Does Your Lease Have an Operating Covenant?

One cannot emphasize enough the importance of the use provisions of the lease as a method of either reinforcing an operating covenant or performing the same function independently. One of the most important provisions of the lease is a narrowly drafted use clause. The more broadly the use covenant is drafted, the less likely that a tenant will remain open and maintain the operation of the exact type of use that the landlord sought to have in the space in the first instance; with a broad use clause it will be possible for the tenant to find a replacement more easily in order to exit primary lease liability. The more narrowly that the use clause is drafted, however, the more likely that a tenant will need to remain operating as the required use until it can either negotiate its lease termination or find a replacement tenant that can meet the lease requirements. By remaining open, a tenant in essence mitigates its potential damages. For instance, if the landlord initially bargained for and negotiated a use clause requiring the tenant to operate only as an Italian restaurant and not as a restaurant generally, and with the presumption that the tenant indeed does not want to be in default of the lease, the tenant will maintain its use as an Italian restaurant rather than close its business in order to find any restaurant that it can to fill the space prior to a negotiated settlement. One could argue, and certainly if you are a tenant ' or representing a tenant ' one will argue, that if the use clause is more broadly drafted, the tenant will change its menu in an attempt to find a menu which will make the restaurant profitable, and, therefore, avoid a closure. Under these circumstances, however, the landlord may not get the restaurant that it bargained for.

Perhaps the solution that would be most satisfying to both parties is to permit the tenant to change menus with the landlord's consent (not to be unreasonably withheld) so that the strength of the use and the express or implied operating covenant is maintained, while permitting the tenant flexibility of use. Note that for the reasons stated below, this right to seek a change of use should be drafted either to expressly include or exclude changes in the context of assignment and subletting. The consent should expressly exclude assignment and subletting due to the inclusion in the lease of pre-negotiated changes in use as discussed below.

A use clause also often contains a covenant that the tenant may not close its business or “go dark” for any reason, other than for specified events, such as required or approved renovations, an annual taking of an accounting of existing inventory in the premises or time to rebuild or restore the premises which suffered damages as a result of a casualty or condemnation. Again, these clauses must be viewed with a critical eye, since they act as an unstated operating covenant. To further this unstated requirement of operation, the lease will often contain limited periods of time for these exceptions to the “no going dark” covenant in order to force the tenant to reopen its business as soon as possible. In order to make sure that the tenant understands that going dark is a serious beach of its otherwise stated covenant to operate in the premises, the penalties and/or remedies available to the landlord, which arise as a result of such a breach, will range from significant monetary penalties until the breach is cured to the right of the landlord to terminate the lease. The tenant may also be required to reimburse the landlord for costs and expenses ' including attorneys' fees and costs ' that the landlord or its agents incur, as a result of the breach.

Finally, the use clause may contain specified hours of operation for the tenant's business operations in the premises as another method by which the landlord attempts to create an operating covenant ' whether or not an express obligation to operate is contained in the lease. Landlords always desire to have the maximum number of retail tenants in a shopping center open for business at the same time and during the same hours. Uniformity of required hours of operation affords customers the ability to plan their shopping time at a particular location. It also allows a landlord to provide consistent services at the shopping center because it knows each day what hours certain services are required, such as HVAC and security. Landlords can utilize these goals of consistency in providing services to customers and tenants through maintaining precise hours of operation to achieve one of their goals ' to create an operating covenant on the part of the tenants.

Assignment and Subletting Provisions

While the use clause obviously contains many significant provisions, correctly drafted and detailed assignment and subletting provisions can also provide support to an express operating covenant or achieve the goals of an operating covenant if it is not expressly stated. Most leases contain a prohibition against assignment and subletting, though the restriction is often modified to state that the landlord will not unreasonably withhold its consent to a proposed assignment or sublet. The question is whether the drafter of the lease specifically defines what it means to “not unreasonably withhold consent” or whether the issue is left open as to the meaning of what is unreasonable or not in the then existing context of the law and the market. Again, the more defined the covenants, the more possible it is to predict with certainty whether an assignment or sublet will be permitted or not. In turn, this certainty can provide for a smooth transition to another tenancy providing for continued operations in the space. That is not to say that some temporary closure may not need to take place. However, the closure is just that ' temporary.

The outcome of proposed assignment and subletting can be made even more certain by including in the lease pre-negotiated clauses permitting specific changes in use, time limits for closure in the event of change of use, and recapture clauses in favor of the landlord. In many leases, the issue of change of use in the event of assignment or sublet is not addressed possibly because the landlord does not realize that the language drafted for consent for a change of use will apply to an assignment or sublet in the absence of language expressly to the contrary (contracts being read as a whole with integration clauses). Instead, landlords expect that the tenant will come to them for consents required because they are outside the terms of the lease.

Recapture Clauses

What course of action most directly supports the operating covenant? Pre-negotiated permission for specific changes in use when coupled with express time limits for closure in the event of a change of use is perhaps the most supportive of a continuing tenancy, as the tenant would then be able to target possible replacement tenants and the landlord would have the certainty of how much time a premises will be closed for business. It would seem to be counterintuitive that a recapture clause advances the goals of the operating covenant and the goal of certainty for the parties. However, a recapture right can permit the landlord to terminate a tenancy that is failing and unable to be rehabilitated through the tenant's efforts on its own behalf or through assignment or subletting. A recapture right can provide the tenant an opportunity to “put” the tenancy to the landlord so that it terminates its liability.

Percentage Rent

It may seem obvious that the use and assignment and subletting clauses can be used to support the operating covenant or act in lieu thereof, but it may not be obvious to some that the obligation to pay percentage rent equally acts as an operating covenant if drafted correctly. Where a lease requires the tenant to pay percentage rent, this obligation will only arise if tenant's sales exceed a certain level, known as a breakpoint, and the percentage is stated as a percentage of tenant's sales that exceed the breakpoint. Landlords will often tie the obligation to pay percentage rent with an obligation by tenant to maximize sales from the premises. In order to ensure the tenant's efforts to maximize sales, as stated above, the lease often contains stated minimum hours that the tenant's business must remain open for business, that the tenant's inventory of goods must be sold, that the premises must remain at all times fully stocked with new and current inventory, and that the number of employees at the premises is sufficient for the tenant to operate and produce the greatest level of sales. These covenants are clearly an indirect way of stating that the tenant must operate.

Conclusion

Whether a party is a landlord or tenant, it needs to consider the interplay of all lease clauses in order to meet the goals for the tenancy. Nowhere is this principle more evident than in the interplay of lease clauses that support the express or implied operating covenant.

A retail lease should include a covenant requiring a tenant to operate in the premises. The covenant needs to state clearly and unequivocally that a tenant will be required to operate in the premises for the term of the lease. The active and open operation of tenancies is the essence of retail and what ultimately makes for a successful shopping center. A clear operating covenant, or lack thereof, also facilitates the party's exit strategy from the lease, something which is often more important than the actual operation of the business in the premises.

Landlords can best serve their goal of maintaining operation of a tenancy not only by having a clear and unequivocal operating covenant in the lease, but by drafting other clauses in the lease with the mindset that these other clauses can and should reinforce the unequivocal nature of the operating covenant. With the proper use of these other clauses and a strong operating covenant, the landlord will obtain the best outcome in the event that the tenant desires to terminate the lease earlier than the last day of the term. Yet these clauses, even when standing on their own, can also serve the same function as an operating covenant. This article discusses a number of the clauses that reinforce the operating covenant or perform the same function independently in the lease.

Use Clauses

One cannot emphasize enough the importance of the use provisions of the lease as a method of either reinforcing an operating covenant or performing the same function independently. One of the most important provisions of the lease is a narrowly drafted use clause. The more broadly the use covenant is drafted, the less likely that a tenant will remain open and maintain the operation of the exact type of use that the landlord sought to have in the space in the first instance; with a broad use clause it will be possible for the tenant to find a replacement more easily in order to exit primary lease liability. The more narrowly that the use clause is drafted, however, the more likely that a tenant will need to remain operating as the required use until it can either negotiate its lease termination or find a replacement tenant that can meet the lease requirements. By remaining open, a tenant in essence mitigates its potential damages. For instance, if the landlord initially bargained for and negotiated a use clause requiring the tenant to operate only as an Italian restaurant and not as a restaurant generally, and with the presumption that the tenant indeed does not want to be in default of the lease, the tenant will maintain its use as an Italian restaurant rather than close its business in order to find any restaurant that it can to fill the space prior to a negotiated settlement. One could argue, and certainly if you are a tenant ' or representing a tenant ' one will argue, that if the use clause is more broadly drafted, the tenant will change its menu in an attempt to find a menu which will make the restaurant profitable, and, therefore, avoid a closure. Under these circumstances, however, the landlord may not get the restaurant that it bargained for.

Perhaps the solution that would be most satisfying to both parties is to permit the tenant to change menus with the landlord's consent (not to be unreasonably withheld) so that the strength of the use and the express or implied operating covenant is maintained, while permitting the tenant flexibility of use. Note that for the reasons stated below, this right to seek a change of use should be drafted either to expressly include or exclude changes in the context of assignment and subletting. The consent should expressly exclude assignment and subletting due to the inclusion in the lease of pre-negotiated changes in use as discussed below.

A use clause also often contains a covenant that the tenant may not close its business or “go dark” for any reason, other than for specified events, such as required or approved renovations, an annual taking of an accounting of existing inventory in the premises or time to rebuild or restore the premises which suffered damages as a result of a casualty or condemnation. Again, these clauses must be viewed with a critical eye, since they act as an unstated operating covenant. To further this unstated requirement of operation, the lease will often contain limited periods of time for these exceptions to the “no going dark” covenant in order to force the tenant to reopen its business as soon as possible. In order to make sure that the tenant understands that going dark is a serious beach of its otherwise stated covenant to operate in the premises, the penalties and/or remedies available to the landlord, which arise as a result of such a breach, will range from significant monetary penalties until the breach is cured to the right of the landlord to terminate the lease. The tenant may also be required to reimburse the landlord for costs and expenses ' including attorneys' fees and costs ' that the landlord or its agents incur, as a result of the breach.

Finally, the use clause may contain specified hours of operation for the tenant's business operations in the premises as another method by which the landlord attempts to create an operating covenant ' whether or not an express obligation to operate is contained in the lease. Landlords always desire to have the maximum number of retail tenants in a shopping center open for business at the same time and during the same hours. Uniformity of required hours of operation affords customers the ability to plan their shopping time at a particular location. It also allows a landlord to provide consistent services at the shopping center because it knows each day what hours certain services are required, such as HVAC and security. Landlords can utilize these goals of consistency in providing services to customers and tenants through maintaining precise hours of operation to achieve one of their goals ' to create an operating covenant on the part of the tenants.

Assignment and Subletting Provisions

While the use clause obviously contains many significant provisions, correctly drafted and detailed assignment and subletting provisions can also provide support to an express operating covenant or achieve the goals of an operating covenant if it is not expressly stated. Most leases contain a prohibition against assignment and subletting, though the restriction is often modified to state that the landlord will not unreasonably withhold its consent to a proposed assignment or sublet. The question is whether the drafter of the lease specifically defines what it means to “not unreasonably withhold consent” or whether the issue is left open as to the meaning of what is unreasonable or not in the then existing context of the law and the market. Again, the more defined the covenants, the more possible it is to predict with certainty whether an assignment or sublet will be permitted or not. In turn, this certainty can provide for a smooth transition to another tenancy providing for continued operations in the space. That is not to say that some temporary closure may not need to take place. However, the closure is just that ' temporary.

The outcome of proposed assignment and subletting can be made even more certain by including in the lease pre-negotiated clauses permitting specific changes in use, time limits for closure in the event of change of use, and recapture clauses in favor of the landlord. In many leases, the issue of change of use in the event of assignment or sublet is not addressed possibly because the landlord does not realize that the language drafted for consent for a change of use will apply to an assignment or sublet in the absence of language expressly to the contrary (contracts being read as a whole with integration clauses). Instead, landlords expect that the tenant will come to them for consents required because they are outside the terms of the lease.

Recapture Clauses

What course of action most directly supports the operating covenant? Pre-negotiated permission for specific changes in use when coupled with express time limits for closure in the event of a change of use is perhaps the most supportive of a continuing tenancy, as the tenant would then be able to target possible replacement tenants and the landlord would have the certainty of how much time a premises will be closed for business. It would seem to be counterintuitive that a recapture clause advances the goals of the operating covenant and the goal of certainty for the parties. However, a recapture right can permit the landlord to terminate a tenancy that is failing and unable to be rehabilitated through the tenant's efforts on its own behalf or through assignment or subletting. A recapture right can provide the tenant an opportunity to “put” the tenancy to the landlord so that it terminates its liability.

Percentage Rent

It may seem obvious that the use and assignment and subletting clauses can be used to support the operating covenant or act in lieu thereof, but it may not be obvious to some that the obligation to pay percentage rent equally acts as an operating covenant if drafted correctly. Where a lease requires the tenant to pay percentage rent, this obligation will only arise if tenant's sales exceed a certain level, known as a breakpoint, and the percentage is stated as a percentage of tenant's sales that exceed the breakpoint. Landlords will often tie the obligation to pay percentage rent with an obligation by tenant to maximize sales from the premises. In order to ensure the tenant's efforts to maximize sales, as stated above, the lease often contains stated minimum hours that the tenant's business must remain open for business, that the tenant's inventory of goods must be sold, that the premises must remain at all times fully stocked with new and current inventory, and that the number of employees at the premises is sufficient for the tenant to operate and produce the greatest level of sales. These covenants are clearly an indirect way of stating that the tenant must operate.

Conclusion

Whether a party is a landlord or tenant, it needs to consider the interplay of all lease clauses in order to meet the goals for the tenancy. Nowhere is this principle more evident than in the interplay of lease clauses that support the express or implied operating covenant.