In the Spotlight: Limiting the Impact of Co-Tenancy Requirements

Part One of a Two-Part Series

A co-tenancy requirement may have substantial negative effects, including a domino effect if more than one tenant ceases to operate. Most landlords resist giving such rights to a tenant, especially an in-line tenant. However, if an important tenant has sufficient negotiating leverage, a landlord may be forced to roll the dice, agree to a co-tenancy requirement, and hope that the designated co-tenant will continue to operate during the term of the benefited tenant's lease. This article focuses on ways a landlord can limit the impact of co-tenancy requirements.

Broadly Define Co-Tenancy Requirement

Percentage Tests: The benefited tenant may be willing to live with a requirement that a specified percentage of tenants remain open, rather than a requirement that one or more particular co-tenants remain open. Any percentage occupancy condition should specify whether the required percentage relates to the percentage of stores or the percentage of the rentable floor area in the center. Based on the arrangement of the center, one alternative may be more advantageous to the landlord than the other. For example, a landlord may prefer to have the provision refer to a percentage of stores if the landlord owns a center with a number of tenants leasing small stores that reflect a minor percentage of the rentable floor area. If the provision instead refers to the percentage of the rentable floor area, consideration should be given to whether certain large stores should be excluded. If one large tenant ceases to operate, it might be difficult to satisfy the co-tenancy requirement, even though the rest of the tenants continue to operate. On the other hand, such an exclusion would prove to be detrimental to the landlord if the large tenant continues to operate.

If a co-tenancy requirement is satisfied only by operation of both a percentage of stores (or rentable floor area) and one or more specific tenants, the landlord should consider whether the specific tenants (typically larger stores) should be included or excluded in determining whether the percentage test has been satisfied. Moreover, in mixed-use projects, should non-retail uses, such as office and residential, be included and, if so, how should their floor area be measured for purposes of satisfying percentage tests?

Specific Co-Tenants: When the benefited tenant insists on a big box or department store co-tenancy requirement, the hardship of such a requirement may be limited by referring to the occupancy of the applicable building or a retailer in excess of a minimum size, as distinguished from a named occupant. In multiple big box or department store co-tenancy situations, the impact can be diminished by providing for alternate ways to satisfy the co-tenancy requirement, such as including only some of the big boxes or department stores (say, three out of the four located in the center) within the co-tenancy requirement and requiring that only two of those three continue to operate. The benefited tenant may insist on proximity requirements.

When a specific set of co-tenants is required, it is important to create some flexibility by permitting the specified co-tenants to: 1) change names, such as in connection with a merger or sale of substantially all of such co-tenant's assets, and 2) be replaced by suitable replacement co-tenants. If a tenant is included in a co-tenancy requirement of another tenant, it is important to negotiate a recapture right upon cessation of operation after any required operating period so that the tenant can be replaced. The definition of a suitable replacement co-tenant should be as broad as possible and could include an exhibit with a list of specific
suitable replacement co-tenants. Preferably, the list should be representative rather than exhaustive, with a basket category that contains either objective criteria or a reference to the list for comparison purposes. If the benefited tenant's consent is required for a replacement co-tenant, it should not be unreasonably withheld. The concept of permitting replacement co-tenants to be located elsewhere in the center, perhaps with the benefited tenant's reasonable consent, should be broached. It is important to be creative, since it is difficult to determine in advance the mix of tenants that will be attainable for the center at any time in the future.

Limit the Duration

Another way to limit the impact of a co-tenancy requirement is to reduce its duration. It is preferable (though often not achievable) to limit the co-tenancy requirement to an opening co-tenancy or, if an ongoing co-tenancy is required, to provide that it terminates when the center stabilizes. This approach may be used to entice a benefited tenant to enter into a lease at a newly developed or redeveloped center. The co-tenancy requirement should terminate if the benefited tenant has permanently closed for business or fails to operate under a specified name or for a specified use or in a specified portion of the store. It should also terminate in the event of at least some types of assignment and subletting transactions. The co-tenancy requirement is often for the term of the lease, including options, but there is no reason it cannot be limited to a specified period.

Narrowly Define Violations

The co-tenancy provision should be drafted to limit or delay when a co-tenancy requirement will be deemed to have been violated.

For an opening co-tenancy requirement, the landlord should insist on additional cure periods and lower percentage thresholds before draconian remedies kick in because the landlord may need some time to lease up the center in the case of a new development or redevelopment. For example, the benefited tenant may have the right to delay opening for business and pay a reduced rent but may not have the right to terminate the lease. The relationship between opening and ongoing co-tenancy requirements should also be thought through. The landlord should make sure that there is a grace period and perhaps a worsening of the situation before any ongoing co-tenancy requirement is triggered after violation of an opening co-tenancy requirement so that if the benefited tenant opens for business notwithstanding the violation of an opening co-tenancy requirement, the landlord will not be in immediate violation of the ongoing co-tenancy requirement.

A violation of the co-tenancy requirement should also be tolled while the benefited tenant is in default under its lease. (The benefited tenant may demand that the violation be postponed only after notice and after cure periods lapse and only during a material default.) The violation may be tempered by limiting when a co-tenant is deemed to have failed to operate ' for example, only a closure continuing at least several months, exclusive of closures due to force majeure events, including casualty, and closures attributable to remodeling. It will be easier to negotiate a mutually acceptable definition of a closure if the benefited tenant loses its rights to enforce the co-tenancy requirement in the event of its closure (as suggested above).

Next month's installment will address notice and cure rights and limiting the tenant's remedies.

Sheldon A. Halpern, a member of this newsletter's Editorial Board, is a partner and Xavier Gutierrez is an associate in Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago.

Part One of a Two-Part Series

A co-tenancy requirement may have substantial negative effects, including a domino effect if more than one tenant ceases to operate. Most landlords resist giving such rights to a tenant, especially an in-line tenant. However, if an important tenant has sufficient negotiating leverage, a landlord may be forced to roll the dice, agree to a co-tenancy requirement, and hope that the designated co-tenant will continue to operate during the term of the benefited tenant's lease. This article focuses on ways a landlord can limit the impact of co-tenancy requirements.

Broadly Define Co-Tenancy Requirement

Percentage Tests: The benefited tenant may be willing to live with a requirement that a specified percentage of tenants remain open, rather than a requirement that one or more particular co-tenants remain open. Any percentage occupancy condition should specify whether the required percentage relates to the percentage of stores or the percentage of the rentable floor area in the center. Based on the arrangement of the center, one alternative may be more advantageous to the landlord than the other. For example, a landlord may prefer to have the provision refer to a percentage of stores if the landlord owns a center with a number of tenants leasing small stores that reflect a minor percentage of the rentable floor area. If the provision instead refers to the percentage of the rentable floor area, consideration should be given to whether certain large stores should be excluded. If one large tenant ceases to operate, it might be difficult to satisfy the co-tenancy requirement, even though the rest of the tenants continue to operate. On the other hand, such an exclusion would prove to be detrimental to the landlord if the large tenant continues to operate.

If a co-tenancy requirement is satisfied only by operation of both a percentage of stores (or rentable floor area) and one or more specific tenants, the landlord should consider whether the specific tenants (typically larger stores) should be included or excluded in determining whether the percentage test has been satisfied. Moreover, in mixed-use projects, should non-retail uses, such as office and residential, be included and, if so, how should their floor area be measured for purposes of satisfying percentage tests?

Specific Co-Tenants: When the benefited tenant insists on a big box or department store co-tenancy requirement, the hardship of such a requirement may be limited by referring to the occupancy of the applicable building or a retailer in excess of a minimum size, as distinguished from a named occupant. In multiple big box or department store co-tenancy situations, the impact can be diminished by providing for alternate ways to satisfy the co-tenancy requirement, such as including only some of the big boxes or department stores (say, three out of the four located in the center) within the co-tenancy requirement and requiring that only two of those three continue to operate. The benefited tenant may insist on proximity requirements.

When a specific set of co-tenants is required, it is important to create some flexibility by permitting the specified co-tenants to: 1) change names, such as in connection with a merger or sale of substantially all of such co-tenant's assets, and 2) be replaced by suitable replacement co-tenants. If a tenant is included in a co-tenancy requirement of another tenant, it is important to negotiate a recapture right upon cessation of operation after any required operating period so that the tenant can be replaced. The definition of a suitable replacement co-tenant should be as broad as possible and could include an exhibit with a list of specific
suitable replacement co-tenants. Preferably, the list should be representative rather than exhaustive, with a basket category that contains either objective criteria or a reference to the list for comparison purposes. If the benefited tenant's consent is required for a replacement co-tenant, it should not be unreasonably withheld. The concept of permitting replacement co-tenants to be located elsewhere in the center, perhaps with the benefited tenant's reasonable consent, should be broached. It is important to be creative, since it is difficult to determine in advance the mix of tenants that will be attainable for the center at any time in the future.

Limit the Duration

Another way to limit the impact of a co-tenancy requirement is to reduce its duration. It is preferable (though often not achievable) to limit the co-tenancy requirement to an opening co-tenancy or, if an ongoing co-tenancy is required, to provide that it terminates when the center stabilizes. This approach may be used to entice a benefited tenant to enter into a lease at a newly developed or redeveloped center. The co-tenancy requirement should terminate if the benefited tenant has permanently closed for business or fails to operate under a specified name or for a specified use or in a specified portion of the store. It should also terminate in the event of at least some types of assignment and subletting transactions. The co-tenancy requirement is often for the term of the lease, including options, but there is no reason it cannot be limited to a specified period.

Narrowly Define Violations

The co-tenancy provision should be drafted to limit or delay when a co-tenancy requirement will be deemed to have been violated.

For an opening co-tenancy requirement, the landlord should insist on additional cure periods and lower percentage thresholds before draconian remedies kick in because the landlord may need some time to lease up the center in the case of a new development or redevelopment. For example, the benefited tenant may have the right to delay opening for business and pay a reduced rent but may not have the right to terminate the lease. The relationship between opening and ongoing co-tenancy requirements should also be thought through. The landlord should make sure that there is a grace period and perhaps a worsening of the situation before any ongoing co-tenancy requirement is triggered after violation of an opening co-tenancy requirement so that if the benefited tenant opens for business notwithstanding the violation of an opening co-tenancy requirement, the landlord will not be in immediate violation of the ongoing co-tenancy requirement.

A violation of the co-tenancy requirement should also be tolled while the benefited tenant is in default under its lease. (The benefited tenant may demand that the violation be postponed only after notice and after cure periods lapse and only during a material default.) The violation may be tempered by limiting when a co-tenant is deemed to have failed to operate ' for example, only a closure continuing at least several months, exclusive of closures due to force majeure events, including casualty, and closures attributable to remodeling. It will be easier to negotiate a mutually acceptable definition of a closure if the benefited tenant loses its rights to enforce the co-tenancy requirement in the event of its closure (as suggested above).

Next month's installment will address notice and cure rights and limiting the tenant's remedies.

Sheldon A. Halpern, a member of this newsletter's Editorial Board, is a partner and Xavier Gutierrez is an associate in Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago.