The Co-Tenancy Clause

When purchasing a car from the local dealership, or a new outfit from, say, Ann Taylor, the often-stated legal maxim is caveat emptor, let the buyer beware. After Kleban v. Ann Taylor (USDC Connecticut, CV-01879), when a mall or shopping center landlord is marketing space and offers a potential retail tenant a co-tenancy provision, the most applicable legal maxim is caveat venditor, let the seller beware. Landlords can suffer great unintended consequences from a co-tenancy clause that is negotiated as an accommodation to get a tenant into the space and then explodes years later.

Co-Tenancy Clauses

A typical co-tenancy clause allows a retail tenant to obtain a reduction in rent if: 1) key or anchor tenants vacate or stop operating in the center; or 2) a certain number of the other tenants vacate or stop operating in the center. This gives the retail tenant some reassurance that it will have rent protection if a vacancy at the center reduces the anticipated foot traffic. But the right mix of retailers is just as important as the volume of foot traffic. As a result, smaller retailers may also want a co-tenancy clause that offers some protection with regard to the type of retailers that are in the center. The proper assortment of retailers will ensure that the foot traffic consists of shoppers with the ideal customer profile for the given retailer. It is unlikely, for example, that the retail jeweler Tiffany will open up next to Shop Rite in a shopping center. On the other hand, Tiffany is commonly seen in malls and shopping centers with department stores such as Saks, Bloomingdales and Nordstrom.

Landlords must exhibit caution and restraint when negotiating a co-tenancy clause. The advantage of using a co-tenancy clause to attract a retailer may be financially advantageous at first, but the long-term consequence of an overly generous co-tenancy clause could be financially disastrous. The circumstances in Kleban v. Ann Taylor illustrate one such landlord horror tale.

The Case

The facts in Kleban are fairly straightforward. Kleban is the successor-by-assignment to the landlord that signed a lease in 2000 with Ann Taylor for space in the landlord's shopping center in Fairfield, CT. The lease had an initial term of 10 years with two five-year renewal options. Ann Taylor exercised its renewal option in April 2011, and thus extended the lease through January 2017. The lease also contained a co-tenancy clause, which stated the following:

61. CO-TENANCY. (a) Opening: Landlord agrees that the Delivery Date will not occur until Landlord notifies Tenant that eighty percent (80%) of the retail area of the Center is under construction and that Borders, Inc., Banana Republic and Victoria's Secret have executed leases on or before March 1, 2001. If Landlord is unable to enter into such leases by March 1, 2001, Tenant shall have the right to terminate this Lease and Landlord shall reimburse Tenant for its reasonable out-of-pocket legal and architectural expenses. Notwithstanding the foregoing, Landlord may replace Victoria's Secret or Banana Republic with a suitable replacement Tenant.

(b) Operating: In the event Borders, Inc. or fifty percent (50%) of the other retail space in the Center, excluding Tenant, are not open and operating, Tenant shall be entitled to abate Minimum Annual Rent and in lieu thereof pay five percent (5%) of Gross Sales, not to exceed the Minimum Annual Rent otherwise payable in the absence of this paragraph, until the tenants meeting the foregoing requirements are again open and operating.

Within thirty (30) days after the end of each calendar month that this Paragraph 61(b) shall be applicable, Tenant shall provide Landlord a statement showing the Gross Sales for such month and shall pay the amount due as percentage rent for such month ' .

Borders signed a lease for space in the center on April 11, 2000. However, on May 16, 2011, Borders closed its store in the center as a result of its bankruptcy filing. The Borders store never reopened. Kleban replaced the Borders store with Book Warehouse from May through September 2011, and then with Fairfield University Bookstore, which continues to operate in the former Borders space.

In July 2011, Ann Taylor started paying abated rent in an amount equal to 5% of its gross sales, pursuant to the co-tenancy clause instead of the minimum annual rent of $170,000 reserved in the lease. Over the five-year extension period, this represents a rental difference in excess of $800,000.

Kleban commenced an action against Ann Taylor, alleging three causes of action: 1) breach of lease for failure to pay the minimum rent reserved under the lease; 2) anticipating breach of lease based on Ann Taylor's intention to pay reduced rent under the co-tenancy clause for the balance of the term; and 3) unjust enrichment. Both Ann Taylor and Kleban moved for summary judgment. The district court found in favor of Ann Taylor and granted summary judgment dismissing Kleban's complaint based on a plain reading of the co-tenancy clause language and found Kleban's arguments without merit.

The Court's Reasoning

The court focused its attention on the fact that the co-tenancy clause specifically named Borders, not any other bookstore, as a necessary tenant. The co-tenancy clause states:

(a) Opening: Landlord agrees that the Delivery Date will not occur until Landlord notifies Tenant that ' Borders, Inc., Banana Republic and Victoria's Secret have executed leases on or before March 1, 2001 ' Notwithstanding the foregoing, Landlord may replace Victoria's Secret or Banana Republic with a suitable replacement Tenant [emphasis added].

It is clear that Ann Taylor insisted that Borders had to be a tenant in the center. There is no mention of the landlord having the right to replace Borders with a suitable replacement.

Similarly, in the operating portion of the co-tenancy clause, there is no right to replace Borders if it vacates. See, (b) above. Borders is specifically named as a necessary tenant. If Borders is not open and operating, then Ann Taylor is entitled to abate its rent and pay reduced rent equivalent to 5% of its gross sales.

The court easily disposed of Kleban's arguments, the best of which was that “Borders” could be replaced with a suitable like-kind tenant notwithstanding the specific language in the co-tenancy clause.

Crafting the Lease

The Kleban case demonstrates the tensions between landlords and tenants crafting a lease that accurately reflects their respective short- and long-term competing interests. Ann Taylor was insistent on having the center 80% leased and Borders as its anchor tenant. Victoria's Secret and Banana Republic were desirable, but could be replaced by suitable like-kind retailers.

The case illustrates the dilemma in negotiating a co-tenancy clause that offers sufficient protection to the landlord and yet is acceptable to a tenant like Ann Taylor. This is especially difficult in a new center. Landlords of new shopping centers, understandably, want such centers fully leased as quickly as possible with as many credit tenants as possible. As a result, such landlords are more willing to make concessions, especially ones that may not have an impact until sometime in the future. In 2000, the risk that Borders would fail was perceived as minimal. In hindsight, this was clearly a mistake. The co-tenancy clause should have allowed Kleban to replace Borders with a suitable tenant within a reasonable period of time before Ann Taylor was to receive any rent reductions.

Lessons for Landlords

Bankruptcy, however, is not the only risk to a landlord when offering a co-tenancy clause. A key or anchor tenant may fail to extend or renew its lease. The landlord, of course, should confirm that the duration of the co-tenancy clause will not outlast the term of the anchor tenant's lease, but the co-tenancy clause must address other possibilities, such as the risk that the key or anchor tenant may vacate the center before the expiration of the term. The co-tenancy clause must therefore allow the landlord to replace the key or anchor tenant with a suitable new tenant. Also, while negotiating to allow a replacement for Borders, the landlord might have considered suggesting a replacement by any national or regional tenant that occupies at least 80% of the original space that was compatible with the other uses in the shopping center (instead of limiting itself to another similar use, which is often asserted as the tenant's first position), and might have further negotiated to have Borders replaced with up to three other tenants which collectively occupy the 80% requirement (or such other negotiated percentage).

Permitting a replacement in a co-tenancy clause, however, is not a landlord's only protection. In Kleban, the landlord could have also instituted a floor to the rent reduction that was less onerous on the landlord than 5% of gross sales. Such a floor could have been a fair market rent calculation or other calculation put in place to limit the rent reduction. Furthermore, the rent reduction could have had a limited time span and not have been for the balance of the lease term inclusive of extension periods. At the expiration of such period, a tenant could be given the right to either restore rent or terminate the lease. This too comes with material considerations for both parties. One can assume that this case was driven by the landlord's desire to quickly lease up a new center while not fully appreciating or anticipating the possibility that Borders, its anchor tenant ' which at the time was a New York Stock Exchange listed company ' might actually go out of business within a decade.

As we have seen, no financial institution, retailer, or other entity is too big to fail. Therefore, most co-tenancy clauses today should anticipate the worst by affording landlords the opportunity to replace anchor or key tenants with suitable replacement tenants within a reasonable period of time and limit the reduction of a tenant's rent obligation while the tenant is operating.

Conclusion

In order to achieve a successful balance between landlords' and tenants' competing short- and long-term interests, both parties must endeavor to enter into a lease that provides enough flexibility and fairness to handle the various scenarios that could arise over the course of the lease term.

Seth A. Fersko is an associate in the Real Estate practice in the New York office of Paul Hastings LLP. He can be reached at 212-318-6224 or [email protected].

When purchasing a car from the local dealership, or a new outfit from, say, Ann Taylor, the often-stated legal maxim is caveat emptor, let the buyer beware. After Kleban v. Ann Taylor (USDC Connecticut, CV-01879), when a mall or shopping center landlord is marketing space and offers a potential retail tenant a co-tenancy provision, the most applicable legal maxim is caveat venditor, let the seller beware. Landlords can suffer great unintended consequences from a co-tenancy clause that is negotiated as an accommodation to get a tenant into the space and then explodes years later.

Co-Tenancy Clauses

A typical co-tenancy clause allows a retail tenant to obtain a reduction in rent if: 1) key or anchor tenants vacate or stop operating in the center; or 2) a certain number of the other tenants vacate or stop operating in the center. This gives the retail tenant some reassurance that it will have rent protection if a vacancy at the center reduces the anticipated foot traffic. But the right mix of retailers is just as important as the volume of foot traffic. As a result, smaller retailers may also want a co-tenancy clause that offers some protection with regard to the type of retailers that are in the center. The proper assortment of retailers will ensure that the foot traffic consists of shoppers with the ideal customer profile for the given retailer. It is unlikely, for example, that the retail jeweler Tiffany will open up next to Shop Rite in a shopping center. On the other hand, Tiffany is commonly seen in malls and shopping centers with department stores such as Saks, Bloomingdales and Nordstrom.

Landlords must exhibit caution and restraint when negotiating a co-tenancy clause. The advantage of using a co-tenancy clause to attract a retailer may be financially advantageous at first, but the long-term consequence of an overly generous co-tenancy clause could be financially disastrous. The circumstances in Kleban v. Ann Taylor illustrate one such landlord horror tale.

The Case

The facts in Kleban are fairly straightforward. Kleban is the successor-by-assignment to the landlord that signed a lease in 2000 with Ann Taylor for space in the landlord's shopping center in Fairfield, CT. The lease had an initial term of 10 years with two five-year renewal options. Ann Taylor exercised its renewal option in April 2011, and thus extended the lease through January 2017. The lease also contained a co-tenancy clause, which stated the following:

61. CO-TENANCY. (a) Opening: Landlord agrees that the Delivery Date will not occur until Landlord notifies Tenant that eighty percent (80%) of the retail area of the Center is under construction and that Borders, Inc., Banana Republic and Victoria's Secret have executed leases on or before March 1, 2001. If Landlord is unable to enter into such leases by March 1, 2001, Tenant shall have the right to terminate this Lease and Landlord shall reimburse Tenant for its reasonable out-of-pocket legal and architectural expenses. Notwithstanding the foregoing, Landlord may replace Victoria's Secret or Banana Republic with a suitable replacement Tenant.

(b) Operating: In the event Borders, Inc. or fifty percent (50%) of the other retail space in the Center, excluding Tenant, are not open and operating, Tenant shall be entitled to abate Minimum Annual Rent and in lieu thereof pay five percent (5%) of Gross Sales, not to exceed the Minimum Annual Rent otherwise payable in the absence of this paragraph, until the tenants meeting the foregoing requirements are again open and operating.

Within thirty (30) days after the end of each calendar month that this Paragraph 61(b) shall be applicable, Tenant shall provide Landlord a statement showing the Gross Sales for such month and shall pay the amount due as percentage rent for such month ' .

Borders signed a lease for space in the center on April 11, 2000. However, on May 16, 2011, Borders closed its store in the center as a result of its bankruptcy filing. The Borders store never reopened. Kleban replaced the Borders store with Book Warehouse from May through September 2011, and then with Fairfield University Bookstore, which continues to operate in the former Borders space.

In July 2011, Ann Taylor started paying abated rent in an amount equal to 5% of its gross sales, pursuant to the co-tenancy clause instead of the minimum annual rent of $170,000 reserved in the lease. Over the five-year extension period, this represents a rental difference in excess of $800,000.

Kleban commenced an action against Ann Taylor, alleging three causes of action: 1) breach of lease for failure to pay the minimum rent reserved under the lease; 2) anticipating breach of lease based on Ann Taylor's intention to pay reduced rent under the co-tenancy clause for the balance of the term; and 3) unjust enrichment. Both Ann Taylor and Kleban moved for summary judgment. The district court found in favor of Ann Taylor and granted summary judgment dismissing Kleban's complaint based on a plain reading of the co-tenancy clause language and found Kleban's arguments without merit.

The Court's Reasoning

The court focused its attention on the fact that the co-tenancy clause specifically named Borders, not any other bookstore, as a necessary tenant. The co-tenancy clause states:

(a) Opening: Landlord agrees that the Delivery Date will not occur until Landlord notifies Tenant that ' Borders, Inc., Banana Republic and Victoria's Secret have executed leases on or before March 1, 2001 ' Notwithstanding the foregoing, Landlord may replace Victoria's Secret or Banana Republic with a suitable replacement Tenant [emphasis added].

It is clear that Ann Taylor insisted that Borders had to be a tenant in the center. There is no mention of the landlord having the right to replace Borders with a suitable replacement.

Similarly, in the operating portion of the co-tenancy clause, there is no right to replace Borders if it vacates. See, (b) above. Borders is specifically named as a necessary tenant. If Borders is not open and operating, then Ann Taylor is entitled to abate its rent and pay reduced rent equivalent to 5% of its gross sales.

The court easily disposed of Kleban's arguments, the best of which was that “Borders” could be replaced with a suitable like-kind tenant notwithstanding the specific language in the co-tenancy clause.

Crafting the Lease

The Kleban case demonstrates the tensions between landlords and tenants crafting a lease that accurately reflects their respective short- and long-term competing interests. Ann Taylor was insistent on having the center 80% leased and Borders as its anchor tenant. Victoria's Secret and Banana Republic were desirable, but could be replaced by suitable like-kind retailers.

The case illustrates the dilemma in negotiating a co-tenancy clause that offers sufficient protection to the landlord and yet is acceptable to a tenant like Ann Taylor. This is especially difficult in a new center. Landlords of new shopping centers, understandably, want such centers fully leased as quickly as possible with as many credit tenants as possible. As a result, such landlords are more willing to make concessions, especially ones that may not have an impact until sometime in the future. In 2000, the risk that Borders would fail was perceived as minimal. In hindsight, this was clearly a mistake. The co-tenancy clause should have allowed Kleban to replace Borders with a suitable tenant within a reasonable period of time before Ann Taylor was to receive any rent reductions.

Lessons for Landlords

Bankruptcy, however, is not the only risk to a landlord when offering a co-tenancy clause. A key or anchor tenant may fail to extend or renew its lease. The landlord, of course, should confirm that the duration of the co-tenancy clause will not outlast the term of the anchor tenant's lease, but the co-tenancy clause must address other possibilities, such as the risk that the key or anchor tenant may vacate the center before the expiration of the term. The co-tenancy clause must therefore allow the landlord to replace the key or anchor tenant with a suitable new tenant. Also, while negotiating to allow a replacement for Borders, the landlord might have considered suggesting a replacement by any national or regional tenant that occupies at least 80% of the original space that was compatible with the other uses in the shopping center (instead of limiting itself to another similar use, which is often asserted as the tenant's first position), and might have further negotiated to have Borders replaced with up to three other tenants which collectively occupy the 80% requirement (or such other negotiated percentage).

Permitting a replacement in a co-tenancy clause, however, is not a landlord's only protection. In Kleban, the landlord could have also instituted a floor to the rent reduction that was less onerous on the landlord than 5% of gross sales. Such a floor could have been a fair market rent calculation or other calculation put in place to limit the rent reduction. Furthermore, the rent reduction could have had a limited time span and not have been for the balance of the lease term inclusive of extension periods. At the expiration of such period, a tenant could be given the right to either restore rent or terminate the lease. This too comes with material considerations for both parties. One can assume that this case was driven by the landlord's desire to quickly lease up a new center while not fully appreciating or anticipating the possibility that Borders, its anchor tenant ' which at the time was a New York Stock Exchange listed company ' might actually go out of business within a decade.

As we have seen, no financial institution, retailer, or other entity is too big to fail. Therefore, most co-tenancy clauses today should anticipate the worst by affording landlords the opportunity to replace anchor or key tenants with suitable replacement tenants within a reasonable period of time and limit the reduction of a tenant's rent obligation while the tenant is operating.

Conclusion

In order to achieve a successful balance between landlords' and tenants' competing short- and long-term interests, both parties must endeavor to enter into a lease that provides enough flexibility and fairness to handle the various scenarios that could arise over the course of the lease term.

Seth A. Fersko is an associate in the Real Estate practice in the New York office of Paul Hastings LLP. He can be reached at 212-318-6224 or [email protected].