Workout Negotiations for Commercial Leases

By Sanford R. Landress and Charles R. Markley

June 2011

Difficult economic times breed trouble for commercial leases.
As tenants fall behind in making their monthly payments, many landlords consider filing a lawsuit to recover their damages. However, in some cases, a workout negotiation may be a better option.

Why bother with a workout negotiation? In most cases, workout negotiations are chosen because of the perceived risks of litigation. Both the landlord and the tenant fear something. The landlord may fear the tenant's potential defense, the uncertainty of finding a new tenant, the bad publicity of having a vacant property, or a Chapter 11 bankruptcy. The tenant may fear loss of the leased premises and the potential liability for damages. In such situations, both sides have something to offer the other. For many landlords and tenants, this makes workout negotiations more attractive than a lawsuit.

Effective workout negotiations require preparation and the right approach. Specifically, landlords and tenants must consider the importance of due diligence, the proper timing, and the right mediation structure in preparing for workout negotiations.

Due Diligence
Both the landlord and the tenant need to conduct due diligence before any workout negotiations begin. For the landlord, conducting due diligence means analyzing and fully understanding the lease documents and the tenant's defaults. This requires gathering all the applicable lease agreements, loan documents, amendments, side agreements, and guaranties. The landlord should check to see whether all the documents have been properly executed (the landlord should have signed copies of everything) and then carefully identify all the tenant's monetary and non-monetary defaults.

For the tenant, conducting due diligence means obtaining sufficient information to propose a realistic workout agreement. The tenant must determine the underlying cause(s) of its financial problem, gather the relevant historical financial documents (e.g., balance sheets, income statements, and statements of cash flow), and analyze its potential defenses and counterclaims.

Timing
Once both parties have completed their due diligence, workout negotiations should begin as soon as possible. However, the timing of the negotiations must carefully consider the tenant's progress through the psychological grief cycle, which typically consists of four stages: denial, anger or blame, acceptance, and resolution.

A tenant in denial believes there is no problem and believes that he or she can turn things around. In this unproductive stage, a tenant is rarely ready to discuss realistic solutions. In the next stage, tenants become angry and may blame or attack the landlord ("There wouldn't have been a problem if the landlord had simply...."). This stage is equally unproductive.

At some point, the tenant begins to accept the situation and starts thinking about realistic solutions. This is the time when workout negotiations can begin. Finally, when the tenant is in the resolution stage, the parties are prepared to negotiate and agree on a realistic workout plan.

The psychological grief cycle takes many forms. Some tenants may linger in one of the early stages and never progress through resolution. In those cases, the dispute usually proceeds to litigation. In general, the more time needed to reach the resolution stage, the lower the chances for a successful workout.

Structure
Once negotiations begin, the parties should be aware that there are three basic types of workout agreements: the cure plan, the assignment plan, and the surrender plan.

The cure plan is the most common type of workout agreement for commercial leases. Under most cure plans, the tenant waives all existing defenses and counterclaims, reaffirms the lease, and agrees to a payment plan to cure existing defaults.

Occasionally, either the landlord or the tenant will identify a better prospect to act as the tenant. In this case, the workout agreement takes the form of an assignment plan under which the tenant waives all existing defenses and counterclaims and consents to the assignment of its rights and obligations to a new tenant.

In cases where the tenant's due diligence reveals unsolvable problems, a surrender plan is the most common workout agreement. Under a surrender plan, the tenant waives all existing defenses and counterclaims and obtains additional time to vacate the premises in an orderly manner.

Workout negotiations are not the right solution for all commercial landlords and tenants. When a workout is the right solution, taking the right approach is critical to success. Before beginning negotiations, conduct your due diligence, carefully consider the best time to commence negotiations, and identify the appropriate structure for the workout agreement. Last but not least, before you arrive for the negotiations, draw on your creativity and flexibility to propose potential solutions that will be acceptable to both parties. Following these guidelines can help you avoid the risks of litigation.

Sanford R. Landress and Charles R. Markley are partners at Greene & Markley. Their practice focuses on commercial real estate and the representation of business debtors and creditors in bankruptcy proceedings. They can be reached at sanford.landress@greenemarkley.com, charles.markley@greenemarkley.com, or (503) 295-2668.

This article appeared in the June 2011 issue of the Coast River Business Journal.