California Cannabis Leases: Assignment Headaches

10 Aug California Cannabis Leases: Assignment Headaches

Last month, I wrote a post explaining some of the issues buyers of cannabis businesses face when dealing with the landlords for the purchased business. In a nutshell, leases almost always contain clauses restricting assignment and subletting, and these clauses will often note that certain changes of control of the cannabis tenant are considered assignments requiring landlord pre-approval.

I discussed this concept at a high-level in the context of M&A transactions in that last post, but today I want to get a bit further into what these provisions mean and look like.

First, let’s look at the difference between assignment of a lease, and subletting under a lease. In general terms, in a sublease situation, the original tenant lets the new subtenant lease a part of the leased premises. The original tenant still stays a tenant and there are now two agreements – the master lease and sublease. In an assignment, the original tenant transfers its entire interest in the lease to a third party who becomes the new tenant – there remains only one lease. Notably, assignments don’t necessarily release the assigning party from liability and so an assignor will want that specific language in the assignment agreement.

I should also note that, at least in California, neither of the above situations is permitted under cannabis regulations for licensed businesses. Once a business gets a license, it cannot sublease out the licensed premises. It also can’t simply have a new entity move in under its license and take over.

Instead, the only thing that may work is if a new business comes in any purchases the license-holding entity. In other words, if ABC Co. held a license at 123 Main Street, it could not sublet that property to XYZ Co. It also couldn’t assign its lease to XYZ Co. because then ABC would not have a right to use the property which is a requirement for maintaining a license. But if XYZ purchased ABC, then ABC would still have the license and leased premises. Literally speaking, the concepts of assignment and sublease wouldn’t apply.

This is where landlords get creative. All of the good leases I see will define assignment to include changes of control of a licensee. This happens outside of the cannabis industry as well, and even the popular commercial form leases that are used in the state include them. The purpose of having change of control/assignment/sublease restrictions is so that the landlord knows who it is leasing property to. In the above example, landlord will have vetted ABC to make sure it can pay its bills, etc., before leasing the property to it. From it’s POV, it wants to ensure that any assignee, subtenant, or new owner of ABC is also going to be able to manage the business and pay rent on time.

Change of control provisions are tricky to pin down because it’s not always clear what meets the threshold. When we talk about changes of control, it’s common to set a threshold (e.g., sale of 50% of the stock of a corporation) but even that can get murky. Do we only want the percentage to effect certain classes of stock? Do we also want approval when there is a change in the slate of directors or officers? Are we talking about cumulative changes of control over a certain percentage where a series of small sales may hit the mark, or just single changes of control that go over the percentage (the latter situation would be very easy to get around)? These are just a few of the issues we see when tenants are negotiating change of control provisions, which can be very dynamic.

I should also note that in many leases, landlords will be able to charge tenants money to consider whether to consent to an assignment, sublease, or change of control. Why? Well, landlords often will want to do diligence on the prospective tenant, and this may involve attorney or accountant review which costs money. I’ve seen some leases that charge thousands of dollars to consider any assignments whatsoever. If a tenant anticipates a future assignment (often times in cannabis, a company will lease property then sublease or assign the lease to a special purpose entity formed just to hold one specific license before it applies), it may be a good idea to consider getting a provision in the lease that permits the assignment without further landlord approval.

Now what happens when a lease has clauses restricting assignments and subleases, but does not mention changes of control? Well, the issue’s not clear which is never a good thing for a contract. A tenant never wants to be in a position where the landlord says “you breached the lease by not asking for consent to a change in control” while the tenant says “the lease is silent about this”. Even though a tenant may cede some rights over to a landlord by asking to input change of control provisions in a lease, they will at least provide clarity on the process.

There are twofinal issues I want to address here:

1. What happens when a tenant assigns, sublets, or changes control without landlord consent? Generally, this is an automatic default (breach) of the lease. Some leases say this is not even a curable breach and will give the landlord the right to terminate the lease. It’s obviously a good thing then to understand these provisions.
2. What happens to the original lease guarantors in the case of an assignment? In my experience, many if not most commercial landlords in this industry require tenants to find a person who or company that is willing to guaranty the tenant’s obligations under the lease. In the event that the tenant changes (again, not permitted for licensed cannabis businesses) or is sold, the guarantor may want out but it’s a mistake to assume that they are automatically out. Finding new guarantors and/or negotiating this can often be a headache.

In sum, ownership changes can under a lease can be a real challenge. Stay tuned to the Canna Law Blog for more on cannabis leases.

You can read more about them in some of our prior posts below: