Lease Co-tenancy – A Cautionary Tale

by Andrew R. Lubin

September 2, 2020

To say that the Covid-19 crisis has changed virtually every aspect of life as we knew it is an understatement. Why should leasing be immune? At least in the pre-Covid-19 days, while landlords and tenants could not control uncertainty, at least they had a somewhat communal understanding of a defined set of market risks and were then able to make rational economic decisions. While the recession of 2008-9 caused one form of economic peril, Covid-19 has changed the equation. Governmental regulation, executive orders, supply chain disruption, bankruptcy, cataclysmic cash flow issues and the simple ability to hire or maintain employees have caused parties to not only view new leasing opportunities with caution, but also to dig deeply into their existing lease language.

One of many issues causing alarm in both existing leases and future lease negotiation is tenant co-tenancy. That is, lease provisions that condition a tenant’s performance on the current or future occupancy by one or more of the other property tenants.

DEFINING THE ISSUE:

Co-tenancy provisions generally fall into two broad categories –opening requirements and operating requirements.  As one court has succinctly explained:

“[O]pening cotenancy requirements condition the tenant’s obligation to open for business or commence paying minimum rent on satisfaction of the cotenancy requirement.  Operating cotenancy requirements condition the tenant’s obligation to either continue to conduct business or to continue to pay minimum rent on the active operation of certain named tenants and/or at a predetermined level of occupancy within the shopping center.”  Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc., 182 Cal. Rptr. 3d 235, 244 (Cal. Ct. App. 2015), modified No. F067327, 2015 Cal. App. LEXIS 130 (Cal. Ct. App. Feb. 9, 2015).

A retail tenant (typically one with bargaining power) will often insist on a co-tenancy provision in its lease as a way of protecting itself from the economic consequences of a failed or failing center. By conditioning its tenancy on other tenants operating in the shopping center, a tenant hopes to capitalize on the economic magnet of other tenants to help attract its own customers.  A tenant may insist on either a named tenant(s) or certain percentage of space leased to other tenants as a condition to its initial or continued performance. Tenants find these provisions beneficial because if the co-tenancy requirements are not met, they will then typically not be required to open in the first place or, if open, be permitted to pay reduced rent or even terminate the lease altogether.

While a tenant’s interest in requiring a co-tenancy provision may be understandable, if not drafted with precision, the result may have dire economic consequences for landlords (and their lenders).

JUDICIAL INTERPRETATION

The following cases illustrate some of the arguments used, the judicial analysis and the pitfalls associated with both poorly conceived and poorly drafted co-tenancy lease provisions.  Language matters.

Connecticut

In Kleban Holding Co., LLC v. Ann Taylor Retail, Inc., No. 3:11-CV-01879 (VLB), 2013 U.S. Dist. LEXIS 168231 (D. Conn. Nov. 26, 2013) Ann Taylor (“Tenant”) entered a lease for space in a large strip center with a predecessor landlord to Kleban Holding (“Landlord”). The lease contained both opening and operating opening co-tenancy clauses that had been negotiated by the parties. The opening co-tenancy provision was not an issue.  The operating co-tenancy clause was as follows:

“(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 [emphasis added] are again open and operating.” Id. at *3-*4.

Borders, after filing for bankruptcy, abandoned its lease in May 2011.  In reliance on the co-tenancy operating provision, two months after Borders vacated, Tenant commenced paying 5% of Gross Sales rather than Minimum Annual Rent.

Landlord brought suit alleging three causes of action: 1) breach of lease; 2) anticipatory breach; and 3) unjust enrichment.  Tenant had the matter removed to federal court and both parties filed for summary judgment.  Landlord’s primary position was that the word “tenants” in the operating co-tenancy provision meant that it could replace Borders with any other similar retailer.  Tenant argued to the contrary that the lease “unambiguously” permitted the abatement of rent if the named tenant “Borders” was not open and operating.

After discussing the law of contract interpretation and dismissing a string of Landlord posited linguistic interpretations, the Court concluded that the lease language was in fact unambiguous.  Pursuant to the clause, the Landlord only had the right to collect Minimum Annual Rent if Borders was open and operating.  “[T]he plain language of the Lease dictates that Ann Taylor may pay abated rent until the tenant meeting the foregoing requirement is again open and operating.  The only tenant who could fulfill such a request is Borders Inc.” Id. at *20.  No other tenant or other use could substitute for Borders.

The Landlord also argued that the rent abatement would create an $800,000.00 windfall to the Tenant that no reasonable owner would ever have agreed to.  In support of this argument, the Landlord sought to introduce parole evidence from the president of the Landlord’s predecessor as well as the predecessor’s attorney, who drafted the lease.  In depositions they stated that it was never their intention to preclude a substitute tenant for Borders.  The Landlord’s argument and all extrinsic evidence were rejected because the Court found the lease language was unambiguous and, therefore, extrinsic evidence could not be considered as a matter of law.

The Court stated that it would not “unmake a deal agreed to by two sophisticated parties.”  Accordingly, the Tenant neither breached nor anticipatorily breached the lease.  As to Landlord’s unjust enrichment claim, the Court simply dismissed it holding that such a cause of action is dependent on the absence of a valid contract.  As the lease was valid, there was no unjust enrichment.

If the Court’s decision was not bad enough for the Landlord, there was one final insult to injury.  The Court awarded the Tenant costs, expenses, and attorney fees as the “prevailing party” based upon the attorney fee clause in the lease.

Michigan

Another recent federal district court decision, Sun Valley, Ltd. v. Galyan’s Trading Co., LLC, No. 13-13641, 2014 U.S. Dist. LEXIS 34103 (E.D. Mich. Mar. 17, 2014), also highlights the danger in identifying specific co-tenants in a co-tenancy clause.  This case also dealt with co-tenancy operating requirements.

The defendant tenant Galyan’s Trading Company (“Tenant”) entered into a lease with the plaintiff landlord Sun Valley, Ltd (“Landlord”).  At the time the lease was signed, there was a Sears Great Indoors Store operating at the mall.  The co-tenancy clause required that the “Major Anchor” had to be operating in at least 100,000 square feet.  “Major Anchor” specifically meant “a Sears Great Indoors Store containing at least one hundred thousand square feet” of floor area.  The Sears Great Indoors Store closed and was replaced with a Sears Outlet.  Id. at *3.  Pursuant to the rent abatement provisions of the clause, the Tenant reduced its rent from $84,000.00 to $23,000 and the Landlord brought a breach of contract action, alleging that the Sears Outlet was sufficient to qualify as a “Major Anchor.”  The district court disagreed, and in granting the Tenant’s motion for judgment stated: “The lease is clear.  Under the lease’s terms only a Sears Great Indoors Store triggers the cotenancy requirement.  The Court reads the terms of the lease as the terms appear on the lease’s pages.  Reading the lease’s unambiguous provisions, there is no support that a Sears Outlet Store satisfies the cotenancy requirements.”  Id. at *11-12.

The Court also rejected the Landlord’s request for relief based on substantial performance.  It concluded that the operation of a Sears Great Indoor store was an unambiguous express condition of the co-tenancy requirement.  The Court was additionally unpersuaded that the doctrine of impracticability applied.  Landlord argued that because Sears’ line of Great Indoor Stores no longer existed, it was impracticable/impossible for the Landlord to replace it according to the lease’s definition of Major Anchor.  The court disagreed, noting that “the fact that the ‘Major Anchor’ of [the mall] specifically defined as a Sears Great Indoors, would fail, the fact that any business would fail, is foreseeable.”  Id. at *27.

Interestingly, the court noted that the lease failed to include a clause allowing substitution of an “equivalent” tenant.  This type of saving language that a landlord should employ will be discussed later in this article.

New York

In Staples the Off. Superstore E., Inc. v. Flushing Town Ctr. III L.P., 933 N.Y.S.2d 732 (N.Y. App. Div. 2011), lv. denied, 982 N.E.2d 619 (N.Y. 2012), the landlord, Flushing Town Center, was required as part of an opening co-tenancy provision to lease the premises adjacent to Staples to a “national retailer having not less than 100 stores and occupying not less than 100,000 square feet.”  Id. at 734.  As explained in the trial court decision, the landlord originally intended to rent the neighboring premises to Home Depot, which Staples claimed would have been a “national retailer” pursuant to the lease.  See Staples the Off. Superstore E., Inc. v. Flushing Town Ctr. III L.P., 926 N.Y.S.2d 347, 30 Misc. 3d 1239 (N.Y. Sup. Ct. Feb. 28, 2011).  Instead, the landlord leased the adjacent premises to BJ’s Wholesale Club.  Staples terminated the fifteen-year lease prior to taking possession on the ground that BJ’s was not a “national retailer”. The lease did not contain a definition of “national retailer”.

Staples brought an action for judgment declaring that the Landlord failed to satisfy the co-tenancy requirement.  The trial court granted summary judgment on the ground that BJ’s is not a “national retailer”.  The Appellate Division affirmed, noting that “BJ’s is not a national retailer within the meaning of the lease’s co-tenancy requirement by its submission of undisputed evidence that BJ’s only maintains warehouses in 15 states, principally located along the eastern seaboard and stretching only as far west as Ohio, and does not operate any retail warehouses in the remainder of the United States.”  933 N.Y.S. at 735.  Notably, the trial court rejected the landlord’s argument that BJ’s could be considered a national retailer despite the fact that it is Fortune 500 company listed on the New York Stock Exchange with millions of members, and total annual revenues in excess of $10 billion dollars.

This case once again highlights the need for precise drafting.  The phrase “national retailer” was used.  Had the lease contained some definitional flexibility, perhaps there would have been a different result for the landlord.

Oklahoma

The Tenth Circuit addressed a co-tenancy provision under Oklahoma law in Rockwell Acquisitions, Inc. v. Ross Dress for Less, Inc., 397 Fed. Appx. 424 (10th Cir. 2010).  As in Kleban, this case illustrates the consequences of insufficient landlord flexibility in finding substitute tenants.

In Rockwell Acquisitions, the lease co-tenancy operating requirement provision permitted the tenant, Ross, to pay a lower substituted rent if certain named tenants (or permitted substitutes) failed to be part of the center. The landlord, Rockwell, replaced one of the named tenants, Big Lots, with two small tenants, K & G and Famous Footwear, instead of one large anchor tenant as defined by the lease. The court noted:

“To satisfy the co-tenancy provision, Rockwell must fulfill two requirements: (1) all three of the “named” co-tenants—Target, Big Lots, and PetsMart—must be open and operating in the shopping center, and (2) the named co-tenants must occupy at least 90 percent of the specified floor area.  If Rockwell does not fulfill these two requirements, it can still satisfy the cotenancy provision by exercising the ‘comparable replacement Anchor Tenant’ option.  The anchor tenant option has three requirements: the tenant must (1) be “a national retailer with at least one hundred (100) stores or a regional retailer with at least seventy-five (75) stores,” (2) “replac[e] one (1) or more of the named Co-Tenants,” and (3) “occupy[] no less than ninety percent (90%) of the Required Leasable Floor Area of the Required Co-Tenant being replaced.”  Id. at 427.

The district court granted summary judgment for the tenant and concluded that because Big Lots, an anchor tenant, was not operating, the tenant was entitled to pay the lower substituted rent.  It did not matter that the Landlord filled Big Lots’ store space with two smaller tenants because “the lease’s co-tenancy provision required Rockwell to replace Big Lots with one anchor tenant occupying at least 90 percent of Big Lots’s space.  Rockwell did not do so, and therefore it breached the lease agreement.” Id. at 428.

Once again, this case illustrates that a court will often give a literal interpretation to the plain language of the lease.

California

1. Best Buy Stores. L.P. v Manteca Lifestyle Ctr., LLC, 859 F. Supp. 2d 1138 (E.D. Cal. 2012) also demonstrates the consequences of inexact language.

Best Buy (Tenant) entered into a lease with Manteca Lifestyle Center, LLC (Landlord), which was in the process of developing a shopping center.  The lease provided that two of the following businesses had to be open: J.C. Penney, Bass Pro, and a cinema.  The lease also contained an attached site plan that stated that the shopping center would eventually have a total square footage of 743,908 square feet.  At the time the parties signed the lease, approximately 373,000 square feet had been constructed.  At issue was the portion of the co-tenancy clause that stated:

Tenant shall not be required to open for business unless sixty percent (60%) (not including Best Buy) of the gross leasable area of the Shopping Center are open and operating at the Shopping Center . . . including at least two (2) or more of the following tenants (I) J.C. Penny; (ii) Bass pro; (iii) a cinema.

Should the Co-Tenancy Condition not be satisfied, Tenant may either (i) delay opening for business until the Opening Co-Tenancy Condition is satisfied . . . or (ii) open for business and pay fifty percent (50%) of the monthly Rent (and any additional other costs without reduction) payable pursuant to the terms of this Lease until such time as the Opening Co-Tenancy Condition has been satisfied.

Id. at 1143.

Initially, the other co-tenants were not open.  Best Buy reached a point where it could no longer delay opening, so it elected to open and pay reduced rent.  By the time the rent came due, the cinema and Bass Pro were open.  J.C. Penney opened shortly after.  The Landlord demanded payment of full rent, claiming that with those three tenants approximately 78% of the available space (373,000 sq. feet) had been leased.  Best Buy, however, claimed that “gross leasable area” referred to the total amount contained in the Site Plan (743,908 sq. feet).  Best Buy brought a breach of contract/declaratory judgment action.  The Landlord moved for summary judgment, which the court denied.  The court concluded that there was a genuine issue of material fact as the proper definition of gross leasable area.  The court concluded it could mean the total amount of space completed at the time of the lease, as the Landlord claimed, or it could mean the total amount of the space contained in the Site Plan which was attached to the lease.  Id. at 1148.

Once again, drafting inconsistency lead to lease interpretation uncertainly and litigation.

2. By interesting contrast to the cases above, the more recent Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc., 182 Cal. Rptr. 3d 235 (Cal. Ct. App. 2015), modified No. F067327, 2015 Cal. App. LEXIS 130 (Cal. Ct. App. Feb. 9, 2015) also dealt with opening and operating co-tenancy provisions with the landlord faring somewhat better. In Grand Prospect Partners, the lease conditioned the opening of the tenant’s store and the payment of rent on another major tenant (Mervyn’s) being open. Prior to the tenant’s opening date Mervyn’s filed for bankruptcy.  The tenant neither opened nor paid rent.  A further provision allowed the tenant to terminate the lease if the co-tenancy failure continued for twelve months.  After twelve months the tenant elected to terminate the lease.  The landlord then sued but, unlike the landlord in Kleban, the landlord argued explicitly that the co-tenancy provisions were unenforceable as both unconscionable and a penalty.  The trial court agreed and, after a jury trial, awarded substantial damages.

On appeal, the California Appellate Court reversed the decision after analyzing the rent abatement and termination provisions separately. As to the termination, the Court determined that California had developed a specific rule that applies to lease termination clauses. It held specifically that the termination provision was not a penalty (nor a forfeiture) as it was: (i) agreed upon by sophisticated parties and (ii) Mervyns’s act (bankruptcy) had no relation to any act or default by either of the parties.  Furthermore, this rule of law superseded the law applicable to the analysis as to whether the termination provision constituted a penalty.

The rental co-tenancy provision, however, was a different matter.  Relying on existing California precedent, the Court found that unlike termination provisions, California law required an analysis of whether the rent abatement provision bore any reasonable relationship to the harm anticipated by the tenant.  If no reasonable relationship existed, it would be an unenforceable penalty.  Since the record disclosed that the tenant did not actually anticipate suffering any harm as a result of Mervyn’s closure, the rent provision was held unenforceable due to the lack of any reasonable relationship to the anticipated harm to be suffered. However, because the lease termination provision was held to be enforceable, the Court awarded the landlord one year of rent as damages plus attorney fees. Had there not been a termination provision, it seems likely that the Appellate Court would have sustained the original trial court holding of substantial damages.

Despite its holding, even the Court may have been concerned with the breadth of its decision. In the opinion’s opening lines, it states: “This opinion does not establish a categorical rule of law holding co-tenancy provisions always, or never, enforceable. Instead, it illustrates that the determination whether a co-tenancy provision is unconscionable or an unreasonable penalty depends heavily on the facts proven in a particular case.”

POSSIBLE DRAFTING SOLUTIONS

As illustrated by these cases, co-tenancy provisions may have unpredictable and potentially disastrous consequences. The Kleban court appears to have summarized the prevailing attitude of courts in interpreting co-tenancy provisions: “courts do not unmake bargains unwisely made.”

From the landlord’s perspective, it might be easy to conclude that co-tenancy clauses should be avoided altogether.  Unfortunately, market considerations often mandate that a landlord concede the issue in order to attract “appropriate” new tenants who may be unwilling to take a risk in a new (or weak) center without such a provision.  Assuming that they cannot be avoided, there certainly are considerations that can be employed to help minimize the adverse financial impact of a co-tenancy clause and prevent litigation, while at the same time remaining fair to both parties. While not exhaustive, some of these considerations are as follows:

1. A landlord should avoid the use of specific store name reference to co-tenants at almost at all costs. Generic, descriptive, or “equivalent” tenant replacements should be used.
2. Rent reductions or abatements should be limited to a specified time period. At the end of the time period the tenant should be required to elect to either: (a) re-commence paying the normal lease rent or (b) terminate the lease. A landlord could also reserve for itself the option for early termination if the tenant exercises its rights under an abatement provision. A lease should also specify that any rent reduction should be the tenant’s exclusive remedy for any co-tenancy violation.
3. Based on the holding in Grand Prospect Partners, it would seem desirable to have an acknowledged relationship between the anticipated loss to the tenant and the value of the rent abatement. A landlord could also require the tenant to demonstrate actual proof of loss as a result of the co-tenancy violation (i.e., drop in revenue) before a tenant is able to take advantage of the provision.
4. The lease should provide for liberal landlord cure rights before the co-tenancy provisions can be invoked and that co-tenancy rights cannot be exercised if the tenant is in default.
5. In the event of a lease assignment, the co-tenancy provisions should not be exercisable by the assignee.
6. Rent reduction should not apply to any tenant improvements advanced by the landlord. If early termination, a tenant should be required to reimburse the landlord for any tenant improvements paid for by the landlord.

By their nature, lease co-tenancy provisions deal with uncertain future events over which the parties may have little control. The effects of Covid-19, market downsizing, store closings and mergers have been felt in many markets and more are on the horizon. The cases provide modern day reinforcement for the proposition that careful attention to language should be at a premium. The draftsperson must take great care in attempting to bring certainty into an unpredictable arena.

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