Tenant Exit Strategies: Planning Ahead for a Way Out

The sample co-tenancy agreement contains several customary provisions with a decidedly tenant-oriented slant. The form provides that if certain tenants are not open and continuously operating in the center, or if a certain portion of the balance of the center is not continuously open for business, the tenant may discontinue its operations, continue its operations with a rent abatement, or terminate its lease. Landlords will want to include certain exceptions to the continuous operation obligation of the co-tenants, such as requiring operation only during customary business hours of shopping centers in the geographic area and permitting tenants to close down for reasonable periods of time because of force majeure events, casualty, repairs and remodeling (all exceptions which the tenant would want in its operating covenant). The form also contains a fairly standard provision allowing the landlord to recapture the lease if the tenant discontinues operations for a period of time. This possibly disastrous result is tempered by the tenant's ability to nullify the recapture right by agreeing to re-open ' and actually re-opening ' for business.

Transfer of Tenant's Leasehold Interest

The second category of exit strategies includes those that allow the tenant to transfer its interest in the lease. Perhaps the tenant's business has become successful and an even more successful chain is looking to acquire the tenant's business; or the tenant's owner is looking to retire and sell its business; or the tenant's business is not doing well and the tenant wants to close down. Any one of these scenarios will necessitate the transfer of the tenant's lease. A good way to think about transfer as an exit strategy, while at the negotiating table, is to put yourself in the mind of the prospective acquirer of the tenant's business and/or lease.

The first thing a prospective acquirer of the lease will look at is how the transfer can be accomplished and at what cost. The customary method of acquisition is by assignment, or, if the entire company is purchased, by merger or acquisition of the capital stock of the tenant. With this in mind, a tenant obviously wants to negotiate a liberal transfer provision. Absolute prohibition against assignments, subletting or changes in control of the tenant entity are unacceptable from a tenant's perspective. At a minimum, the tenant should require the landlord not to withhold consent to transfers of the lease unreasonably and should expressly negotiate certain permitted transfers that will not require consent such as: 1) transfers to affiliates; 2) mergers, consolidations or sales of stock; or 3) sales of all, or substantially all, of the tenant's assets. As a compromise position, assignment can be conditioned on certain criteria of the proposed assignee, such as creditworthiness, or the right to transfer may be limited to those in connection with the transfer of a certain number of the tenant's other stores. Tenants should be wary of transfer provisions that are seemingly favorable but have unacceptable results, such as a recapture right by the landlord if a transfer is requested or the inability of a transferee to exercise certain rights such as extension options.

While a favorable right to transfer is obviously critical to the tenant's ability to get out of its lease, the presence of certain other provisions in the lease may effectively nullify the right. For example, if the lease has an operating covenant (or no covenant but a landlord recapture right if the tenant is not open for business), without any exceptions for closure in the context of assignment or other transfer (ie, for fit-up for the new tenant), a transfer of the lease may be practicably impossible. An acquirer of the lease could risk breaching its lease if it is necessary to close business operations for some time during the transition period.

Once a prospective acquirer determines that the transfer can be accomplished without a loss of rights, consideration will be given to what the lease will look like if the acquirer becomes the tenant and wants to use the acquirer's name, remodel the premises or use the premises for a use different from that of the tenant. In many cases, the lease will not look the same with the acquirer as the tenant. Perhaps the lease contains a radius restriction prohibiting the tenant from operating a similar store within a 5-mile radius of the shopping center. Common in percentage rent leases, this restriction may not be a problem for the tenant; however, it may be an enormous problem for a prospective acquirer with stores within the restricted area. The penalty for violation of this covenant is customarily to include the gross sales from the offending store into the gross sales of the store under the lease, thereby inflating any percentage rent due. This result will obviously be unacceptable to the proposed acquirer.

Similarly, a narrow use restriction may work fine for an existing tenant, but will naturally limit the universe of possible transferees of the lease.

A use provision that is too narrow or that requires the tenant to operate and advertise its business in the demised premises under a particular trade name can make the lease impossible to transfer (except perhaps to an acquirer of the tenant's business who plans to continue operations exactly as the original tenant), even with a favorable transfer provision. The requirement in the lease for use of a specific trade name may be explicit (as in the aforementioned example) or more subtle as in lease provisions requiring landlord consent for tenant alterations and improvements or changes in signs or layout of the demised premises. While these provisions are fairly customary (and are likely acceptable to an existing tenant), they are effectively an alternate way for a landlord to prevent a transfer of the lease. These clauses must provide exceptions that tie to the transfer provisions, otherwise, the right to transfer the lease loses meaning if a prospective acquirer must obtain consent from the landlord to alter or replace signs or make other changes to the premises to accommodate the acquirer's business.

While the ultimate resolution of these various provisions will depend largely on the negotiating power of the tenant, it is vital for the tenant to consider at the outset what obstacles the landlord is placing in its way. If the tenant does not keep the concept of exit strategies in mind while negotiating its lease, it may find itself with no way out of its lease. It is therefore crucial for a tenant, at the negotiating stage, to place itself in the mind of a prospective acquirer of the lease to ensure that the tenant negotiates maximum flexibility to allow a future transferee to take over the lease and operate its business easily.

When landlords and tenants negotiate a lease, particularly a retail lease, they typically have in mind a long-term relationship. The parties enter the relationship optimistically with the hope that the tenant's business will be successful at the particular location, that the entire project will be a success and that the tenant's operations will enhance the value of the property. Given the long-term nature of most retail leases, it is vital for tenants to think ahead, while at the negotiating stage, and anticipate how their business or the shopping center in which they are located may change (for better or worse) in the future. Tenants should negotiate maximum flexibility in their leases to ensure that their leases do not contain unacceptable obstacles to the tenant's ability to exit from the lease in the event circumstances change and the tenant no longer wants to remain in the lease. This need for flexibility will be tempered by the landlord's desire to retain the original tenant with which it negotiated and is comfortable. This article discusses two types of tenant exit strategies. First, those that are beneficial to the tenant ' while the tenant remains the tenant under the lease ' such as the alteration or elimination of an operating covenant. Second, those that allow the tenant to transfer its interest in the lease whether by merger, stock sale, assignment, sublease or otherwise.

Co-Tenancy Agreements

Suppose the landlord insists on including an operating covenant in the tenant's lease that obligates the tenant to “continuously operate and use the demised premises.” Aside from the difficulties this language presents if the tenant seeks to transfer the lease (as discussed below), the tenant recognizes that if the anchor tenant in the shopping center ceases operations, or if a certain portion of the center becomes vacant, it may be difficult (if not impossible) for the tenant to remain open and be profitable because business in the center would be expected to diminish. The tenant's exit strategy to counterbalance the landlord's insistence on the inclusion of an operating covenant is the co-tenancy agreement.

The sample co-tenancy agreement contains several customary provisions with a decidedly tenant-oriented slant. The form provides that if certain tenants are not open and continuously operating in the center, or if a certain portion of the balance of the center is not continuously open for business, the tenant may discontinue its operations, continue its operations with a rent abatement, or terminate its lease. Landlords will want to include certain exceptions to the continuous operation obligation of the co-tenants, such as requiring operation only during customary business hours of shopping centers in the geographic area and permitting tenants to close down for reasonable periods of time because of force majeure events, casualty, repairs and remodeling (all exceptions which the tenant would want in its operating covenant). The form also contains a fairly standard provision allowing the landlord to recapture the lease if the tenant discontinues operations for a period of time. This possibly disastrous result is tempered by the tenant's ability to nullify the recapture right by agreeing to re-open ' and actually re-opening ' for business.

Transfer of Tenant's Leasehold Interest

The second category of exit strategies includes those that allow the tenant to transfer its interest in the lease. Perhaps the tenant's business has become successful and an even more successful chain is looking to acquire the tenant's business; or the tenant's owner is looking to retire and sell its business; or the tenant's business is not doing well and the tenant wants to close down. Any one of these scenarios will necessitate the transfer of the tenant's lease. A good way to think about transfer as an exit strategy, while at the negotiating table, is to put yourself in the mind of the prospective acquirer of the tenant's business and/or lease.

The first thing a prospective acquirer of the lease will look at is how the transfer can be accomplished and at what cost. The customary method of acquisition is by assignment, or, if the entire company is purchased, by merger or acquisition of the capital stock of the tenant. With this in mind, a tenant obviously wants to negotiate a liberal transfer provision. Absolute prohibition against assignments, subletting or changes in control of the tenant entity are unacceptable from a tenant's perspective. At a minimum, the tenant should require the landlord not to withhold consent to transfers of the lease unreasonably and should expressly negotiate certain permitted transfers that will not require consent such as: 1) transfers to affiliates; 2) mergers, consolidations or sales of stock; or 3) sales of all, or substantially all, of the tenant's assets. As a compromise position, assignment can be conditioned on certain criteria of the proposed assignee, such as creditworthiness, or the right to transfer may be limited to those in connection with the transfer of a certain number of the tenant's other stores. Tenants should be wary of transfer provisions that are seemingly favorable but have unacceptable results, such as a recapture right by the landlord if a transfer is requested or the inability of a transferee to exercise certain rights such as extension options.

While a favorable right to transfer is obviously critical to the tenant's ability to get out of its lease, the presence of certain other provisions in the lease may effectively nullify the right. For example, if the lease has an operating covenant (or no covenant but a landlord recapture right if the tenant is not open for business), without any exceptions for closure in the context of assignment or other transfer (ie, for fit-up for the new tenant), a transfer of the lease may be practicably impossible. An acquirer of the lease could risk breaching its lease if it is necessary to close business operations for some time during the transition period.

Once a prospective acquirer determines that the transfer can be accomplished without a loss of rights, consideration will be given to what the lease will look like if the acquirer becomes the tenant and wants to use the acquirer's name, remodel the premises or use the premises for a use different from that of the tenant. In many cases, the lease will not look the same with the acquirer as the tenant. Perhaps the lease contains a radius restriction prohibiting the tenant from operating a similar store within a 5-mile radius of the shopping center. Common in percentage rent leases, this restriction may not be a problem for the tenant; however, it may be an enormous problem for a prospective acquirer with stores within the restricted area. The penalty for violation of this covenant is customarily to include the gross sales from the offending store into the gross sales of the store under the lease, thereby inflating any percentage rent due. This result will obviously be unacceptable to the proposed acquirer.

Similarly, a narrow use restriction may work fine for an existing tenant, but will naturally limit the universe of possible transferees of the lease.

A use provision that is too narrow or that requires the tenant to operate and advertise its business in the demised premises under a particular trade name can make the lease impossible to transfer (except perhaps to an acquirer of the tenant's business who plans to continue operations exactly as the original tenant), even with a favorable transfer provision. The requirement in the lease for use of a specific trade name may be explicit (as in the aforementioned example) or more subtle as in lease provisions requiring landlord consent for tenant alterations and improvements or changes in signs or layout of the demised premises. While these provisions are fairly customary (and are likely acceptable to an existing tenant), they are effectively an alternate way for a landlord to prevent a transfer of the lease. These clauses must provide exceptions that tie to the transfer provisions, otherwise, the right to transfer the lease loses meaning if a prospective acquirer must obtain consent from the landlord to alter or replace signs or make other changes to the premises to accommodate the acquirer's business.

While the ultimate resolution of these various provisions will depend largely on the negotiating power of the tenant, it is vital for the tenant to consider at the outset what obstacles the landlord is placing in its way. If the tenant does not keep the concept of exit strategies in mind while negotiating its lease, it may find itself with no way out of its lease. It is therefore crucial for a tenant, at the negotiating stage, to place itself in the mind of a prospective acquirer of the lease to ensure that the tenant negotiates maximum flexibility to allow a future transferee to take over the lease and operate its business easily.