Hidden Lease Liabilities: The Risks That Can Derail a Transaction

Commercial leases are often treated as an ancillary issue in larger transactions. In reality, they can contain liabilities, restrictions and timing issues that materially affect the outcome of a matter.

Over the years, I have found that some of the most significant commercial risks emerge not from the primary transaction documents, but from lease provisions that are discovered late in the process or not considered at all.

Three areas where this frequently arises are mergers and acquisitions, banking and finance matters, and deceased estates.

Mergers and Acquisitions

When acting on the sale or acquisition of a business, attention is naturally focused on price, warranties, employees, intellectual property and taxation issues. For many businesses, though, the lease is one of the most important assets being acquired.

Common issues include:

• landlord consent requirements delaying settlement;
• restrictions on assignment;
• existing tenant defaults;
• personal guarantees needing to be released or replaced or new bank guarantee or security to be provided;
• options nearing expiry;
• incentive repayment provisions triggered by an assignment;
• rights of first refusal or rights of first negotiation in favour of the landlord; and
• lease terms that are too short to support the purchaser’s business model or financing arrangements.

Other issues may be less considered in the context of a change of ownership but can have significant impact.

A purchaser may acquire a profitable business only to discover that the lease requires extensive make good works at the end of the term, including removal of fitout, reinstatement of services, demolition of internal structures or restoration of the premises to a base building condition. Depending on the premises, these costs can run into tens or even hundreds of thousands of dollars.

Similarly, assignment provisions may trigger unexpected consequences. Some leases require repayment of incentives, fitout contributions or landlord works contributions if an assignment occurs within a specified period. Others may trigger rent reviews, increases in security requirements or the provision of replacement guarantees. Whether any such obligation is enforceable will depend on the terms of the lease and the circumstances of the transaction. Some repayment provisions may be challenged as penalties under general law principles, particularly where the amount bears no genuine relationship to the landlord’s actual loss. Early advice on the enforceability of these clauses can assist in assessing transaction risk and structuring the deal accordingly.

Another issue that is easily overlooked is the existence of rights in favour of the landlord before an assignment or sublease can occur, such as a right of first refusal or a requirement to offer a surrender. These provisions may require the tenant to first offer a proposed sale, assignment, sublease or other transaction opportunity to the landlord before proceeding with a third party or to offer to surrender the lease in its entirety. If identified late in the process, they have the potential to delay settlement, disrupt negotiations or alter the commercial dynamics of the transaction.

These obligations are rarely reflected in the headline purchase price but can significantly affect the economics, timing and certainty of a transaction.

Banking and Finance

Commercial leases can also have a direct impact on financing arrangements.

For lenders, the value of a business is often closely connected to its ability to continue operating from its current premises. A business occupying a strategic location under a long-term lease with renewal options presents a very different risk profile to a business whose lease is due to expire within a short period.

Questions worth considering include:

• How much lease term remains?
• Are renewal options available and have they been properly preserved?
• Is landlord consent required for the proposed transaction?
• Are there any unremedied lease breaches?
• Does the tenant have significant make good or reinstatement obligations?

Pre-emptive rights in favour of the landlord, such as rights of first refusal or requirements to offer a surrender before assigning, can also be relevant in a lending context. A lender may require confirmation that no such rights exist, or that they have been waived, before proceeding. Where an unexercised pre-emptive right remains on foot, it may affect the lender’s ability to deal with the leasehold interest as security, or complicate enforcement steps if the borrower defaults.

Deceased Estates

Commercial leases can also introduce unexpected complexity into estate administration.

Where a deceased person operated a business from leased premises, or owned commercial property leased to a tenant, lease obligations continue notwithstanding the administration of the estate.

Issues that frequently arise include:

• option exercise dates occurring during administration;
• rent review notices requiring attention;
• ongoing maintenance obligations;
• tenant disputes;
• personal guarantees given by the deceased; and
• continuing liabilities under the lease while the estate determines whether to continue trading, sell assets or wind up operations.

Missing an option exercise deadline or failing to respond to a lease notice within the prescribed timeframe can have long-term consequences for the estate. A preliminary lease review to identify those obligations early is crucial.

A Practical Reminder

If your matter involves:

• a business acquisition or sale;
• commercial financing;
• a deceased estate that owns or occupies business premises; or
• a client whose operations are dependent on a leased property,

it is worth taking a closer look at the lease.

The most significant leasing issues are often not rent or term. More commonly, they are hidden liabilities and restrictions such as make good obligations, assignment controls, rights of first refusal, guarantee requirements and critical notice dates.

Identifying these issues early can avoid surprises, preserve value and help ensure that the underlying objectives of the transaction are achieved.