A commercial lessee may bring a third party into the lease agreement one of two ways: by sublease or by assignment. The distinguishing factor between the two concepts is the relationship between the original, or head lessee (tenant) and the head lessor (landlord). In the context of a sublease, the head lessee maintains the role of tenant with the head lessor as landlord, while in an assignment, the head lessee is removed from the relationship and the sublessee becomes the tenant of the head lessor in its place.
Historically speaking, the common law in Ontario has maintained that in order for a commercial lease to be considered a sublease rather than an assignment, the head lessee must retain a reversionary interest in the original lease by ending the sublease at least one day before the expiry of the head lease. This serves to guarantee the head lessee’s rights and interests in the property under the head lease. Failure to retain this interest has generally been interpreted to mean that the head lessee has indeed assigned the head lease to the sublessee.
However, a recent decision of the Ontario Court of Appeal (ONCA) has set a new standard for the interpretation of a sublease vs. an assignment, which could have a significant impact for commercial lessors and lessees going forward in Ontario.
Head Lease and Sublease Set to Expire on the Same Day
In this case, the head lessor (Smile Dental) entered into a seven-year commercial lease with the head lessee (Hazelton) in 2010 for a retail property in Toronto. In the lease, Hazelton retained the right to renew the lease for an additional five-year term upon six months’ notice to Smile Dental. In 2013, Hazelton completed extensive renovations to the property, including the removal of a bathroom. In 2016, Hazelton subleased the premises to a third-party clothing retailer (Outhere). Both the head lease and the sublease were set to expire on the same date, September 30, 2017, meaning that Hazelton did not reserve a reversionary right to the property. However, the terms of the sublease expressly stated that Hazelton did not have an obligation to renew or extend the sublease in favour of Outhere.
Six months before the end of the lease term, Hazelton notified Smile Dental that it wished to renew the head lease for a five-year term. The parties began negotiations with respect to the rent amount for the renewal, however, they were not able to come to terms. Two days before the lease was set to expire, Smile Dental notified Hazelton that it had no right to renew, asserting that Hazelton was in default of the lease due to the removal of the bathroom, which had been completed without Smile Dental’s authorization. The lease ended on the 30th, and Smile Dental entered into a direct landlord/tenant relationship with Outhere, allowing it to remain in the space.
Hazelton brought an application seeking the following relief:
- A declaration that it had rightfully exercised its option to a five-year renewal of its lease starting October 1, 2017;
- An order that Smile Dental and Outhere deliver vacant possession of the premises; and
- An order that, in accordance with the terms of the head lease, an arbitrator be appointed to determine the rent payable during the five-year renewal period.
At Trial, Dispute Settled Under Principles of Contract Law
The applications judge acknowledged that Smile Dental had raised the “ancient common law” that stands for the concept that by not reserving the last day of the head lease for itself, a sublessor (in this case, Hazelton) in effect creates an assignment rather than a sublease. The judge also looked at case law standing for the proposition that when a head lease contains rights not granted in a subsequent sublease, those rights are reserved for the tenant under the head lease. However, the judge did not undertake any efforts to reconcile the two concepts. Instead, the court decided the matter on the basis of contract law. The applications judge found that Smile Dental had, in fact, breached its contractual duty to negotiate the renewal with Hazelton in good faith. However, the court found that no actual financial loss or damages had resulted and therefore dismissed Hazelton’s application.
Intent is Key in Determining Sublease vs. Assignment
The ONCA decision delved deeper into the conflicting case law and the issue of assignment vs. sublease, ultimately basing its finding on s. 3 of the Commercial Tenancies Act (the “Act”). The section states:
The relation of landlord and tenant does not depend on tenure, and a reversion in the lessor is not necessary in order to create the relation of landlord and tenant, or to make applicable the incidents by law belonging to that relation; nor is it necessary, in order to give a landlord the right of distress, that there is an agreement for that purpose between the parties.
The ONCA noted that s. 3 specifies that a reversion to the head lessor is not necessary to create a landlord and tenant relationship, indicating that a sublessor need not reserve a day for itself at the end of a sublease. However, the court did not want to create the result that any sublease would remain a sublease, thereby losing the distinction between an assignment and sublease. The ONCA held that regardless of whether there was a reversion to the sublessor, courts should look to the actions of the parties to determine their intent. In the case at hand, Hazelton had specifically retained a right to renew the head lease but had not extended the same right in the sublease to Outhere. This clearly demonstrated an intention to retain the role of lessee under the head lease, and not create an assignment to Outhere.
The ONCA further held that Smile Dental knew of the renovations prior to entering into initial negotiations with Hazelton respecting the renewal of the lease. Since Smile Dental had indicated a willingness to renew after discovering the removal of the bathroom, the ONCA found that it was simply using the renovations as a basis to justify the decision to deal directly with Outhere instead of Hazelton.
The ONCA found that the applications judge erred in undertaking a damages analysis when Hazelton had claimed no damages, but rather injunctive and declaratory relief. Noting that courts should limit analysis to the relief sought by the applicant, the appeals court set this determination aside.
Ultimately, the ONCA found that Hazelton had not in fact assigned its lease to Outhere, as demonstrated by the contents of the sublease and the notification to Smile Dental that it wished to renew the head lease. The court awarded Hazelton the relief it sought and ordered the parties to enter into arbitration to settle the matter of the rental amount to be paid under the renewal.
Takeaways for Commercial Landlords and Tenants
This case serves to add certainty and clarity to the notion that a commercial tenant must retain the last day of a head lease in its own name in order to avoid creating an assignment rather than a sublease. Rather than relying on the right of reversion, courts should look instead to the actions and intentions of the parties when making such a determination. However, best practices still dictate that nothing is better than a clear and carefully set out lease agreement, which expressly sets out the intentions of each party. This can help both landlords and tenants to avoid potential litigation down the road.
Contact GLG LLP in downtown Toronto for assistance with finalizing or renewing a commercial lease agreement. Their real estate and business lawyers have extensive experience drafting and reviewing commercial lease agreements of various sizes and across multiple industries. The firm also represents clients in litigation should that become necessary. To schedule a confidential consultation, call NUMBER or fill out the online form.