Risks of Pre­Leasing

Due to the peculiarities of Russian law – which does not permit the alienation of real property until it is registered with the state – the use of preliminary agreements to commit to office space prior to completion has become standard practice. The contractual relationship between the parties must therefore be set out in full in the preliminary agreement, which should anticipate and cover all possible situations should there be any problems with the completion or registration of the building.
Below, we highlight some of the risks tenants and landlords face and offer some suggestions the parties may take to mitigate such risks.

Identity of the Parties and Financial Guarantees
The tenant’s ability to pay for the space being committed to is, naturally, the landlord’s paramount concern. In order to secure the tenant’s financial obligation, it is typical for a landlord to request the tenant to provide a bank guarantee or a guarantee from the tenant’s parent company (if the parent is a foreign company, the parties have the flexibility to chose a non­Russian governing law and forum for dispute resolution in the preliminary agreement). When a guarantee is not feasible or in addition to the guarantee, a landlord may require an advance lease payment (three months) and a security deposit (one month) from the prospective tenant.
The tenant, in turn, will look closely at the reputation, experience and track record of the landlord, will want to know the identities of the project’s general contractor and of the building’s other tenants, etc. A thorough due diligence at the outset of negotiations by the tenant is essential.

Delivery Delay
Delivery delays are common in Moscow. As such, there are a number of measures each party will want to consider and negotiate. The landlord will want a grace period for any delay during which the landlord has no liability to the tenant, along with an express provision that provides for the possibilities of delays in completion and delivery.
A tenant will want “motivators” for any delay, such as: a day of free rent for each day of delivery; a penalty payment (permitted under Russian law); the right to claim damages caused by any delay (at a minimum in the amount of any hold­over rent the tenant must pay at its old location); the ability to terminate the agreement and claim damages should delivery not occur by a certain date; and the ability to decide not to terminate preliminary agreement and instead extend the delivery date. An important clause a tenant will want to include – unless the agreement allows the tenant to unilaterally terminate the agreement due to delay – is a “time is of the essence” clause, which will confirm the substantial nature of a delivery delay default by the landlord (a very useful clause when the tenant is seeking to terminate a preliminary agreement because of a delay).

Non­Delivery
This is the worst case scenario for both parties. The landlord will want to do everything possible to limit its exposure to no more than the amount of damages the landlord can collect from the general contractor under the construction contract’s security instruments (e.g., bank guarantee, letter of credit, etc.). At a minimum, the landlord will want to insist on an overall limitation of its liability to the tenant for any damages incurred by the tenant due to non­delivery, and should also seek to exclude the tenant’s lost profits from any damages the landlord may have to pay as compensation.
Non­delivery due to the action or inaction of state authorities (e.g., refusal to register or commission the building), whether lawful or not, should be included in the force majeure clause.
There is very little a tenant can do to protect against non­delivery. What a tenant can do is be diligent in monitoring the construction process. This can be accomplished by tying the landlord’s failure to achieve certain construction milestones to default by the landlord under the preliminary agreement. The tenant should also try to include in its recoverable damages any and all costs caused by non­delivery, including the costs of a failed move.

Antimonopoly Requirement
The antimonopoly legislation even affects even real estate. If a tenant wants to lease space which exceeds 10% of the landlord’s assets – which is often the case when the landlord is a special purpose vehicle created for a single project and has no assets other than the building – the tenant will need to seek prior approval for the lease from the Federal Antimonopoly Service of the Russian Federation. Failure to obtain such approval may result in the invalidation of the agreement.

Failure to Execute the Lease
A principal obligation in the preliminary agreement is the execution of the lease by the parties as agreed and attached as soon as the landlord receives the ownership certificate for the building. Each party will want to ensure execution of the lease by the other party. The landlord’s protections include an express right to enforce the security guarantee or to retain the advance payment and security deposit, and the right to terminate the preliminary agreement and claim damages caused by the tenant’s refusal to execute the lease (such as the cost of finding a replacement tenant, management time, broker’s fee and other related expenses).
The tenant’s protection against a landlord who, for example, has found another tenant willing to pay a higher rent for the space, is to make sure its damages are collectable under the preliminary agreement in such an event.

The Force Majeure Clause
Often times the first time the parties will carefully read the force majeure clause will be after an event of force majeure occurs. And more often than not, the force majeure clause will have been taken whole from a different agreement and will not accurately reflect the nature of the transaction. Our recommendation is that the force majeure clause define force majeure circumstances as extraordinary events or circumstances beyond a party’s reasonable control which a party could not prevent by using reasonable efforts. Force majeure circumstances should include natural calamities as well as terrorism, governmental pre­emption in connection with a national emergency, nuclear explosion, radioactive or chemical contamination, boycotts, strikes (other than strikes of employees of either party), and acts of governmental authorities, provided that the tenant’s lack of funds for any reason whatsoever, or failure to receive any licenses or to complete other formalities required for payment, shall not constitute force majeure circumstances.

Waiver of substantial change of circumstances
Over the course of a lease, rents in the given market can fluctuate up or down, sometimes dramatically. To preserve the stability of the transaction, the parties may consider excluding the application of any substantial change of circumstances clause as grounds for amending or terminating the lease or preliminary agreement. The latter is important as the construction process takes time and the preliminary agreement may be entered into in the early stages of the project’s development, thus exposing the transaction to the volatility of the market.

Confidentiality
A tenant who commits to space in a building early in the construction process may receive a significant lease discount. The amount of such discounted rent becomes a commercial secret of the landlord; the landlord will not want other prospective tenants to have knowledge of it, especially during negotiations. The tenant may not want its current landlord to know about its intent to leave its current premises. These two considerations alone require the parties to include a strong confidentiality clause in their preliminary agreement, one which specifically addresses such concerns.

Delay in Tenant’s Payment
Under a standard preliminary agreement the tenant is required to pay the advance payment, the security deposit and a use of the premises payment if delivery of the space occurs prior to the effective date of the lease. Any delay by tenant in making these payments affects the landlord’s cashflow. A daily penalty of, say, 0.5 percent per day for any such delay is one way to ensure timely payment. But a more effective way to ensure timely payment by the tenant is to provide the landlord with the right to unilaterally refuse to perform under the agreement (effectively terminating the preliminary agreement) and to retain in full the advance payment and security deposit.

Limitation of Liability
As any delay may financially expose the landlord and, thus, affect the financing of the project, it is vitally important to the landlord that the landlord limits its aggregate liability under every preliminary agreement and lease to a defined amount. This is a concern that the tenant should share as well.

“Defective” Delivery
In addition to delivery of the premises, the tenant will also be concerned that construction of the building has been completed, that all building systems are operational, the common areas have been fitted out, and that the landlord has obtained the ownership certificate. Accordingly, these and other conditions may be precedent condition that must occur before the tenant must take delivery of the premises.

Deductibility of Lease Payments
The tenant, which is usually a commercial organization, would like to be able to deduct its lease payments from its taxable base for the purpose of calculating its corporate profit tax. In our view, this is possible only after the landlord has title to the building (and the premises) and the lease becomes effective. Tenants should address this issue with their accountants.

Conclusion
Pre­leasing office space in a building under construction requires the tenant and landlord – even in the current pro­landlord market – to undertake a certain amount of risk management. We hope the above will be of assistance in lease negotiations.