Where's the Door?

A retail tenant negotiating a new lease should always consider its alternatives for exiting from the lease relationship in the event that circumstances change in the future. Projected sales may be off the charts, and the demographics of the location may seemingly hold the promise of decades of successful operations, but no one truly knows what the future may hold, and a wise tenant needs to anticipate alternative futures. This is not an illicit exercise borne of impure motives, but simply wise business planning that should benefit not only the tenant, but the landlord as well. A landlord will not be well-served by forcing a struggling tenant to remain in place, when other, more financially viable alternatives are available. The importance of planning well for exit strategies in new leases, and considering how the terms of existing leases affect exit strategies, is amplified exponentially during difficult economic times, as events of the last several months make clear.

Many lease provisions, and many outside factors, affect tenant exit strategies. This two-part article explores some ways in which operating covenants and exclusive use provisions, in particular, affect the ability of a tenant to exit from a lease relationship. Although some specific suggestions are made, the primary intent of this discussion is to alert the leasing practitioner to various issues and pitfalls which may be encountered.

Operating Covenants Generally

It is important to consider at the outset the reasons for operating covenants. The inclusion of operating covenants in leases of certain tenants is based upon a landlord's justifiable desire to establish and maintain an open, operating, vibrant shopping center. Indeed, although there are some stand-alone exceptions, tenants typically share in the desire and need for a successful shopping center environment in which to operate and thrive. Credit considerations imposed by the landlord's lender may also support the “need” to require that certain tenants open and operate, at least for a certain period. In each case, the underlying intent is to assure the financial and operational viability of the center, which in turn attracts other tenants, supports higher rents, and increases customer traffic, to the benefit of landlord and tenant (and lender) alike.

On the other hand, a retailer must take into account the uncertainty of the future, recognizing that a highly successful store of today may turn into an economic black hole in the future. The retailer has an interest in maintaining operational flexibility and controlling future costs, not to mention the ability to undertake transactions in which it may wish to sell or otherwise transfer individual locations or groups of stores. Operating covenants may come in many forms, and may affect tenant exit strategies in many ways.

Covenants to Open

The simplest (and least burdensome to the tenant) operating covenant is a covenant to open. Often included as a compromise in response to a landlord's insistence upon a full operating covenant, a tenant will agree to fixture, stock, staff and open its store for one day, within a stated period. It is important to the tenant to be certain that the effectiveness of such a covenant is subject to the satisfaction by the landlord of appropriate conditions. In a new center, for example, such a provision should be conditioned upon the landlord having obtained all of its permits, and completed all of its work, which is a prerequisite to the tenant's ability to fixture, stock, obtain a certificate of occupancy and open for business, and having done so in sufficient time for the tenant to perform its obligations before the opening deadline. It may seem that a “simple” one-day opening covenant is a major concession by the landlord (as compared with a full operating covenant). As a practical matter, given the expense and effort involved in preparing and opening a store for business, a tenant's compliance with a one-day opening covenant likely assures that, barring catastrophe, the tenant will be operating in the store for a significant period beyond that first day. From the tenant's standpoint, though, it offers much more flexibility, and in fact a savvy tenant will probably not sign a lease containing such a covenant (or any express operating covenant) until it is at a stage in its preparations when it is almost certain that it fully intends, in fact, to open and operate a store in the premises. So a tenant's failure to comply with an express covenant to open for a limited period is not particularly likely, at least during “normal” times.

Express Operating Covenants

Most large retailers will vigorously resist agreeing to express operating covenants. Nevertheless, even large tenants with considerable bargaining power sometimes still agree to such covenants, due to the particular circumstances of a given project. Even if a retailer may now have the power to resist agreeing to such covenants in new leases, it may be saddled with them in older leases, whether “voluntarily” from earlier days when the retailer had less clout, or by “inheriting” such a clause as a result of taking over a site from another retailer.

Any new operating covenant should include certain important carveouts and limitations, including, at the very least, exceptions for casualty and condemnation which allow sufficient time to assess the damage, determine whether to exercise any termination rights, and, assuming that the tenant does not or cannot elect to terminate the lease, sufficient time for the responsible parties to rebuild, re-fixture and re-stock the premises and for the retailer to reopen. Similarly, store closure for periodic remodeling or repairs should not be a violation of an operating covenant, nor should the decision of the retailer to operate its business in less than the entire premises constitute a violation; the latter point will likely require negotiation to establish the minimum size of an operating store that will still be deemed to comply with the covenant.

Limitations on an operating covenant may include co-tenancy requirements that condition the effect of the operating covenant on the continuing presence and operation of certain other tenants. A tenant that agrees to an operating covenant should also attempt to have the covenant automatically expire after a specified period significantly shorter than the entire lease term, making the negative effects of the covenant somewhat more palatable by representing a more finite commitment for the tenant, which permits a greater degree of future flexibility. Furthermore ' and very importantly ' an operating covenant must allow for typical changes in a tenant's business operations (i.e., merchandising mix), entity structure and trade name, as well as transfers of store locations to other retailers. These last concerns are related to assignment and subletting considerations, which are beyond the scope of this article.

Particularly in difficult economic times, retailers often seek to restructure and recover by assigning leases to other retailers, often in packages consisting of multiple locations, and the presence of unwavering operating covenants, may stifle the implementation of this exit strategy. A careful practitioner on either side of a leasing transaction should think twice before including a covenant requiring a tenant to “continuously operate within the entire premises during normal business hours throughout the term of this Lease, as a full-service department (or grocery, or drug, or other category) store operating under the trade name 'XYZ.'” Many leases surprisingly include covenants not very different from this example, and our changing times and evolving market realities, perhaps now more than ever, illustrate the folly of such a rigid formulation.

The conclusion of this article will discuss the remedies for violation of an operating covenant.

John H. Lewis is a partner in the Boston office of Seyfarth Shaw LLP. Phone: 617-946-4924. E-mail: [email protected].

A retail tenant negotiating a new lease should always consider its alternatives for exiting from the lease relationship in the event that circumstances change in the future. Projected sales may be off the charts, and the demographics of the location may seemingly hold the promise of decades of successful operations, but no one truly knows what the future may hold, and a wise tenant needs to anticipate alternative futures. This is not an illicit exercise borne of impure motives, but simply wise business planning that should benefit not only the tenant, but the landlord as well. A landlord will not be well-served by forcing a struggling tenant to remain in place, when other, more financially viable alternatives are available. The importance of planning well for exit strategies in new leases, and considering how the terms of existing leases affect exit strategies, is amplified exponentially during difficult economic times, as events of the last several months make clear.

Many lease provisions, and many outside factors, affect tenant exit strategies. This two-part article explores some ways in which operating covenants and exclusive use provisions, in particular, affect the ability of a tenant to exit from a lease relationship. Although some specific suggestions are made, the primary intent of this discussion is to alert the leasing practitioner to various issues and pitfalls which may be encountered.

Operating Covenants Generally

It is important to consider at the outset the reasons for operating covenants. The inclusion of operating covenants in leases of certain tenants is based upon a landlord's justifiable desire to establish and maintain an open, operating, vibrant shopping center. Indeed, although there are some stand-alone exceptions, tenants typically share in the desire and need for a successful shopping center environment in which to operate and thrive. Credit considerations imposed by the landlord's lender may also support the “need” to require that certain tenants open and operate, at least for a certain period. In each case, the underlying intent is to assure the financial and operational viability of the center, which in turn attracts other tenants, supports higher rents, and increases customer traffic, to the benefit of landlord and tenant (and lender) alike.

On the other hand, a retailer must take into account the uncertainty of the future, recognizing that a highly successful store of today may turn into an economic black hole in the future. The retailer has an interest in maintaining operational flexibility and controlling future costs, not to mention the ability to undertake transactions in which it may wish to sell or otherwise transfer individual locations or groups of stores. Operating covenants may come in many forms, and may affect tenant exit strategies in many ways.

Covenants to Open

The simplest (and least burdensome to the tenant) operating covenant is a covenant to open. Often included as a compromise in response to a landlord's insistence upon a full operating covenant, a tenant will agree to fixture, stock, staff and open its store for one day, within a stated period. It is important to the tenant to be certain that the effectiveness of such a covenant is subject to the satisfaction by the landlord of appropriate conditions. In a new center, for example, such a provision should be conditioned upon the landlord having obtained all of its permits, and completed all of its work, which is a prerequisite to the tenant's ability to fixture, stock, obtain a certificate of occupancy and open for business, and having done so in sufficient time for the tenant to perform its obligations before the opening deadline. It may seem that a “simple” one-day opening covenant is a major concession by the landlord (as compared with a full operating covenant). As a practical matter, given the expense and effort involved in preparing and opening a store for business, a tenant's compliance with a one-day opening covenant likely assures that, barring catastrophe, the tenant will be operating in the store for a significant period beyond that first day. From the tenant's standpoint, though, it offers much more flexibility, and in fact a savvy tenant will probably not sign a lease containing such a covenant (or any express operating covenant) until it is at a stage in its preparations when it is almost certain that it fully intends, in fact, to open and operate a store in the premises. So a tenant's failure to comply with an express covenant to open for a limited period is not particularly likely, at least during “normal” times.

Express Operating Covenants

Most large retailers will vigorously resist agreeing to express operating covenants. Nevertheless, even large tenants with considerable bargaining power sometimes still agree to such covenants, due to the particular circumstances of a given project. Even if a retailer may now have the power to resist agreeing to such covenants in new leases, it may be saddled with them in older leases, whether “voluntarily” from earlier days when the retailer had less clout, or by “inheriting” such a clause as a result of taking over a site from another retailer.

Any new operating covenant should include certain important carveouts and limitations, including, at the very least, exceptions for casualty and condemnation which allow sufficient time to assess the damage, determine whether to exercise any termination rights, and, assuming that the tenant does not or cannot elect to terminate the lease, sufficient time for the responsible parties to rebuild, re-fixture and re-stock the premises and for the retailer to reopen. Similarly, store closure for periodic remodeling or repairs should not be a violation of an operating covenant, nor should the decision of the retailer to operate its business in less than the entire premises constitute a violation; the latter point will likely require negotiation to establish the minimum size of an operating store that will still be deemed to comply with the covenant.

Limitations on an operating covenant may include co-tenancy requirements that condition the effect of the operating covenant on the continuing presence and operation of certain other tenants. A tenant that agrees to an operating covenant should also attempt to have the covenant automatically expire after a specified period significantly shorter than the entire lease term, making the negative effects of the covenant somewhat more palatable by representing a more finite commitment for the tenant, which permits a greater degree of future flexibility. Furthermore ' and very importantly ' an operating covenant must allow for typical changes in a tenant's business operations (i.e., merchandising mix), entity structure and trade name, as well as transfers of store locations to other retailers. These last concerns are related to assignment and subletting considerations, which are beyond the scope of this article.

Particularly in difficult economic times, retailers often seek to restructure and recover by assigning leases to other retailers, often in packages consisting of multiple locations, and the presence of unwavering operating covenants, may stifle the implementation of this exit strategy. A careful practitioner on either side of a leasing transaction should think twice before including a covenant requiring a tenant to “continuously operate within the entire premises during normal business hours throughout the term of this Lease, as a full-service department (or grocery, or drug, or other category) store operating under the trade name 'XYZ.'” Many leases surprisingly include covenants not very different from this example, and our changing times and evolving market realities, perhaps now more than ever, illustrate the folly of such a rigid formulation.

The conclusion of this article will discuss the remedies for violation of an operating covenant.

John H. Lewis is a partner in the Boston office of Seyfarth Shaw LLP. Phone: 617-946-4924. E-mail: [email protected].