Identify Percentage Rent Issues that May Impact the Assignment and Subleasing of Retail Space

Shopping center leases often contain percentage rent clauses that provide for the ability of the landlord to share in the sales of a tenant over a specific sales threshold while providing the tenant with a lower total rent when sales do not meet the sales threshold. A typical percentage rent provision obligates the tenant to pay a percentage (ie, the percentage rent rate) of the amount of gross sales generated by and from the tenant's business operated at the leased premises, that exceed the threshold amount, ie, a “sales” base or “breakpoint,” as additional rent.

The terms of the lease may require that the payments be made by the tenant to the landlord on a monthly or quarterly basis ' which may require estimated or escrow payments similar to common area maintenance payments based upon an estimate and reconciliation after the end of the applicable lease year ' or on a yearly basis. Although the specific terms of the percentage rent provision may vary, based on the bargaining position of the parties, this lease provision is usually tailored to the original tenant's initial use of the leased premises based upon the type of business to be conducted, the anticipated sales volume, the rent, and the term of the lease.

The term of shopping center leases may be long in duration, eg, the initial term of a movie theater, supermarket, or department store lease may be at least 20 years, plus a number of extension options, and the initial terms of leases of other types of big box tenants or national or regional retailers may be at least 10 years in duration plus options. During the term of a lease, many factors, including changing market conditions, change in the character of a shopping center (eg, from predominately retail to office), and/or declining sales, may contribute to a tenant's decision to evaluate its options at a particular retail outlet. These options may include a decision to shutter its space and pursue an assignment of its leasehold interest to a third party or sublease the premises to a third party, who will use the space for a different use. Shopping center leases contain various provisions that may impact a tenant's proposed assignment of its lease or subleasing of the premises to a third party for a different use. One of these provisions is the percentage rent clause. The percentage rent clause may limit the type of user that the tenant may pursue in connection with such an assignment or subletting, due to the economics contained within the percentage rent clause ' unless the landlord is required to amend the percentage rent provision to accommodate the new use.

In conjunction with a tenant's review of its options to assign its leasehold interest or sublease the premises, the tenant should complete a thorough review of its lease to identify all the potential issues associated with entering into an assignment or sublease transaction. Among the questions the tenant needs answered are:

• the specific landlord consent requirements,
• any limitations or restrictions as to lease provisions related to use, alterations, signage, trade name, continuous operations, and
• percentage rent.

There are many provisions in shopping center leases that may restrict the tenant's ability to assign or sublet the premises. Many leases originally may be drafted to provide flexibility to the tenant to assign or sublease without requiring either the landlord's consent or agreement to amend the lease. These leases may, however, include percentage rent provisions or percentage rent-related provisions that limit or restrict a tenant's ability to assign or sublet in connection with a different use due to the burden of increased rent under the percentage rent provision.

The percentage rent provision of a lease may also restrict the ability of a tenant to assign a lease for a different use in the bankruptcy context. A tenant that has filed for protection under Chapter 11 (the reorganization provisions) of the Bankruptcy Code (11 U.S.C. '101 et. seq.) may seek to assume and assign its lease to a third party for a different use and may obtain relief from certain so-called “anti-assignment” provisions of the lease that prohibit, restrict or condition an assignment, eg, provisions that limit or restrict the proposed use, the right to make alterations, a requirement that the tenant operate under a particular trade name, the right to change signage, and provisions requiring landlord consent or providing the landlord with the ability to share in any profit achieved in the proposed assignment. However, 11 U.S.C. '365 of the Bankruptcy Code restricts the ability of a debtor-tenant to seek relief from the terms of the percentage rent provision. A Chapter 11 debtor-tenant may seek relief from some percentage rent-related terms of the lease that may be deemed anti-assignment provisions; however, a discussion of this issue is beyond the scope of this article.

Identification of Percentage Rent and Percentage Rent-Related Terms

In addition to identifying and reviewing the percentage rent clause, both the tenant and the proposed assignee/subtenant in an assignment or subleasing transaction, should identify the following types of percentage rent-related provisions that may be contained in the lease and the effect of said provisions on a potential transaction based upon the proposed use:

1) The rights of a landlord to recapture the leased premises if a minimum level of gross sales is not achieved over a specific period of time;

2) Any restriction on a tenant's ability to exercise an option, or to extend or renew the term of the lease if a minimum sales volume is not achieved;

3) The definition of gross sales as it relates to the proposed assignee or subtenant, including whether the gross sales definition provides for the inclusion in “gross sales” of the rent paid by a subtenant or of the difference between the rent payable by the subtenant and the rent payable by the tenant for the portion of the space sublet;

4) A radius restriction that provides for the inclusion of the gross sales made in another store of the tenant (which would include gross sales of an assignee or subtenant), which is located within a specific distance from the leased premises, in the determination of gross sales for purposes of calculating percentage rent; and

5) A provision that modifies the determination of gross sales based upon the average of a specific number of prior years' gross sales or that provides for a fixed percentage rent based upon prior years' percentage rent payments, which becomes effective upon an assignment or subletting or upon the election of the landlord.

Drafting Suggestions to Allow for Change of Use in an Assignment or Subleasing Transaction

Assume the intention of the parties of the original lease is to give the tenant flexibility to assign or sublet for lawful retail uses ' without requiring the landlord's agreement to modify the percentage rent provision of the lease ' and relief from the types of lease provisions that restrict or condition assignment or subleasing. The lease can be drafted so as to provide i) protection to the landlord as to the additional percentage rent it contemplated receiving as to the initial use and ii) flexibility to the tenant when assigning the lease or subletting the leased premises to a third party for a different use, in the following ways:

1) The lease can include a provision that tolls the applicability of the percentage rent provision upon the tenant's assignment of the lease or sublease of the whole of the leased premises during the period the premises are used for a use other than the initial planned use. In addition, the lease can provide for the landlord's right to recapture the leased premises if the tenant seeks to assign or sublet the space for a different use. This provision provides some protection to the landlord, as it may elect to take back the space and re-let to another tenant for the same use, thereby generating similar gross sales. At the same time, although this limits the tenant's assignment and subletting rights, the landlord's exercise of this recapture right would have the effect of providing the tenant with a release.

2) The lease can include a clause that provides for the recalculation of the gross sales of a tenant upon the assignment of the lease or subleasing of the leased premises for a different use, based upon the average of the gross sales for a preceding fixed period. This clause provides protection to the landlord as it relates to the anticipated percentage rent it bargained for at the time it entered into the original lease transaction and also provides flexibility to the tenant to assign or sublet to different types of users whose anticipated gross sales may not have fit within the parameters of the original percentage rent provision.

3) The lease can include a clause that provides for the minimum rent to increase to the actual minimum rent plus the average percentage rent paid (if any) for a preceding fixed period, with increases to the percentage rent portion every 5 years based upon a fixed percentage or CPI increase. The landlord will be protected because the provision relates to the anticipated percentage rent the landlord contemplated at the time it entered into the lease, and the tenant is provided with the ability to assign the lease or sublet the premises for a different use.

Furthermore, if the Overlease requires the reporting of gross sales and/or the payment of percentage rent to the landlord ' whether the tenant in a sublease transaction is subleasing the whole or a portion of the leased premises for a different use ' the tenant should include a provision in the sublease that provides for sufficient “lead” time for the subtenant to report its gross sales (and pay any percentage rent due). This will enable the tenant to report the gross sales from the leased premises (and pay any percentage rent due) in compliance with the time parameters of the Overlease.

In conclusion, shopping center leases that attempt to provide flexibility for a tenant to assign or sublet its leasehold interest to a third party for another use may still contain percentage rent clauses that effectively preclude the tenant from assigning the lease or subletting the premises to certain users. Many years after the commencement of the lease term, the tenant may seek to avail itself of what originally were intended by the parties to be expansive rights by the tenant to assign or sublet. At that time, the tenant may not have sufficient leverage, and the landlord may not have any incentive (unless offered some form of cash or other consideration) to agree to modify the percentage rent provision. If the parties' intention is to provide for this flexibility, the lease should contain provisions, such as those described herein, that both protect the landlord and allow the tenant an exit strategy from a location it may no longer wish to operate.

Shopping center leases often contain percentage rent clauses that provide for the ability of the landlord to share in the sales of a tenant over a specific sales threshold while providing the tenant with a lower total rent when sales do not meet the sales threshold. A typical percentage rent provision obligates the tenant to pay a percentage (ie, the percentage rent rate) of the amount of gross sales generated by and from the tenant's business operated at the leased premises, that exceed the threshold amount, ie, a “sales” base or “breakpoint,” as additional rent.

The terms of the lease may require that the payments be made by the tenant to the landlord on a monthly or quarterly basis ' which may require estimated or escrow payments similar to common area maintenance payments based upon an estimate and reconciliation after the end of the applicable lease year ' or on a yearly basis. Although the specific terms of the percentage rent provision may vary, based on the bargaining position of the parties, this lease provision is usually tailored to the original tenant's initial use of the leased premises based upon the type of business to be conducted, the anticipated sales volume, the rent, and the term of the lease.

The term of shopping center leases may be long in duration, eg, the initial term of a movie theater, supermarket, or department store lease may be at least 20 years, plus a number of extension options, and the initial terms of leases of other types of big box tenants or national or regional retailers may be at least 10 years in duration plus options. During the term of a lease, many factors, including changing market conditions, change in the character of a shopping center (eg, from predominately retail to office), and/or declining sales, may contribute to a tenant's decision to evaluate its options at a particular retail outlet. These options may include a decision to shutter its space and pursue an assignment of its leasehold interest to a third party or sublease the premises to a third party, who will use the space for a different use. Shopping center leases contain various provisions that may impact a tenant's proposed assignment of its lease or subleasing of the premises to a third party for a different use. One of these provisions is the percentage rent clause. The percentage rent clause may limit the type of user that the tenant may pursue in connection with such an assignment or subletting, due to the economics contained within the percentage rent clause ' unless the landlord is required to amend the percentage rent provision to accommodate the new use.

In conjunction with a tenant's review of its options to assign its leasehold interest or sublease the premises, the tenant should complete a thorough review of its lease to identify all the potential issues associated with entering into an assignment or sublease transaction. Among the questions the tenant needs answered are:

• the specific landlord consent requirements,
• any limitations or restrictions as to lease provisions related to use, alterations, signage, trade name, continuous operations, and
• percentage rent.

There are many provisions in shopping center leases that may restrict the tenant's ability to assign or sublet the premises. Many leases originally may be drafted to provide flexibility to the tenant to assign or sublease without requiring either the landlord's consent or agreement to amend the lease. These leases may, however, include percentage rent provisions or percentage rent-related provisions that limit or restrict a tenant's ability to assign or sublet in connection with a different use due to the burden of increased rent under the percentage rent provision.

The percentage rent provision of a lease may also restrict the ability of a tenant to assign a lease for a different use in the bankruptcy context. A tenant that has filed for protection under Chapter 11 (the reorganization provisions) of the Bankruptcy Code (11 U.S.C. '101 et. seq.) may seek to assume and assign its lease to a third party for a different use and may obtain relief from certain so-called “anti-assignment” provisions of the lease that prohibit, restrict or condition an assignment, eg, provisions that limit or restrict the proposed use, the right to make alterations, a requirement that the tenant operate under a particular trade name, the right to change signage, and provisions requiring landlord consent or providing the landlord with the ability to share in any profit achieved in the proposed assignment. However, 11 U.S.C. '365 of the Bankruptcy Code restricts the ability of a debtor-tenant to seek relief from the terms of the percentage rent provision. A Chapter 11 debtor-tenant may seek relief from some percentage rent-related terms of the lease that may be deemed anti-assignment provisions; however, a discussion of this issue is beyond the scope of this article.

Identification of Percentage Rent and Percentage Rent-Related Terms

In addition to identifying and reviewing the percentage rent clause, both the tenant and the proposed assignee/subtenant in an assignment or subleasing transaction, should identify the following types of percentage rent-related provisions that may be contained in the lease and the effect of said provisions on a potential transaction based upon the proposed use:

1) The rights of a landlord to recapture the leased premises if a minimum level of gross sales is not achieved over a specific period of time;

2) Any restriction on a tenant's ability to exercise an option, or to extend or renew the term of the lease if a minimum sales volume is not achieved;

3) The definition of gross sales as it relates to the proposed assignee or subtenant, including whether the gross sales definition provides for the inclusion in “gross sales” of the rent paid by a subtenant or of the difference between the rent payable by the subtenant and the rent payable by the tenant for the portion of the space sublet;

4) A radius restriction that provides for the inclusion of the gross sales made in another store of the tenant (which would include gross sales of an assignee or subtenant), which is located within a specific distance from the leased premises, in the determination of gross sales for purposes of calculating percentage rent; and

5) A provision that modifies the determination of gross sales based upon the average of a specific number of prior years' gross sales or that provides for a fixed percentage rent based upon prior years' percentage rent payments, which becomes effective upon an assignment or subletting or upon the election of the landlord.

Drafting Suggestions to Allow for Change of Use in an Assignment or Subleasing Transaction

Assume the intention of the parties of the original lease is to give the tenant flexibility to assign or sublet for lawful retail uses ' without requiring the landlord's agreement to modify the percentage rent provision of the lease ' and relief from the types of lease provisions that restrict or condition assignment or subleasing. The lease can be drafted so as to provide i) protection to the landlord as to the additional percentage rent it contemplated receiving as to the initial use and ii) flexibility to the tenant when assigning the lease or subletting the leased premises to a third party for a different use, in the following ways:

1) The lease can include a provision that tolls the applicability of the percentage rent provision upon the tenant's assignment of the lease or sublease of the whole of the leased premises during the period the premises are used for a use other than the initial planned use. In addition, the lease can provide for the landlord's right to recapture the leased premises if the tenant seeks to assign or sublet the space for a different use. This provision provides some protection to the landlord, as it may elect to take back the space and re-let to another tenant for the same use, thereby generating similar gross sales. At the same time, although this limits the tenant's assignment and subletting rights, the landlord's exercise of this recapture right would have the effect of providing the tenant with a release.

2) The lease can include a clause that provides for the recalculation of the gross sales of a tenant upon the assignment of the lease or subleasing of the leased premises for a different use, based upon the average of the gross sales for a preceding fixed period. This clause provides protection to the landlord as it relates to the anticipated percentage rent it bargained for at the time it entered into the original lease transaction and also provides flexibility to the tenant to assign or sublet to different types of users whose anticipated gross sales may not have fit within the parameters of the original percentage rent provision.

3) The lease can include a clause that provides for the minimum rent to increase to the actual minimum rent plus the average percentage rent paid (if any) for a preceding fixed period, with increases to the percentage rent portion every 5 years based upon a fixed percentage or CPI increase. The landlord will be protected because the provision relates to the anticipated percentage rent the landlord contemplated at the time it entered into the lease, and the tenant is provided with the ability to assign the lease or sublet the premises for a different use.

Furthermore, if the Overlease requires the reporting of gross sales and/or the payment of percentage rent to the landlord ' whether the tenant in a sublease transaction is subleasing the whole or a portion of the leased premises for a different use ' the tenant should include a provision in the sublease that provides for sufficient “lead” time for the subtenant to report its gross sales (and pay any percentage rent due). This will enable the tenant to report the gross sales from the leased premises (and pay any percentage rent due) in compliance with the time parameters of the Overlease.

In conclusion, shopping center leases that attempt to provide flexibility for a tenant to assign or sublet its leasehold interest to a third party for another use may still contain percentage rent clauses that effectively preclude the tenant from assigning the lease or subletting the premises to certain users. Many years after the commencement of the lease term, the tenant may seek to avail itself of what originally were intended by the parties to be expansive rights by the tenant to assign or sublet. At that time, the tenant may not have sufficient leverage, and the landlord may not have any incentive (unless offered some form of cash or other consideration) to agree to modify the percentage rent provision. If the parties' intention is to provide for this flexibility, the lease should contain provisions, such as those described herein, that both protect the landlord and allow the tenant an exit strategy from a location it may no longer wish to operate.