notwithstanding anything contained in this Lease to the contrary, the subordination of this Lease to any future superior mortgage, deed of trust, ground lease or lien or other instrument superior to this Lease (each a “Future Lien”) is expressly contingent upon Landlord’s delivery to Tenant and recoding of an SNDA from the holder of such Future Lien, at Landlord’s sole cost and expense.
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