Limits of Profit Sharing in Leases

Limits of Profit Sharing in Leases  

By Bryan Mashian, Esq.

A commercial lease can give the landlord all or any part of profits from an assignment or sublease. While such an express provision is legally valid and enforceable, there are limits on the amount the landlord can charge for granting consent to an assignment or sublease. A lease provision can require that the tenant pay to landlord all or part of the lease value. But, a lease provision is unconscionable if, as consideration for approval of a transfer, the tenant has to pay a portion of the sales proceeds of the tenant’s business, such as the value of fixtures or goodwill.

In one case, a drycleaner’s lease in a shopping center required the tenant to pay three-fourths of any consideration received for the tenant’s business, good will, or covenant not to compete. The tenant sold his business for $120,000, allocated $80,000 to fixtures and $40,000 to a covenant not to compete. The lease rent exceeded market rates, so no consideration was allocated to the value of the lease. The landlord demanded payment of $30,000 as consideration for consent to the assignment of the lease (three-fourths of
the $40,000). When the $40,000 was reallocated by the tenant and the buyer from a covenant not to compete to leasehold improvements, the landlord continued to refuse consent without payment of the $30,000. The sale of the business was not consummated, and the tenant sued the landlord.

The court of appeal affirmed an award of $40,000 of damages in favor of the tenant. The court noted that the applicable statute provides that a lease may require payment to the landlord of “some or all of the consideration the tenant receives” from an assignee or sublessee for the landlord’s consent to an assignment or sublease. The court interpreted the term “consideration” to refer to the value of the lease created by the lease rent being under market rent. The court ruled that the legislation did not authorize a landlord to charge as consideration for a transfer a portion of the value allocated to the tenant’s business or fixtures.

In addition to including a profit sharing provision, the lease in this case gave the landlord the right to increase the lease rent to market rates and/or to terminate the lease (i.e., exercise recapture rights). Exercising either of these options would have allowed the landlord to receive the full market rent. In ruling that the profit sharing in this lease was unconscionable, the court noted the landlord refused to negotiate, and the provision was found buried in the small print of a form contract. The court also noted that the landlord’s attempt to appropriate a portion of the sales price of the business was “blatant overreaching,” and gouging the tenant in the name of freedom of contract.

The conditions governing the tenant’s ability to assign or sublet are critical for both the landlord and the tenant, regardless of whether market rents are increasing or decreasing. The tenant wants to have flexibility, such as being able to readily sell the tenant’s business if the business is doing well, or shed excess vacant space through a sublease if the business is depressed. The landlord wants to be sure to continue to collect market rents and not to have the tenant profit from the real estate aspect of its business. So, the landlord would like to have all options available, such as profit sharing, increasing rent to market rates and recapture right. These provisions determine who will reap the benefits from the appreciation in rental values – the landlord who owns the property or the tenant who took the risk that market rents would decline.