Will That Restriction Hold Up?

For both commercial tenants and landlords, use restrictions are a valuable asset. For the tenant, use restrictions are critical to protecting the value of its business by preventing another tenant from competing for customers in the same shopping center by selling the same or similar goods and services. For the landlord, use restrictions enable the owner to implement its strategy to produce the “tenant mix” it believes will maximize customer traffic and sales, thereby enhancing the value of the property. Given their critical nature to both parties, use clauses, exclusives and prohibited uses are among the most heavily negotiated provisions of any retail lease. As a result, the final draft may contain a number of compromises and vagaries that are understood only by the original parties involved. Moreover, use restrictions are unique due to the frequency with which they are reviewed and referred to during the day-to-day operations of a shopping center, long after the lease has been signed. Use restrictions are a constant topic of conversation among retailers, leasing and management personnel and their attorneys: whether a proposed new tenant is going to create controversy due to restrictions in existing leases, whether to seek or grant a waiver letter to allow a use that would otherwise be prohibited, and so on.

Most disputes over use restrictions are resolved amicably before litigation. However, it is important to understand the legal framework within which the matters would be litigated in court rather than to rely on intuition, even intuition that may have been informed by years of experience in the industry. This article summarizes the most important factors affecting the enforceability of use restrictions, both from a landlord and a tenant perspective.

General Principles of Use Restrictions in Leases

Use restrictions are provisions that either prohibit a certain use (e.g., tenant shall not sell hamburgers on the premises), require a certain use (e.g., tenant shall operate a department store), or provide exclusive use to the tenant for a particular purpose (e.g., tenant has the exclusive right to operate an electronics store at the shopping center). Radius restrictions expand the geographical reach of a use restriction by prohibiting a use on land that is not adjacent to the benefited party's property, but is within a specified distance from it. They either restrict where a tenant may open other stores (e.g., tenant shall not open another location or an affiliate within a five-mile radius of the shopping center) or, in what is commonly referred to as a “reverse radius restriction,” prohibit the landlord from leasing geographically distant parcels to another tenant that would then be in competition with an existing tenant (e.g., landlord shall not use or lease any of its property, now owned or later acquired, to a pharmacy within a five-mile radius of tenant's premises).

How Are Use Restrictions Challenged?

Generally, use restrictions and radius restrictions in commercial leases are enforceable. Such restrictions are not favored in the law, however, and will be strictly construed and interpreted because the law favors the free alienability of property and disfavors restraints on trade. (Strict construction appears to be the majority rule. Check the authorities in your state, however, to determine if this strict standard of review has been abrogated by statute or case law.)

Courts that have reviewed challenges to use restrictions have taken one of several routes, or a combination thereof: 1) review the restriction as a restrictive covenant that “runs with the land” and thus applies and is enforceable against successors-in-interest; 2) review the restriction on strict contract-law terms; and/or 3) review the restriction under principles akin to antitrust and the law of unfair competition.

State law is relatively uniform on the prerequisites for a covenant “running with the land.” (However, there may still be some nuances in each state. Conduct appropriate research to determine the rules applicable in your jurisdiction.) Generally speaking, to be enforceable as a covenant running with the land the prerequisites are:

• The restriction must touch and concern the land.
• There must be privity of estate between the party enforcing the restriction and the party against whom the restriction is to be enforced.
• The intent of the original covenanting parties must be that the restriction would run with the land and bind successors.
• There must be notice to successors.

The significance of a covenant running with the land is that it will be enforceable against successors-in-interest, rather than limited to just the original parties to a lease or deed. To satisfy the “touch and concern” element, the covenant must have an economic impact on the two properties to be affected by the covenant ' i.e., one parcel will benefit economically from the use restriction and the other will be burdened by it.

“Privity of estate” exists where there is a sufficient legal relationship between two individuals or entities, which allows one party to enforce legal rights against another concerning the other's land. There must be privity between the original covenanting parties, meaning that an interest in land (e.g., a leasehold interest) was conveyed from one to the other in connection with the covenant. This is often referred to as “horizontal privity.”

There is horizontal privity between a landlord and a tenant by reason of the leasehold interest that is conveyed in the lease. By contrast, there is no horizontal privity when a homeowner makes an agreement with his neighbor that he will not raise chickens in his backyard because no interest in land was conveyed in connection with the restriction. Where either the benefited or burdened land has been sold, or a lease has been assigned, there must also be a conveyance of an interest in land from each of the original covenanting parties to their successors-in-interest. This latter form of privity is called “vertical privity.” Without vertical privity, the restriction cannot be enforced by or against a subsequent owner, lessor or lessee. A minority of jurisdictions hold that vertical privity will suffice and that there is no need to show horizontal privity.

The requirement of “notice” for a restriction running with the land does not mean actual notice, though actual notice would generally satisfy this requirement ' except in pure race states such as North Carolina that require a recorded instrument to effectuate notice. Recording a memorandum of lease serves as constructive notice of the use restrictions described therein, and is sufficient to bind successors. Note that the affected land must be sufficiently described in the recorded memorandum. For example, if an outparcel tenant intends for its exclusive to apply to the main shopping center, a memorandum containing only a legal description of the leased outparcel may be insufficient to bind a shopping center that constitutes a separate parcel of land.

Radius restrictions particularly are subject to challenges that they unreasonably restrict competition. The overarching question in such challenges is whether the restriction is reasonably necessary to protect the landlord or tenant's legitimate business interest, much like a non-competition agreement in the employment context. Courts may examine the geographic scope and duration of the restriction in reaching a conclusion, though there may be additional or different factors relevant to your jurisdiction. Factors that have led to rulings that a radius restriction was unenforceable include an overly broad radius; the inclusion of towns distantly located from the shopping center where the landlord owned no property; and, in the case of a reverse radius restriction, a finding that the restriction applied only to the original landlord and not a subsequent purchaser of the shopping center.

Drafting and Counseling Tips

Landlords and tenants are advised to focus carefully on the use and radius restriction in their leases and to ensure that those provisions are as clear and precise as possible, that they apply to successors-in-interest, and that they bear a reasonable relation to the business interest sought to be protected. Careful, thoughtful drafting at the outset may avoid costly litigation (or the threat of it) over “gray areas” down the road.

Ideally, use restrictions should specifically state that the parties to the lease intend the restrictions to “run with the land.” They should expressly state that the restriction is a covenant that to which both parties intend to bind their respective heirs, successors and assigns. Be sure to state clearly the economic benefit and burden of the restriction/covenant, and recite that it “touches and concerns the land.” Drafting the restriction carefully to run with the land is important: If the owner transfers title to other properties within the shopping center to new owners a week after executing your lease, your exclusivity clause may not be worth the paper it is written on absent an express assumption of the lease by the subsequent owner. As a practical matter, consider a requirement that subsequent leases, subleases and/or amendments specifically incorporate any use restrictions. Including the existing restrictions in each subsequent lease document should aid landlords in their enforcement of use restrictions against future violators, though this is not necessarily required for enforcement by the tenant benefitting from the original restriction against the landlord.

From a contract-law perspective, give careful thought to how you define what uses are prohibited on the premises and what is prohibited within the shopping center. For example, if it is prohibited for the landlord to lease space to another bank, is a grocery store with a bank teller window inside also prohibited? Or, does a restriction against another drug store in the shopping center prohibit a grocery superstore from having a full-time pharmacist? Keep in mind that courts will interpret these provisions in a manner that favors full and free use of property, and will construe ambiguous language against whomever drafted the lease. Avoid ambiguity in a use restriction by describing the activity or goods that are restricted rather than solely mentioning a type of business. Prohibiting “the sale of prescription drugs dispensed by a licensed pharmacist” will lead to less confusion than prohibiting “a drug store.” Also, consider carefully whether the passage of time could render the terms in the restriction outdated and unenforceable, or overly broad, given the evolving nature of the manner in which goods and services are delivered. For example, would a use restriction drafted in 1950 regarding “drive-in” restaurants prohibit a fast-food restaurant with “drive-thru” service today? An agreement to restrict “massage parlors” in the 1970s could prohibit a day spa offering massage services in the present day.

While it is impossible to predict how society and technology will change, there should be a balance between specificity of what is prohibited and flexibility that the language can withstand the test of time. In this age of superstores, it is common for anchor tenants to expect that existing exclusives should not apply to their operations. Landlords can help themselves in future anchor negotiations by including a carve-out in their use restrictions that is applicable to anchor tenants, which are typically defined as retailers of more than a minimum leasable floor area (e.g., 50,000 square feet). It is also important to exclude existing tenants from being bound by use restrictions contained in leases with new tenants because by then the landlord has lost the ability to impose additional limitations on existing tenants without their consent.

Reflect on the business interest you are seeking to protect, depending on your role as either a tenant or landlord. As a landlord, would you be harmed (i.e., reduction in percentage rent) if the tenant opened another location two miles away? Five miles? Ten miles? Would you be harmed if the tenant ceased operating a shoe store and began operating a bookstore? What if your tenant instead began operating an adult bookstore? As a tenant, how much would your sales decline if another tenant moved into the shopping center and offered a product that comprises 5%, 10% or 30% of your revenue? What new goods or services might you like to offer in the future? Will it be necessary to protect the tenant from competition from its landlord with a radius restriction and, if so, what should be the radius? Answers to questions like these will inform the reasonableness of a use restriction and/or radius restriction and avoid the risk that an aggressive restriction might be challenged or declared to be an unlawful restraint on trade.

The hard work necessary to enforce a matrix of use restrictions does not end after the lease is signed. The restrictions must be organized and reviewed on a regular basis. Whether landlord or tenant, keeping an eye on what goods and services other tenants are actually offering will be necessary to preserve legal rights to enforce use restrictions. When your landlord client is leasing space to a new tenant, it is important to investigate and understand the prospective tenant's goods, services, and intended current and future use of the property.

Could even a minor part of the new tenant's business be within the ambit of a use restriction already in place that benefits an existing tenant? If your client is a prospective tenant, it will have its own concerns about existing tenants and use restrictions already in place that benefit them. A prospective tenant that induces a landlord to allow a competing use, which is prohibited by an existing tenant's lease, could become liable for tortious interference with contract and be subjected to punitive damages. To avoid such risk, the prospective tenant should not sign a lease unless the landlord first obtains a waiver from the existing tenant. Or, if a waiver is not granted and the circumstances warrant a legal challenge to the validity of the restriction, obtain a declaratory judgment that the restriction is invalid.

Conclusion

Whether landlord or tenant, it is critical to focus carefully on the use and radius restrictions in a proposed lease and draft accordingly to ensure their enforceability. Time and effort expended on the front end of negotiations, with careful drafting of use and radius restrictions, will return dividends down the road and avoid the prospect of threatened or actual litigation that challenges those provisions.

Peter J. Marino is a Partner at Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan, L.L.P. in Raleigh, NC. He chairs the firm's Construction and Real Estate Development practice group. Scott A. Miskimon is a Partner at the firm, and chairs the firm's Real Estate Litigation group. Lauren H. Bradley is an Associate, focusing her practice on commercial litigation.

For both commercial tenants and landlords, use restrictions are a valuable asset. For the tenant, use restrictions are critical to protecting the value of its business by preventing another tenant from competing for customers in the same shopping center by selling the same or similar goods and services. For the landlord, use restrictions enable the owner to implement its strategy to produce the “tenant mix” it believes will maximize customer traffic and sales, thereby enhancing the value of the property. Given their critical nature to both parties, use clauses, exclusives and prohibited uses are among the most heavily negotiated provisions of any retail lease. As a result, the final draft may contain a number of compromises and vagaries that are understood only by the original parties involved. Moreover, use restrictions are unique due to the frequency with which they are reviewed and referred to during the day-to-day operations of a shopping center, long after the lease has been signed. Use restrictions are a constant topic of conversation among retailers, leasing and management personnel and their attorneys: whether a proposed new tenant is going to create controversy due to restrictions in existing leases, whether to seek or grant a waiver letter to allow a use that would otherwise be prohibited, and so on.

Most disputes over use restrictions are resolved amicably before litigation. However, it is important to understand the legal framework within which the matters would be litigated in court rather than to rely on intuition, even intuition that may have been informed by years of experience in the industry. This article summarizes the most important factors affecting the enforceability of use restrictions, both from a landlord and a tenant perspective.

General Principles of Use Restrictions in Leases

Use restrictions are provisions that either prohibit a certain use (e.g., tenant shall not sell hamburgers on the premises), require a certain use (e.g., tenant shall operate a department store), or provide exclusive use to the tenant for a particular purpose (e.g., tenant has the exclusive right to operate an electronics store at the shopping center). Radius restrictions expand the geographical reach of a use restriction by prohibiting a use on land that is not adjacent to the benefited party's property, but is within a specified distance from it. They either restrict where a tenant may open other stores (e.g., tenant shall not open another location or an affiliate within a five-mile radius of the shopping center) or, in what is commonly referred to as a “reverse radius restriction,” prohibit the landlord from leasing geographically distant parcels to another tenant that would then be in competition with an existing tenant (e.g., landlord shall not use or lease any of its property, now owned or later acquired, to a pharmacy within a five-mile radius of tenant's premises).

How Are Use Restrictions Challenged?

Generally, use restrictions and radius restrictions in commercial leases are enforceable. Such restrictions are not favored in the law, however, and will be strictly construed and interpreted because the law favors the free alienability of property and disfavors restraints on trade. (Strict construction appears to be the majority rule. Check the authorities in your state, however, to determine if this strict standard of review has been abrogated by statute or case law.)

Courts that have reviewed challenges to use restrictions have taken one of several routes, or a combination thereof: 1) review the restriction as a restrictive covenant that “runs with the land” and thus applies and is enforceable against successors-in-interest; 2) review the restriction on strict contract-law terms; and/or 3) review the restriction under principles akin to antitrust and the law of unfair competition.

State law is relatively uniform on the prerequisites for a covenant “running with the land.” (However, there may still be some nuances in each state. Conduct appropriate research to determine the rules applicable in your jurisdiction.) Generally speaking, to be enforceable as a covenant running with the land the prerequisites are:

• The restriction must touch and concern the land.
• There must be privity of estate between the party enforcing the restriction and the party against whom the restriction is to be enforced.
• The intent of the original covenanting parties must be that the restriction would run with the land and bind successors.
• There must be notice to successors.

The significance of a covenant running with the land is that it will be enforceable against successors-in-interest, rather than limited to just the original parties to a lease or deed. To satisfy the “touch and concern” element, the covenant must have an economic impact on the two properties to be affected by the covenant ' i.e., one parcel will benefit economically from the use restriction and the other will be burdened by it.

“Privity of estate” exists where there is a sufficient legal relationship between two individuals or entities, which allows one party to enforce legal rights against another concerning the other's land. There must be privity between the original covenanting parties, meaning that an interest in land (e.g., a leasehold interest) was conveyed from one to the other in connection with the covenant. This is often referred to as “horizontal privity.”

There is horizontal privity between a landlord and a tenant by reason of the leasehold interest that is conveyed in the lease. By contrast, there is no horizontal privity when a homeowner makes an agreement with his neighbor that he will not raise chickens in his backyard because no interest in land was conveyed in connection with the restriction. Where either the benefited or burdened land has been sold, or a lease has been assigned, there must also be a conveyance of an interest in land from each of the original covenanting parties to their successors-in-interest. This latter form of privity is called “vertical privity.” Without vertical privity, the restriction cannot be enforced by or against a subsequent owner, lessor or lessee. A minority of jurisdictions hold that vertical privity will suffice and that there is no need to show horizontal privity.

The requirement of “notice” for a restriction running with the land does not mean actual notice, though actual notice would generally satisfy this requirement ' except in pure race states such as North Carolina that require a recorded instrument to effectuate notice. Recording a memorandum of lease serves as constructive notice of the use restrictions described therein, and is sufficient to bind successors. Note that the affected land must be sufficiently described in the recorded memorandum. For example, if an outparcel tenant intends for its exclusive to apply to the main shopping center, a memorandum containing only a legal description of the leased outparcel may be insufficient to bind a shopping center that constitutes a separate parcel of land.

Radius restrictions particularly are subject to challenges that they unreasonably restrict competition. The overarching question in such challenges is whether the restriction is reasonably necessary to protect the landlord or tenant's legitimate business interest, much like a non-competition agreement in the employment context. Courts may examine the geographic scope and duration of the restriction in reaching a conclusion, though there may be additional or different factors relevant to your jurisdiction. Factors that have led to rulings that a radius restriction was unenforceable include an overly broad radius; the inclusion of towns distantly located from the shopping center where the landlord owned no property; and, in the case of a reverse radius restriction, a finding that the restriction applied only to the original landlord and not a subsequent purchaser of the shopping center.

Drafting and Counseling Tips

Landlords and tenants are advised to focus carefully on the use and radius restriction in their leases and to ensure that those provisions are as clear and precise as possible, that they apply to successors-in-interest, and that they bear a reasonable relation to the business interest sought to be protected. Careful, thoughtful drafting at the outset may avoid costly litigation (or the threat of it) over “gray areas” down the road.

Ideally, use restrictions should specifically state that the parties to the lease intend the restrictions to “run with the land.” They should expressly state that the restriction is a covenant that to which both parties intend to bind their respective heirs, successors and assigns. Be sure to state clearly the economic benefit and burden of the restriction/covenant, and recite that it “touches and concerns the land.” Drafting the restriction carefully to run with the land is important: If the owner transfers title to other properties within the shopping center to new owners a week after executing your lease, your exclusivity clause may not be worth the paper it is written on absent an express assumption of the lease by the subsequent owner. As a practical matter, consider a requirement that subsequent leases, subleases and/or amendments specifically incorporate any use restrictions. Including the existing restrictions in each subsequent lease document should aid landlords in their enforcement of use restrictions against future violators, though this is not necessarily required for enforcement by the tenant benefitting from the original restriction against the landlord.

From a contract-law perspective, give careful thought to how you define what uses are prohibited on the premises and what is prohibited within the shopping center. For example, if it is prohibited for the landlord to lease space to another bank, is a grocery store with a bank teller window inside also prohibited? Or, does a restriction against another drug store in the shopping center prohibit a grocery superstore from having a full-time pharmacist? Keep in mind that courts will interpret these provisions in a manner that favors full and free use of property, and will construe ambiguous language against whomever drafted the lease. Avoid ambiguity in a use restriction by describing the activity or goods that are restricted rather than solely mentioning a type of business. Prohibiting “the sale of prescription drugs dispensed by a licensed pharmacist” will lead to less confusion than prohibiting “a drug store.” Also, consider carefully whether the passage of time could render the terms in the restriction outdated and unenforceable, or overly broad, given the evolving nature of the manner in which goods and services are delivered. For example, would a use restriction drafted in 1950 regarding “drive-in” restaurants prohibit a fast-food restaurant with “drive-thru” service today? An agreement to restrict “massage parlors” in the 1970s could prohibit a day spa offering massage services in the present day.

While it is impossible to predict how society and technology will change, there should be a balance between specificity of what is prohibited and flexibility that the language can withstand the test of time. In this age of superstores, it is common for anchor tenants to expect that existing exclusives should not apply to their operations. Landlords can help themselves in future anchor negotiations by including a carve-out in their use restrictions that is applicable to anchor tenants, which are typically defined as retailers of more than a minimum leasable floor area (e.g., 50,000 square feet). It is also important to exclude existing tenants from being bound by use restrictions contained in leases with new tenants because by then the landlord has lost the ability to impose additional limitations on existing tenants without their consent.

Reflect on the business interest you are seeking to protect, depending on your role as either a tenant or landlord. As a landlord, would you be harmed (i.e., reduction in percentage rent) if the tenant opened another location two miles away? Five miles? Ten miles? Would you be harmed if the tenant ceased operating a shoe store and began operating a bookstore? What if your tenant instead began operating an adult bookstore? As a tenant, how much would your sales decline if another tenant moved into the shopping center and offered a product that comprises 5%, 10% or 30% of your revenue? What new goods or services might you like to offer in the future? Will it be necessary to protect the tenant from competition from its landlord with a radius restriction and, if so, what should be the radius? Answers to questions like these will inform the reasonableness of a use restriction and/or radius restriction and avoid the risk that an aggressive restriction might be challenged or declared to be an unlawful restraint on trade.

The hard work necessary to enforce a matrix of use restrictions does not end after the lease is signed. The restrictions must be organized and reviewed on a regular basis. Whether landlord or tenant, keeping an eye on what goods and services other tenants are actually offering will be necessary to preserve legal rights to enforce use restrictions. When your landlord client is leasing space to a new tenant, it is important to investigate and understand the prospective tenant's goods, services, and intended current and future use of the property.

Could even a minor part of the new tenant's business be within the ambit of a use restriction already in place that benefits an existing tenant? If your client is a prospective tenant, it will have its own concerns about existing tenants and use restrictions already in place that benefit them. A prospective tenant that induces a landlord to allow a competing use, which is prohibited by an existing tenant's lease, could become liable for tortious interference with contract and be subjected to punitive damages. To avoid such risk, the prospective tenant should not sign a lease unless the landlord first obtains a waiver from the existing tenant. Or, if a waiver is not granted and the circumstances warrant a legal challenge to the validity of the restriction, obtain a declaratory judgment that the restriction is invalid.

Conclusion

Whether landlord or tenant, it is critical to focus carefully on the use and radius restrictions in a proposed lease and draft accordingly to ensure their enforceability. Time and effort expended on the front end of negotiations, with careful drafting of use and radius restrictions, will return dividends down the road and avoid the prospect of threatened or actual litigation that challenges those provisions.

Peter J. Marino is a Partner at Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan, L.L.P. in Raleigh, NC. He chairs the firm's Construction and Real Estate Development practice group. Scott A. Miskimon is a Partner at the firm, and chairs the firm's Real Estate Litigation group. Lauren H. Bradley is an Associate, focusing her practice on commercial litigation.