Where's the Door?

Part One of this article described the types of operating covenants. The conclusion herein explains the remedies for violating these covenants.

Remedies for Violations of Express Opening and Operating Covenants

In negotiating a new lease, or analyzing an existing lease, great care must be taken with respect to the effect of, and remedies for, the violation of an express opening or operating covenant. In the worst case for a retailer, such a violation would be deemed to be a default under the lease, with the landlord entitled to all available remedies, including specific performance, in which case the opening or operating covenant may be considered the ultimate “anti-exit” strategy. However, one must question the practical value to the landlord of the ability to force an unwilling tenant to operate, and consider whether both parties would be better served by characterizing the violation of such a covenant in different terms, with different remedies.

What should a landlord do if the tenant agreed in good faith to open, and circumstances change significantly in the time before the triggering conditions are satisfied? All hope is not lost for a mutually agreeable exit if the tenant was careful in negotiating the terms of the covenant. As noted above, landlords will typically insist that a violation of an opening covenant should be a full-blown default, with all remedies available. However, if a tenant is not willing to open and operate its store at the outset of the lease relationship, typical default remedies are of questionable value. Instead, it is more productive to characterize the failure to comply with an opening covenant not as a default, but rather as a violation or failure, which has a specific and exclusive remedy, usually taking the form of liquidated damages or a recapture right, or some combination of the two.

Similarly, both landlord and tenant are better served if they acknowledge, at the outset of the landlord/tenant relationship, that despite their mutual best intentions for a long-term relationship, neither party can predict the future, including the future viability of the center, the particular store, or the tenant itself. Entering into an agreement under which a landlord's remedy for a tenant violation would consist of forcing the tenant to operate its business, many years in the future, in a location which may no longer be profitable does not assure a good result for the landlord. As with opening covenants, the best course may be to characterize a tenant's future violation of an operating covenant not as a default, but as a violation or failure for which the landlord and tenant have negotiated a remedy up front, usually consisting of a recapture right and/or liquidated damages. Depending on how the original transaction was structured, the landlord may be entitled to repayment of unamortized tenant improvement contributions, unamortized building construction costs, free rent, or other financial incentives, or the parties may agree upon an early termination fee. While certain remedies are typical in such situations, the possibilities are seemingly endless, and invite creative practitioners and their clients to craft solutions which will provide the landlord with needed comfort and security and the tenant with needed operational flexibility.

Implied Operating Covenants, and other Factors Affecting Operating Covenant
Considerations

Even if a lease contains no express covenant to open or operate, the tenant may not be home free, able to cease (or never start) operations at its discretion. Careful attention must be given to certain language and certain facts which could support the argument that an implied operating covenant exists under the lease. The likely outcome of a dispute on this topic varies from jurisdiction to jurisdiction, but practitioners must be aware of the possible pitfalls.

The use clause, for example, presents a potential trap. Beware of a use clause in which the operative term is “shall” instead of “may,” e.g., “The Premises shall be used for the operation of ___________.” In addition, beware of provisions stating, in absolute terms, that the tenant will operate its business during certain specified hours and days.

There are other facts to consider:

• Is the tenant's continuing presence in the center a co-tenancy on which other leases are contingent?
• Are any of the landlord's permits or approvals conditioned upon the opening and operating of the particular tenant? If so, did the tenant know these facts when it entered into the lease in question?
• If percentage rent is payable under the lease, consider whether the landlord is truly depending on the tenant's operating business for part of its actual, anticipated rent stream (thereby strengthening an argument of an implied operating covenant), or is realization of percentage rent only a dream in a “home run” situation?

In the absence of an express operating covenant a landlord seeking to require operation, and a tenant seeking to avoid such a requirement, should consider all of these factors.

While it may be an uphill battle for a landlord to establish an implied operating covenant, there is no sense inviting such a fight, even if it may not occur until many years in the future. Accordingly, if no operating covenant is intended, then in negotiating new leases, and in clarifying existing leases for which there may be ambiguity as to any operation requirement, a retail tenant should push to include, in every lease, REA, COREA, OEA, CC&R or other operative document, language which clearly states that the retailer has no obligation to build (if applicable), open or operate.

Exclusive Use Provisions, Generally

Exclusive use provisions also affect tenant exit strategies, and again it is important to consider the underlying reasons for such provisions. Most importantly, and obviously, from the retailer's standpoint, an exclusive is intended to protect its business from competition. Landlords, on the other hand, have a strong interest in retaining flexibility in attracting tenants and occupants to a center, and thus will try to minimize the number and scope of exclusives they will grant, or use exclusives as a market tool to obtain “early” tenants and, once granted, as a negotiating tool to counter the requests of later tenants for exclusives and other restrictions. It should be noted that not all retailers have the same philosophy with respect to exclusives. To a supermarket or a home improvement center, for example, an exclusive is very important, as these retailers do not want a competitor to be located in the same center, or even nearby. Large department stores, however, do not typically object to the presence of other department stores, with some exceptions and limitations. Moreover, some specialty retailers (e.g., clothing stores) thrive when there are competitors nearby, contributing to customer traffic. Exclusives do give rise, however, to legal concerns due to their inherent nature of limiting competition, but those issues are, again, beyond the scope of this article.

Types of Exclusive Use Provisions

Exclusive use provisions come in many forms and flavors. Typically, they grant to the benefited tenant or occupant an exclusive right within the shopping center to sell goods or services in certain categories or of certain specified types (e.g., lumber, or food for off-premises consumption, meats, produce, or prescription drugs), or they grant the exclusive right to operate a particular type of business (e.g., a home improvement warehouse store, a grocery store or supermarket, or a drug store/pharmacy). Very often, exclusives will include carveouts for pre-existing uses, and for incidental sales by other tenants of otherwise-prohibited items, often limited by square footage or linear footage of selling area, or as a percentage of selling area or sales volume.

Sometimes, an exclusive will prohibit specific retailers, although this practice may give rise to the legal concerns noted briefly above. Alternatively, and perhaps more typically in current practice, an exclusive may prohibit a category of operation but then allow operations of a particular type which might, at first glance, be prohibited (e.g., “provided, however, that the foregoing prohibition against the operation of a _____________ [OR the sale of ___________ ] shall not prohibit the operation of a store of the type presently operated by ABC Company”). An exclusive may apply not only to the shopping center in which the benefited premises are located, but also to other property located within a given radius of the center which is owned, operated or controlled by the landlord or its affiliates; it does a tenant little good to obtain an exclusive if its own landlord can install a competitor next door or across the street simply because it is not in the same shopping center.

How Do Exclusive Use Provisions Affect, or Turn Into, Tenant Exit Strategies?

Exclusive use provisions can affect tenant exit strategies in various ways. If the landlord does not agree to grant an exclusive use provision in lease negotiations, the retailer tenant may be able to push for greater exit flexibility, based on the concept that if the landlord will not protect the retailer's business, the retailer should have more freedom to depart if business is not successful. On the other hand, if the landlord does agree to grant the tenant an exclusive, the landlord may then be less amenable to broad flexibility in granting the tenant exit options in lease negotiations. From the tenant's standpoint, however, even the strongest retailer with the “best” exclusive cannot be assured of the continuing viability of its business operations, either generally or in a specific location, over the long term, so viable exit strategies remain an important concern for the retailer.

Even a tenant that does not benefit from an exclusive use provision in its lease may be adversely, sometimes critically, affected by the presence of exclusives and use restrictions that benefit other tenants and occupants. A given lease may be freely assignable on the most favorable terms possible for the tenant, seemingly giving the tenant free rein to transfer its lease to a new operator and move on. Great care, however, must be taken to evaluate how any other exclusives or use restrictions may affect the future use of the premises. The same may be said of provisions that limit, for example, the size or number of spaces into which a tenant's space may be divided in the event of an assignment or subletting of less than the whole premises. In the worst case, such restrictions may severely limit the universe of potential transferees, leaving the tenant with no effective exit route.

Remedies for Landlord's Violation of Exclusive Use Provision

A landlord's violation of an exclusive may occur either directly, when the landlord leases or sells to a prohibited competitor, or indirectly, by the actions of a rogue tenant. Remedies often vary, depending upon whether the violation was the
willful (or at least negligent) act of the landlord, or resulted from the actions of a third party; the remedies will likely be more severe in the former case than in the latter. Remedies are really where exclusives meet tenant exit strategies. Typically, after a notice and cure period, remedies may include rent reduction or abatement for the injured tenant, or limiting the tenant's rental obligation to percentage rent only, both based on the concept of compensating the injured tenant for the loss of business caused by the violation of the exclusive. While these particular remedies do not immediately provide the tenant with an exit, they may at least ameliorate the economic hardship suffered by a tenant with a declining business, and at some point the loss of rental income may prompt the landlord to reconsider either: 1) more vigorous enforcement of the exclusive against the offending party; or 2) a more lenient approach of allowing the injured tenant to exit the scene, to be replaced by a new tenant paying full rent once again.

Remedies may also include, in the case of a third-party violation of an exclusive, the right of the injured tenant either to force the landlord to take legal action against the offending tenant or occupant, or the right to take such action itself, directly. Landlords and tenants alike, however, may not find these remedies the most palatable alternatives.

When other remedies fail, or sometimes from the outset in the case of an egregious violation, the lease may permit an injured tenant to terminate the lease. From the landlord's perspective, this is the tenant's nuclear option, to be avoided if possible. From the tenant's perspective, it is a “necessary” protection to maintain the viability of the tenant's business in the premises, providing the tenant with the ultimate exit strategy. Accordingly, at many points in the life of a lease, including during initial lease negotiations, and when considering an assignment or subletting, tenants and landlords should both carefully review and consider the impact of exclusive use provisions, use restrictions, and other limitations on the ways in which tenant may exit from its lease obligations.

Conclusion

There is, of course, an infinite variety of provisions that may or should be included in a lease, an amendment or a transfer document, and which affect the rights of the landlord and the tenant with respect to tenant exit strategies, depending upon the facts of the particular case. This discussion has addressed several provisions and possibilities, but no such discussion can contemplate all of the scenarios which may potentially arise. The important point is that counsel for the parties must consider carefully the case at hand, and how best to address all applicable facts and circumstances in light of the legitimate needs and concerns of both parties. Finally, it may seem odd to spend so much effort on considering exit strategies, particularly in connection with initial lease negotiations, even in difficult economic times. After all, one may ask, are the parties committed to this relationship or are they not? However, this is not a case of expecting to abandon ship before even leaving port. Rather, it is a matter of planning prudently for unforeseen rough waters that may be found beyond the current horizon, and doing so in a way that will allow the tenant and landlord both to stay afloat.

John H. Lewis is a partner in the Boston office of Seyfarth Shaw LLP.

Part One of this article described the types of operating covenants. The conclusion herein explains the remedies for violating these covenants.

Remedies for Violations of Express Opening and Operating Covenants

In negotiating a new lease, or analyzing an existing lease, great care must be taken with respect to the effect of, and remedies for, the violation of an express opening or operating covenant. In the worst case for a retailer, such a violation would be deemed to be a default under the lease, with the landlord entitled to all available remedies, including specific performance, in which case the opening or operating covenant may be considered the ultimate “anti-exit” strategy. However, one must question the practical value to the landlord of the ability to force an unwilling tenant to operate, and consider whether both parties would be better served by characterizing the violation of such a covenant in different terms, with different remedies.

What should a landlord do if the tenant agreed in good faith to open, and circumstances change significantly in the time before the triggering conditions are satisfied? All hope is not lost for a mutually agreeable exit if the tenant was careful in negotiating the terms of the covenant. As noted above, landlords will typically insist that a violation of an opening covenant should be a full-blown default, with all remedies available. However, if a tenant is not willing to open and operate its store at the outset of the lease relationship, typical default remedies are of questionable value. Instead, it is more productive to characterize the failure to comply with an opening covenant not as a default, but rather as a violation or failure, which has a specific and exclusive remedy, usually taking the form of liquidated damages or a recapture right, or some combination of the two.

Similarly, both landlord and tenant are better served if they acknowledge, at the outset of the landlord/tenant relationship, that despite their mutual best intentions for a long-term relationship, neither party can predict the future, including the future viability of the center, the particular store, or the tenant itself. Entering into an agreement under which a landlord's remedy for a tenant violation would consist of forcing the tenant to operate its business, many years in the future, in a location which may no longer be profitable does not assure a good result for the landlord. As with opening covenants, the best course may be to characterize a tenant's future violation of an operating covenant not as a default, but as a violation or failure for which the landlord and tenant have negotiated a remedy up front, usually consisting of a recapture right and/or liquidated damages. Depending on how the original transaction was structured, the landlord may be entitled to repayment of unamortized tenant improvement contributions, unamortized building construction costs, free rent, or other financial incentives, or the parties may agree upon an early termination fee. While certain remedies are typical in such situations, the possibilities are seemingly endless, and invite creative practitioners and their clients to craft solutions which will provide the landlord with needed comfort and security and the tenant with needed operational flexibility.

Implied Operating Covenants, and other Factors Affecting Operating Covenant
Considerations

Even if a lease contains no express covenant to open or operate, the tenant may not be home free, able to cease (or never start) operations at its discretion. Careful attention must be given to certain language and certain facts which could support the argument that an implied operating covenant exists under the lease. The likely outcome of a dispute on this topic varies from jurisdiction to jurisdiction, but practitioners must be aware of the possible pitfalls.

The use clause, for example, presents a potential trap. Beware of a use clause in which the operative term is “shall” instead of “may,” e.g., “The Premises shall be used for the operation of ___________.” In addition, beware of provisions stating, in absolute terms, that the tenant will operate its business during certain specified hours and days.

There are other facts to consider:

• Is the tenant's continuing presence in the center a co-tenancy on which other leases are contingent?
• Are any of the landlord's permits or approvals conditioned upon the opening and operating of the particular tenant? If so, did the tenant know these facts when it entered into the lease in question?
• If percentage rent is payable under the lease, consider whether the landlord is truly depending on the tenant's operating business for part of its actual, anticipated rent stream (thereby strengthening an argument of an implied operating covenant), or is realization of percentage rent only a dream in a “home run” situation?

In the absence of an express operating covenant a landlord seeking to require operation, and a tenant seeking to avoid such a requirement, should consider all of these factors.

While it may be an uphill battle for a landlord to establish an implied operating covenant, there is no sense inviting such a fight, even if it may not occur until many years in the future. Accordingly, if no operating covenant is intended, then in negotiating new leases, and in clarifying existing leases for which there may be ambiguity as to any operation requirement, a retail tenant should push to include, in every lease, REA, COREA, OEA, CC&R or other operative document, language which clearly states that the retailer has no obligation to build (if applicable), open or operate.

Exclusive Use Provisions, Generally

Exclusive use provisions also affect tenant exit strategies, and again it is important to consider the underlying reasons for such provisions. Most importantly, and obviously, from the retailer's standpoint, an exclusive is intended to protect its business from competition. Landlords, on the other hand, have a strong interest in retaining flexibility in attracting tenants and occupants to a center, and thus will try to minimize the number and scope of exclusives they will grant, or use exclusives as a market tool to obtain “early” tenants and, once granted, as a negotiating tool to counter the requests of later tenants for exclusives and other restrictions. It should be noted that not all retailers have the same philosophy with respect to exclusives. To a supermarket or a home improvement center, for example, an exclusive is very important, as these retailers do not want a competitor to be located in the same center, or even nearby. Large department stores, however, do not typically object to the presence of other department stores, with some exceptions and limitations. Moreover, some specialty retailers (e.g., clothing stores) thrive when there are competitors nearby, contributing to customer traffic. Exclusives do give rise, however, to legal concerns due to their inherent nature of limiting competition, but those issues are, again, beyond the scope of this article.

Types of Exclusive Use Provisions

Exclusive use provisions come in many forms and flavors. Typically, they grant to the benefited tenant or occupant an exclusive right within the shopping center to sell goods or services in certain categories or of certain specified types (e.g., lumber, or food for off-premises consumption, meats, produce, or prescription drugs), or they grant the exclusive right to operate a particular type of business (e.g., a home improvement warehouse store, a grocery store or supermarket, or a drug store/pharmacy). Very often, exclusives will include carveouts for pre-existing uses, and for incidental sales by other tenants of otherwise-prohibited items, often limited by square footage or linear footage of selling area, or as a percentage of selling area or sales volume.

Sometimes, an exclusive will prohibit specific retailers, although this practice may give rise to the legal concerns noted briefly above. Alternatively, and perhaps more typically in current practice, an exclusive may prohibit a category of operation but then allow operations of a particular type which might, at first glance, be prohibited (e.g., “provided, however, that the foregoing prohibition against the operation of a _____________ [OR the sale of ___________ ] shall not prohibit the operation of a store of the type presently operated by ABC Company”). An exclusive may apply not only to the shopping center in which the benefited premises are located, but also to other property located within a given radius of the center which is owned, operated or controlled by the landlord or its affiliates; it does a tenant little good to obtain an exclusive if its own landlord can install a competitor next door or across the street simply because it is not in the same shopping center.

How Do Exclusive Use Provisions Affect, or Turn Into, Tenant Exit Strategies?

Exclusive use provisions can affect tenant exit strategies in various ways. If the landlord does not agree to grant an exclusive use provision in lease negotiations, the retailer tenant may be able to push for greater exit flexibility, based on the concept that if the landlord will not protect the retailer's business, the retailer should have more freedom to depart if business is not successful. On the other hand, if the landlord does agree to grant the tenant an exclusive, the landlord may then be less amenable to broad flexibility in granting the tenant exit options in lease negotiations. From the tenant's standpoint, however, even the strongest retailer with the “best” exclusive cannot be assured of the continuing viability of its business operations, either generally or in a specific location, over the long term, so viable exit strategies remain an important concern for the retailer.

Even a tenant that does not benefit from an exclusive use provision in its lease may be adversely, sometimes critically, affected by the presence of exclusives and use restrictions that benefit other tenants and occupants. A given lease may be freely assignable on the most favorable terms possible for the tenant, seemingly giving the tenant free rein to transfer its lease to a new operator and move on. Great care, however, must be taken to evaluate how any other exclusives or use restrictions may affect the future use of the premises. The same may be said of provisions that limit, for example, the size or number of spaces into which a tenant's space may be divided in the event of an assignment or subletting of less than the whole premises. In the worst case, such restrictions may severely limit the universe of potential transferees, leaving the tenant with no effective exit route.

Remedies for Landlord's Violation of Exclusive Use Provision

A landlord's violation of an exclusive may occur either directly, when the landlord leases or sells to a prohibited competitor, or indirectly, by the actions of a rogue tenant. Remedies often vary, depending upon whether the violation was the
willful (or at least negligent) act of the landlord, or resulted from the actions of a third party; the remedies will likely be more severe in the former case than in the latter. Remedies are really where exclusives meet tenant exit strategies. Typically, after a notice and cure period, remedies may include rent reduction or abatement for the injured tenant, or limiting the tenant's rental obligation to percentage rent only, both based on the concept of compensating the injured tenant for the loss of business caused by the violation of the exclusive. While these particular remedies do not immediately provide the tenant with an exit, they may at least ameliorate the economic hardship suffered by a tenant with a declining business, and at some point the loss of rental income may prompt the landlord to reconsider either: 1) more vigorous enforcement of the exclusive against the offending party; or 2) a more lenient approach of allowing the injured tenant to exit the scene, to be replaced by a new tenant paying full rent once again.

Remedies may also include, in the case of a third-party violation of an exclusive, the right of the injured tenant either to force the landlord to take legal action against the offending tenant or occupant, or the right to take such action itself, directly. Landlords and tenants alike, however, may not find these remedies the most palatable alternatives.

When other remedies fail, or sometimes from the outset in the case of an egregious violation, the lease may permit an injured tenant to terminate the lease. From the landlord's perspective, this is the tenant's nuclear option, to be avoided if possible. From the tenant's perspective, it is a “necessary” protection to maintain the viability of the tenant's business in the premises, providing the tenant with the ultimate exit strategy. Accordingly, at many points in the life of a lease, including during initial lease negotiations, and when considering an assignment or subletting, tenants and landlords should both carefully review and consider the impact of exclusive use provisions, use restrictions, and other limitations on the ways in which tenant may exit from its lease obligations.

Conclusion

There is, of course, an infinite variety of provisions that may or should be included in a lease, an amendment or a transfer document, and which affect the rights of the landlord and the tenant with respect to tenant exit strategies, depending upon the facts of the particular case. This discussion has addressed several provisions and possibilities, but no such discussion can contemplate all of the scenarios which may potentially arise. The important point is that counsel for the parties must consider carefully the case at hand, and how best to address all applicable facts and circumstances in light of the legitimate needs and concerns of both parties. Finally, it may seem odd to spend so much effort on considering exit strategies, particularly in connection with initial lease negotiations, even in difficult economic times. After all, one may ask, are the parties committed to this relationship or are they not? However, this is not a case of expecting to abandon ship before even leaving port. Rather, it is a matter of planning prudently for unforeseen rough waters that may be found beyond the current horizon, and doing so in a way that will allow the tenant and landlord both to stay afloat.

John H. Lewis is a partner in the Boston office of Seyfarth Shaw LLP.