Avoid Getting Tripped Up in a Pre-lease Deal

It has become common practice in China for commercial and industrial premises to be leased before being certified for occupation. This usually happens because the legal process for certifying the completion of a building cannot keep up with the high demand for new space. The result, however, is that premises are often fitted-out by tenants only to discover later that they cannot move in because the building has not been certified for occupation. Who then is responsible for the tenant’s losses?

Such problems with pre-leasing have become so prevalent that China’s Supreme Court has specifically addressed it in its Judicial Interpretation On Several Issues on Application of Law In Trials of Disputes Arising From Lease Contracts , which came into effect in September 2009 Using this type of reference feels a bit too legalistic for an article. Unfortunately, the Interpretation adds little clarity to the general law and does little to remedy the tenant’s vulnerability when entering into pre-leases with unscrupulous or careless landlords. In the absence of specific legal protection there are 5 simple rules that prospective tenants should abide by before signing a lease for uncompleted premises.

Rule 1: Pre-Leases are Invalid Where the Premises Infringe Planning Regulations

The Interpretation has made it clear that lease contracts for premises which are pre-leased without first securing a construction planning permit for the development of the premises or if the shall be invalid. Such agreements will also be invalid if the premises are not developed in accordance with the construction planning permit. Unfortunately, it is still common for premises to be built without a permit in China, especially in second and third tier cities, or for the conditions of permits to be exceeded. The Supreme Court has said that a lease of such premises will be invalid because it violates mandatory provisions of law (see Contract Law §52v). The rationale for this interpretation is that it would be a violation of planning regulations to use premises built without, or in contravention of, a planning permit.

Rule2: Invalid Pre-Leases May Not Be Worth the Paper They're Written On

Where a pre-lease is invalid, it is viewed in Chinese law as void from the roots up.. Unfortunately, this means that even if the tenant negotiated favorable representations, warranties and indemnities concerning the landlord’s compliance with planning regulations, these terms would also be as invalid. The Supreme Court does not suggest that any of these terms could be severable from the invalid terms of the contract, which is likely to render the entire agreement invalid and leave tenants to rely on general law remedies.

In certain major cities, for example in Shanghai, it is possible to register a pre-lease as a real estate transaction. Registration will usually ensure that the planning permit has been obtained (the permit must be registered too) but registration will not protect the tenant against breaches of the permit that may render the lease invalid.

Rule3: Risks Associated with General Law Remedies for Invalid Contracts

In civil law countries, the remedies for an invalid contract do not depend on the terms of the contract but on “fault”. Fault is either the intentional or negligent conduct of the parties. The Interpretation confirms that the party which bears responsibility for the wasted fit-out will depend on the parties’ respective fault, but this fault is often difficult to assess. If both landlord and tenant sign a lease knowing that the planning permit has not yet been issued, are they both at fault? Probably. But how do you apportion blame? 50:50? 75:25? This will always be arguable. In this respect, a representation and warranty from the landlord that he has obtained a valid planning permit is helpful because it may establish that the tenant was innocent.

Rule 4: Further Remedies Provided in the Interpretation

The Interpretation provides that where a lease contract is found to be invalid, the landlord and tenant may agree that the tenant’s fit-out of the premises be assigned to the landlord. However, if they cannot reach an agreement on assignment of the fit-out of the leased premises, the unused fit-out shall be disposed of as follows:

• if it is economically impractical to remove the fit-out from the premises, the landlord and tenant shall share the costs of the fit-out based on fault (see “Rule 3” above).
• if it is economically feasible to remove the fit-out from the premises, the tenant shall be responsible for doing so.

The Interpretation does not make clear whether the tenant is entitled to claim the costs of the fit-out in the latter case, however, given that the tenant is required to remove the fit out, it seems unlikely that the tenant is able to recoup this investment This result is consistent with the general rule which holds that ofproperty transferred under an invalid contract must be returned to its original owner. The Supreme Court’s thinking seems to be that if the tenant can take back its fit-out without a disproportionate loss to itself, it should do so.

If the landlord is wholly at fault for the invalid lease contract, for example, for violations of the planning permit, then the tenant should be entitled to claim the whole of the cost of the fit-out based on fault liability (see “Rule 3” above).

Rule 5: Do’s and Don’ts of Pre-Leasing

If you do lease uncompleted premises, it is recommended that you do not start fit-out before the premises are certified for occupation.

If you wish to commence early fit-out, it is recommended that you perform due diligence to confirm that the premises have a construction planning permit and that the landlord gives clear representations and warranties that the premises have been developed according to the terms of the construction planning permit.

This Advisory was prepared by TROUTMAN SANDERS LLP and is intended to inform you of recent changes in the law, upcoming regulatory deadlines or significant judicial opinions that may affect your business. It does not render legal advice or legal opinion. You are urged to consult an attorney concerning your own situation and any specific legal questions you may have.

You may find out more about Troutman Sanders LLP at (www.troutmansanders.com ) or you may contact Managing Partner, Edward Epstein at edward.epstein(at)troutmansanders.com