Out of Bounds: Radius Restrictions in Shopping Center Leases

Enforceability of Radius Restrictions: The Legal Landscape

Perhaps somewhat surprisingly, despite their frequent use, radius restrictions have seldom been tested in the courts. However, there is no doubt that radius restrictions limit trade to some degree, so drafters must be aware of common law rules regarding restraints on trade, as well as federal and state antitrust laws.

Commentators have argued that radius restrictions are an antitrust violation under the Sherman Act, and various state antitrust laws, as an illegal restraint on trade. The Sherman Act makes illegal “every contract … combination … or conspiracy, in restraint of trade”; however, courts have consistently found that the Sherman Act bars only unreasonable restraints on trade. 15 U.S.C.A. '1 (2001). Federal courts use two standards in analyzing restraints on trade – the “rule of reason” analysis and the “per se” violation rule. Courts have generally applied the “rule of reason” analysis to radius restrictions and other restrictive covenants in leases. In applying the rule of reason analysis, a court will evaluate the anticompetitive effects of a radius restriction in a lease by considering whether the restriction is reasonable in terms of time, distance and purpose. See Dalmo Sales Co. v. Tysons Corner Regional Shopping Center, 429 F.2d 206 (D.C. Cir. 1970). Applying this analysis, federal courts most often uphold radius restrictions when the purpose of the provision is to protect the landlord's percentage rent and not to restrain trade.

Most state antitrust laws mirror the Sherman Act, and courts interpreting those laws generally apply a similar rule of reason analysis. State courts generally analyze whether the restriction: 1) protects a legitimate business interest and 2) has been drawn as narrowly as possible. The court in Winrock Enterprises, Inc. v. House of Fabrics of New Mexico, Inc., 579 P.2d 787 (N.M. 1978), described the radius restriction as a “genuine necessity” and, in applying the rule of reason analysis, found the restriction at issue to be reasonable in terms of time and space and therefore enforceable. Note, however, the Michigan Court of Appeals has interpreted its state antitrust statute to ban all radius restrictions completely. See Saginaw Joint Venture v. Elias Brothers Restaurants, Inc., 307 N.W. 2d 759 (Mich. Ct. App. 1981).

The court in Cox v. Simon, 651 A2d 476, 480 (N.J. App. Div. 1996), took into account the following factors to evaluate the reasonableness of a restrictive covenant in a retail lease: 1) intention, 2) consideration, 3) clarity, 4) written notice, 5) reasonable in terms of area, time, and duration, 6) restraint on trade, 7) public interest, and 8) changed circumstances. While this eight-part test may seem unwieldy at best, it might offer some guidance in crafting a radius restriction that will stand up to a rule of reason review.

Finally, drafters should be aware that, as with most restrictive covenants, courts generally apply strict scrutiny to radius restrictions, such that any unreasonable element of a particular radius clause, whether duration or distance, might very well lead the court to declare the radius restriction void in its entirety, rather than construing it without regard to the offensive element at issue.

General Terms and Negotiation Issues

A typical radius restriction might read: “During the term of this lease, tenant will not own or operate a competing business within a radius of five (5) miles from the shopping center.” This brief clause perhaps begs more questions than it answers, and representatives for both landlords and tenants should be careful to flesh out several more considerations relevant to such restrictions, not only to protect their respective interests, but to ensure that the provision survives court scrutiny should that day come. Below is a sampling of some of those considerations:

1) Radius Duration: Do not assume that a radius restriction should be for the entire term of the lease. While landlord-drafted leases will often provide that the restriction is for the entire term, tenants will often negotiate a clause that is for a limited number of years. Leases often limit the duration of the radius restriction to the first 3 or 4 years of a lease, especially where market conditions are expected to change rapidly (after all, what seems reasonable today might not seem reasonable 10 years from now, say, for example, in a fast-growing, urban setting). However, we could find no relevant case in which a court found the duration of a radius restriction to be unreasonable when it coincided with the lease term. While a landlord might want to extend a radius restriction beyond the termination of the lease so that a tenant would not be able to terminate the lease and go to the shopping center across the street, landlords should be cautious of trying to extend the restriction beyond the lease term, as courts could find this unreasonable and, under a strict scrutiny analysis, strike the provision in its entirety.

2) Entities Restricted: Clearly, any radius restriction will restrict the named tenant, but the definition of tenant will often be more comprehensive and include “related entities.” Landlords will want to include those entities that are controlled by or are under common control with the tenant, including any parent, subsidiary or other affiliates. A tenant, on the other hand, will seek to limit the restriction to businesses operating under the same trade name or the same type of business operation. For tenants that are part of a chain that operates different stores under different names, it is critical to determine the trade names and specific business practices and/or products that are to be covered by the restriction.

3) Radius Size: Landlords will push to expand the radius and tenants will push to narrow it. Factors to consider during negotiations to determine the radius size include the size of the shopping center and the “market area” it is reasonably expected to serve, the size and population of the surrounding area, and the target demographic for each of the landlord and tenant. Typical radius clauses have a radius of 2-3 miles, with 5 miles representing the general outer boundary of “reasonableness,” at least in the typical suburban setting. However, commentators have argued that even a radius restriction of 2-3 miles could be unreasonable in an area that is relatively small and densely populated, such as the central business district in a major metropolitan area.

Landlords and tenants must also give thought to how to measure the radius, and be as specific as possible in doing so. The radius can be measured by, among other things, 1) a straight line in all directions from the outside boundary of the shopping center, 2) a certain amount of miles measured along roads from the outside boundary of the shopping center, or 3) a certain amount of miles from the boundary of the leased premises. While distance might be a reasonable standard in some circumstances, other boundaries, such as major highways, might provide a clear line of demarcation between separate market areas.

4) Exclusions: In negotiating a radius restriction, the tenant (and, equally as important, those representing the tenant) should have a clear idea of its present operations and any future plans so that they can be taken into account. The tenant should require that the radius restriction not apply to stores already in existence at the time of lease execution, stores the tenant plans to open in the near future, or stores that are acquired (or that acquire tenant) by merger or acquisition.

5) Remedies: If a tenant breaches a radius restriction, there are a number of remedies available to the landlord. Landlords may be able to seek an injunction to prevent the opening of the offending store. Generally, a landlord-drafted lease will provide that a breach of the radius restriction constitutes a default under the lease that entitles the landlord to all of its remedies, including lease termination. However, the landlord will likely be more concerned with receiving damages for the breach, and the proper measurement of damages tends to be one of the most hotly contested elements of the radius restriction. A landlord-drafted provision typically requires that 100% of the gross sales at the violating store be included in the gross sales of the tenant's existing store for the purposes of calculating percentage rent for the existing store. Many commentators suggest that this approach tests the boundaries of reasonableness (and arguably slips into the realm of unenforceable penalty) given that not all of the sales at the violating store would necessarily have been made at the existing store had the violating store never opened. Whether true or not, the national trend appears to favor instead rent stabilization or “make whole” type remedies which do no more than ensure that the landlord's percentage rents do not drop due to the existence of the violating store. Such a provision might, for example, add to the base rent for the existing store the average percentage rent paid on gross sales from the existing store for the 3 years immediately preceding the year in which the violating store opened for business.

Conclusion

Clearly, many considerations go into drafting and negotiating a valid and effective radius restriction. This discussion does not attempt to address all such considerations or any one such consideration fully, but simply attempts to alert readers to some of the issues that should be taken into account in drafting these provisions and representing the client, whether it be a tenant or a landlord, as effectively as possible.

Sample 'Radius Restriction' Clause

Tenant agrees that neither Tenant (and if Tenant is a corporation, partnership or limited liability company, its stockholders, partners or members) nor any affiliates thereof shall, at any time that Tenant is required to pay Percentage Rent hereunder, directly or indirectly, own, operate, manage or have any interest in any other store or business within a radius of [two (2) miles] of the Premises (the “Restriction Area”) (unless the same is in operation on the date of this Lease or is hereafter acquired by Tenant or any such stockholders, affiliates, partners or members through a third party stock or asset acquisition) which is similar to or in competition with the Permitted Use. Without limiting any of Landlord's other remedies under this Lease, in the event of a breach of this Section, then, from and after the date on which such violating store opens for business and for the duration of the Term, the Annual Basic Rental due under this Lease shall be increased by the greater of (i) the average Percentage Rent payable by Tenant hereunder for the three (3) full calendar years immediately preceding the calendar year in which such breach occurred, or (ii) ten percent (10%), and the Breakpoint shall be increased accordingly.

A common restrictive covenant in shopping center leases is the so-called “radius restriction,” a lease provision that prohibits a tenant from opening a competing establishment within a proscribed distance from the present location. Typically, a radius restriction goes hand in hand with a percentage rent provision, which allows the landlord to participate in the tenant's gross sales after a certain threshold or “break point” is achieved.

Landlords argue that the radius restriction is necessary to prevent a shopping center tenant from operating from a nearby location to the detriment of the landlord and its center. The presumption by landlords is that a competing establishment within a certain distance from their shopping center would divert customers away from the center and result in a dilution of percentage rent. On the other hand, tenants argue that a radius restriction does not protect either the landlord's competitive position or percentage rents, but is anticompetitive and prevents them from acting aggressively in a quickly-expanding market (which, in turn, hinders their ability to compete vigorously in the marketplace).

The arguments surrounding radius restrictions are heightened in rapidly growing and increasingly competitive market areas. In light of the potential impact on both landlord and tenant, each of the terms and conditions in a radius restriction requires careful negotiation and drafting to ensure the most effective and enforceable restriction possible.

Enforceability of Radius Restrictions: The Legal Landscape

Perhaps somewhat surprisingly, despite their frequent use, radius restrictions have seldom been tested in the courts. However, there is no doubt that radius restrictions limit trade to some degree, so drafters must be aware of common law rules regarding restraints on trade, as well as federal and state antitrust laws.

Commentators have argued that radius restrictions are an antitrust violation under the Sherman Act, and various state antitrust laws, as an illegal restraint on trade. The Sherman Act makes illegal “every contract … combination … or conspiracy, in restraint of trade”; however, courts have consistently found that the Sherman Act bars only unreasonable restraints on trade. 15 U.S.C.A. '1 (2001). Federal courts use two standards in analyzing restraints on trade – the “rule of reason” analysis and the “per se” violation rule. Courts have generally applied the “rule of reason” analysis to radius restrictions and other restrictive covenants in leases. In applying the rule of reason analysis, a court will evaluate the anticompetitive effects of a radius restriction in a lease by considering whether the restriction is reasonable in terms of time, distance and purpose. See Dalmo Sales Co. v. Tysons Corner Regional Shopping Center , 429 F.2d 206 (D.C. Cir. 1970). Applying this analysis, federal courts most often uphold radius restrictions when the purpose of the provision is to protect the landlord's percentage rent and not to restrain trade.

Most state antitrust laws mirror the Sherman Act, and courts interpreting those laws generally apply a similar rule of reason analysis. State courts generally analyze whether the restriction: 1) protects a legitimate business interest and 2) has been drawn as narrowly as possible. The court in Winrock Enterprises, Inc. v. House of Fabrics of New Mexico, Inc. , 579 P.2d 787 (N.M. 1978), described the radius restriction as a “genuine necessity” and, in applying the rule of reason analysis, found the restriction at issue to be reasonable in terms of time and space and therefore enforceable. Note, however, the Michigan Court of Appeals has interpreted its state antitrust statute to ban all radius restrictions completely. See Saginaw Joint Venture v. Elias Brothers Restaurants, Inc. , 307 N.W. 2d 759 (Mich. Ct. App. 1981).

The court in Cox v. Simon , 651 A2d 476, 480 (N.J. App. Div. 1996), took into account the following factors to evaluate the reasonableness of a restrictive covenant in a retail lease: 1) intention, 2) consideration, 3) clarity, 4) written notice, 5) reasonable in terms of area, time, and duration, 6) restraint on trade, 7) public interest, and 8) changed circumstances. While this eight-part test may seem unwieldy at best, it might offer some guidance in crafting a radius restriction that will stand up to a rule of reason review.

Finally, drafters should be aware that, as with most restrictive covenants, courts generally apply strict scrutiny to radius restrictions, such that any unreasonable element of a particular radius clause, whether duration or distance, might very well lead the court to declare the radius restriction void in its entirety, rather than construing it without regard to the offensive element at issue.

General Terms and Negotiation Issues

A typical radius restriction might read: “During the term of this lease, tenant will not own or operate a competing business within a radius of five (5) miles from the shopping center.” This brief clause perhaps begs more questions than it answers, and representatives for both landlords and tenants should be careful to flesh out several more considerations relevant to such restrictions, not only to protect their respective interests, but to ensure that the provision survives court scrutiny should that day come. Below is a sampling of some of those considerations:

1) Radius Duration: Do not assume that a radius restriction should be for the entire term of the lease. While landlord-drafted leases will often provide that the restriction is for the entire term, tenants will often negotiate a clause that is for a limited number of years. Leases often limit the duration of the radius restriction to the first 3 or 4 years of a lease, especially where market conditions are expected to change rapidly (after all, what seems reasonable today might not seem reasonable 10 years from now, say, for example, in a fast-growing, urban setting). However, we could find no relevant case in which a court found the duration of a radius restriction to be unreasonable when it coincided with the lease term. While a landlord might want to extend a radius restriction beyond the termination of the lease so that a tenant would not be able to terminate the lease and go to the shopping center across the street, landlords should be cautious of trying to extend the restriction beyond the lease term, as courts could find this unreasonable and, under a strict scrutiny analysis, strike the provision in its entirety.

2) Entities Restricted: Clearly, any radius restriction will restrict the named tenant, but the definition of tenant will often be more comprehensive and include “related entities.” Landlords will want to include those entities that are controlled by or are under common control with the tenant, including any parent, subsidiary or other affiliates. A tenant, on the other hand, will seek to limit the restriction to businesses operating under the same trade name or the same type of business operation. For tenants that are part of a chain that operates different stores under different names, it is critical to determine the trade names and specific business practices and/or products that are to be covered by the restriction.

3) Radius Size: Landlords will push to expand the radius and tenants will push to narrow it. Factors to consider during negotiations to determine the radius size include the size of the shopping center and the “market area” it is reasonably expected to serve, the size and population of the surrounding area, and the target demographic for each of the landlord and tenant. Typical radius clauses have a radius of 2-3 miles, with 5 miles representing the general outer boundary of “reasonableness,” at least in the typical suburban setting. However, commentators have argued that even a radius restriction of 2-3 miles could be unreasonable in an area that is relatively small and densely populated, such as the central business district in a major metropolitan area.

Landlords and tenants must also give thought to how to measure the radius, and be as specific as possible in doing so. The radius can be measured by, among other things, 1) a straight line in all directions from the outside boundary of the shopping center, 2) a certain amount of miles measured along roads from the outside boundary of the shopping center, or 3) a certain amount of miles from the boundary of the leased premises. While distance might be a reasonable standard in some circumstances, other boundaries, such as major highways, might provide a clear line of demarcation between separate market areas.

4) Exclusions: In negotiating a radius restriction, the tenant (and, equally as important, those representing the tenant) should have a clear idea of its present operations and any future plans so that they can be taken into account. The tenant should require that the radius restriction not apply to stores already in existence at the time of lease execution, stores the tenant plans to open in the near future, or stores that are acquired (or that acquire tenant) by merger or acquisition.

5) Remedies: If a tenant breaches a radius restriction, there are a number of remedies available to the landlord. Landlords may be able to seek an injunction to prevent the opening of the offending store. Generally, a landlord-drafted lease will provide that a breach of the radius restriction constitutes a default under the lease that entitles the landlord to all of its remedies, including lease termination. However, the landlord will likely be more concerned with receiving damages for the breach, and the proper measurement of damages tends to be one of the most hotly contested elements of the radius restriction. A landlord-drafted provision typically requires that 100% of the gross sales at the violating store be included in the gross sales of the tenant's existing store for the purposes of calculating percentage rent for the existing store. Many commentators suggest that this approach tests the boundaries of reasonableness (and arguably slips into the realm of unenforceable penalty) given that not all of the sales at the violating store would necessarily have been made at the existing store had the violating store never opened. Whether true or not, the national trend appears to favor instead rent stabilization or “make whole” type remedies which do no more than ensure that the landlord's percentage rents do not drop due to the existence of the violating store. Such a provision might, for example, add to the base rent for the existing store the average percentage rent paid on gross sales from the existing store for the 3 years immediately preceding the year in which the violating store opened for business.

Conclusion

Clearly, many considerations go into drafting and negotiating a valid and effective radius restriction. This discussion does not attempt to address all such considerations or any one such consideration fully, but simply attempts to alert readers to some of the issues that should be taken into account in drafting these provisions and representing the client, whether it be a tenant or a landlord, as effectively as possible.

Sample 'Radius Restriction' Clause

Tenant agrees that neither Tenant (and if Tenant is a corporation, partnership or limited liability company, its stockholders, partners or members) nor any affiliates thereof shall, at any time that Tenant is required to pay Percentage Rent hereunder, directly or indirectly, own, operate, manage or have any interest in any other store or business within a radius of [two (2) miles] of the Premises (the “Restriction Area”) (unless the same is in operation on the date of this Lease or is hereafter acquired by Tenant or any such stockholders, affiliates, partners or members through a third party stock or asset acquisition) which is similar to or in competition with the Permitted Use. Without limiting any of Landlord's other remedies under this Lease, in the event of a breach of this Section, then, from and after the date on which such violating store opens for business and for the duration of the Term, the Annual Basic Rental due under this Lease shall be increased by the greater of (i) the average Percentage Rent payable by Tenant hereunder for the three (3) full calendar years immediately preceding the calendar year in which such breach occurred, or (ii) ten percent (10%), and the Breakpoint shall be increased accordingly.