Featured Article

June 2002

Crafting Cotenancy Provisions

By David P. Kassoy and Nicolas M. Kublicki

Ongoing threats to national security, an uncertain economy, and other perils confronting the American retail industry are increasing the pressure on financially strong shopping center tenants, known as credit tenants, to demand co-tenancy protection in their long term leases. Co-tenancy protection consists of remedies that a tenant may exercise if a popular retailer, depended upon to draw customers to the shopping center (often referred to as a draw retailer), fails to open for business, delays its opening, ceases to operate after being open, i.e., goes dark, or if a percentage of the center's leasable space or a particular portion of the center either does not lease-up or subsequently becomes vacant. The credit tenant's co-tenancy remedies may include the right to delay the term commencement date, to abate minimum rent, to reduce its share or the amount of its payments of common area operating expenses and property taxes, to go dark, and/or to cancel the lease. The usual reason why a credit tenant elects to go dark or exercise an early termination right is that its store is losing money. When exercised, co-tenancy remedies can have a draconian effect, often resulting in massive shopping center vacancies, tenant failures, and landlord loan defaults. Nonetheless, landlords have a strong interest in attracting credit tenants to their shopping centers and continue to grant co-tenancy protection in order to make deals. Consequently, landlords would be well advised to craft co-tenancy clauses that fairly and realistically balance the need of the credit tenant for rent relief and/or an exit strategy with the landlord's need for time and flexibility to institute measures necessary to attract replacement patronage when a draw retailer fails to open or subsequently goes dark and, also, to attract new tenants to fill resulting vacancies.

1. Limit circumstances that trigger co-tenancy remedies.

Landlords should put reasonable limitations on the circumstances that trigger co-tenancy remedies. First, by limiting the types of draw retailer closures that will trigger them. Second, by imposing certain requirements on the credit tenant that must be satisfied before it becomes entitled to exercise them. Third, by giving the landlord an opportunity to overcome the potentially harmful consequences to the credit tenant of the draw retailer's closure before co-tenancy remedies may be invoked.

1. Narrow the circumstances when a draw retailer closure will trigger co-tenancy remedies.

For example:

1. Require that the draw retailer be closed for a substantial period of time, e.g., 6-18 months, before the credit tenant may exercise its co-tenancy remedies.
2. Measure the period of time during which the draw retailer is closed in consecutive days; not in a total number of days.
3. Require that the draw retailer closure be permanent; not temporary.
4. Require that the draw retailer closure be total or near-total; not merely partial.
5. If a credit tenant demands co-tenancy remedies when a certain percentage of the center's tenants go dark, such co-tenancy remedies should become exercisable upon the later to occur of: (a) the closure of a certain percentage of the shopping center's total gross leasable area, or (b) a decrease in the center's gross sales revenue on a per square foot basis below a certain level. In this manner, the co-tenancy remedies will not be exercisable--even if the center suffers substantial vacancies--if the shopping center's gross sales on a per square foot basis do not fall below an agreed level, and vice-versa.
6. Require that any draw retailer on which the co-tenancy clause is based be a tenant of, and located within, the shopping center. In such circumstances, the landlord at least has some ability to induce the draw retailer to stay, for example, by offering rent relief or by funding improvements. If the draw retailer owns its own premises, the landlord may have little or no ability to prevent the closure. If the draw retailer is actually located outside the boundaries of the center, the link between its operation and the draw it generates for the credit tenant may or may not even be significant at the time of the closure.

2. Require that co-tenancy remedies be contingent on the credit tenant's full compliance with its own lease obligations.

For example:

1. Being open for business, fully staffed, fully stocked, and conducting its business in good faith.
2. Being in full compliance with all laws and regulations applicable to the operation of its business in the center.
3. In all other respects being in full compliance with the terms of its lease.

3. Condition co-tenancy remedies on a measurable decrease in the shopping center's gross sales, or, only if landlord cannot substantially mitigate adverse impact on credit tenant's sales volume.

A credit tenant's co-tenancy remedies should not apply if it has not been adversely affected by the draw retailer's closure, or, if the landlord is able to mitigate the impact on the credit tenant of the draw retailer's closure within a reasonable period of time:

1. Require proof of a measurable decrease in the credit tenant's monthly gross sales over a period of time when compared with the same periods in previous years.
2. Give the landlord adequate time to replace the draw retailer with a new draw retailer.
3. Give the landlord an opportunity to relocate the credit tenant, at landlord's cost, to a location in the shopping center where the draw retailer's closure will not impact the credit tenant's business.

2. Limit the scope of the co-tenancy remedies.

A landlord may be able to reduce the adverse impact of co-tenancy remedies on the rest of the center by limiting the number of co-tenancy remedies available at a specific time and by requiring that they be exercised within a certain window period, by insisting that certain kinds of credit tenant conduct will constitute a waiver of the co-tenancy remedies, and by giving the landlord a right to terminate the credit tenant's lease if the latter chooses to exercise certain co-tenancy remedies.

1. Specify the order in which co-tenancy remedies may be exercised after a draw tenant's closure.

While still granting a credit tenant co-tenancy remedies that are responsive to its concerns, a landlord may require the application of such remedies sequentially over time rather than allowing the credit tenant to choose among all the different co-tenancy remedies immediately upon the draw retailer's closure. For example, if the credit tenant's rent consists of both minimum rent and percentage rent, co-tenancy remedies can be limited to the abatement of minimum rent for a reasonable period of time, e.g. 6-18 months after the draw retailer's closure. Likewise, if the credit tenant pays only fixed rent, co-tenancy remedies can be limited to a specified reduction in the rate of monthly fixed rent for a reasonable period of time after the draw retailer's closure. Only after expiration of that period, if the landlord has been unable to relet the draw retailer's premises or otherwise mitigate the potential economic harm to the credit tenant as a consequence of the draw retailer's closure, permit a right to terminate the lease to vest.

Even if the landlord agrees to abate the credit tenant's minimum rent after a draw retailer's closure, the credit tenant should not necessarily be excused from the payment of the credit tenant's pro rata share of operating expenses and real estate taxes. The percentage figure used to calculate monthly percentage rent in such circumstances should be adjusted, if necessary, so that the amount of annual percentage rent payable will not be less than the amount of annual minimum rent formerly payable for the same amount of gross sales volume as was formerly required to reach the so-called "break point."

The credit tenant should not be allowed to go dark in the premises until the effective date of the lease termination. Obviously, a closed retail establishment, while the tenant decides whether or not to exercise its right to terminate the lease, detracts from the appearance of a shopping center to customers. Additionally, such cessation usually precipitates other closures of existing tenants, further discouraging potential new tenants from coming to the shopping center.

If the credit tenant elects to terminate the lease, the effective date of lease termination should not be so soon as to make it impractical for the landlord to implement a contingency plan. For example, the tenant should not have the right to make its election to terminate the lease until twelve months after the draw retailer's closure, with the actual termination not becoming effective until at least twelve months after notice of the credit tenant's election to terminate, thus maintaining the lease in effect (and rental income) for at least a full two years after the draw retailer's closure. If the draw retailer is replaced after the credit tenant's election to terminate the lease, but a specified time before its effective date (e.g., 30 days), the election to terminate should become null and void.

2. Limit amount of time in which co-tenancy remedies must be exercised.

The landlord should insist that the credit tenant's right to terminate the lease shall expire unless the tenant terminates the lease within a specified time after a draw retailer's closure, e.g., 24 months.

3. Require waiver of co-tenancy remedies in certain circumstances.

The landlord should insist that, after a draw retailer's closure, the credit tenant's exercise of options to extend its lease term, to expand its premises, or to relocate within the center, will constitute a waiver of some or all of the credit tenant's co-tenancy remedies.

4. Counterbalance credit tenant co-tenancy remedies with corresponding landlord remedies.

A credit tenant's co-tenancy remedies should not be automatic and should be exercisable only after a specified time following the credit tenant's written notice of its election to exercise the co-tenancy remedies. As a counterbalance to the credit tenant's co-tenancy remedies, the credit tenant's exercise of such remedies ipso facto should, in some circumstances, give the landlord a right to terminate the credit tenant's lease. This may make a credit tenant think twice before invoking co-tenancy remedies, and it will reduce a credit tenant's inclination to threaten exercise of co-tenancy remedies in order to extract additional lease concessions.

5. Make co-tenancy remedies exclusive remedies.

To avoid a claim for consequential and/or compensatory damages allegedly caused by the draw retailer's closure, a landlord should insist upon acknowledgment that the credit tenant's co-tenancy remedies are its sole and exclusive remedies against the landlord in the event that occurs.

In conclusion, short of seeking protection under Chapter XI of the Bankruptcy Act, co-tenancy remedies are often a credit tenant's best strategy for reducing losses pending expiration of a lease term. From a landlord's perspective, however, co-tenancy provisions in credit tenant leases make attempts to predict future rental streams perilous and, therefore, adversely affect the value of the shopping center to potential buyers as well as to potential lenders. The magnitude of a landlord's need to make a deal with a credit tenant, and the urgency of a credit tenant's desire to locate in the landlord's shopping center are, in the first instance, the prime determinants of whether co-tenancy protection will be included in a lease. However, when co-tenancy remedies must be included in a lease, careful crafting by the landlord's attorney of the circumstances that trigger co-tenancy remedies and thoughtful limitation of the scope thereof can be of inestimable benefit to the landlord and the on-going viability of the shopping center.

David P. Kassoy is a senior partner and Nicolas M. Kublicki is a junior partner in the real estate law department of Ervin, Cohen & Jessup LLP in Beverly Hills, California.

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