OPERATIONS COVENANT. By Joel R. Hall The Gap, Inc. San Bruno, California Copyright 1999

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1 OPERATIONS COVENANT By Joel R. Hall The Gap, Inc. San Bruno, California Copyright Covenant to Operate/Express v. Implied. Shopping center lease forms, as they first developed, generally did not contain an express covenant of the tenant to operate from his premises. While many of these leases did include percentage rent clauses, few contained an express covenant of the tenant to operate so as to ensure that the tenant would be generating sales. There is a substantial body of case law wherein the covenant of a tenant to operate has been implied by the courts from a variety of factors including the presence of other operating requirements in the lease1 or the adequacy of the minimum rent being paid as compared to the percentage rent provisions. This last factor of the adequacy of rent has been the most influential in determining whether a continuous operations covenant will be implied. If the court found that the minimum rent was nominal, it often concluded that the parties intended that the landlord also rely on the percentage rent generated from tenant's sales to ensure an adequate rental return from the premises. Conversely, if the minimum rent was found to have been adequate -- when viewed at the time of lease execution, not at the time of the lawsuit -- then no covenant would be implied, the court refusing to protect the landlord from its own imprudence in failing to include an express covenant or providing for rent increases over the term. In modern shopping center leasing practice landlords rely principally upon the express covenant to support the tenant's obligation to operate the store and produce percentage rent The Obligation: General Obligation v. Specific Hours Requirement. As shopping center leases evolved, they began to include a general covenant of the tenant to operate from the premises such as the following: Figure 4-1 General Covenant to Operate Tenant agrees to continuously and uninterruptedly occupy and use during the term the entire Premises for the Permitted Use and to conduct Tenant's business therein in a reputable manner.

2 A slightly more specific clause, like the one which follows, was also found in early leases (including the ancestral version of the International Council of Shopping Centers' standard form) and referred to hours of operation in a general way: Figure 4-2 General Reference to Hours of Operation Tenant agrees to remain open for business during the usual days and hours for such business as are customary in the vicinity of the Shopping Center. Today, most shopping center leases include rather specific requirements, with the right of the landlord to change hours from time to time such as the following clause: Figure 4-3 Specific Reference to Hours of Operation Tenant will operate Monday through Saturday from 10:00 A.M. until 9:00 P.M., on Sundays from 12:00 Noon until 6:00 P.M. or during such other days and hours as are designated by Landlord. As a general rule, as each form of the covenant evolved in leasing practice it did not replace the former one but rather was merely added to it. Now one can find all three versions in one lease, recited one right after another. The reason for this, aside from the pull of tradition, was the theory that if for some reason the other stores were not operating in a uniform fashion - e.g., if the department stores or satellite stores operated every day but closed early or at different times - then the Landlord could still rely on clauses like Figure 4-2 to retain some residual, general (and vague) obligation to operate for at least some period of time (for example, until 3:00 P.M. when most of the tenants were still open). Thus, those landlords willing to include a cotenancy requirement in their lease would write them in the following form: Figure 4-4 Reference to Operation of Other Tenants Tenant will operate during such days and hours that the ABC Department Store plus tenants occupying at least seventy-five percent (75%) of the GLA of the Shopping Center are open and operating. (Emphasis added) 4.03 The Covenant to Operate from a Landlord's Perspective.2 A fundamental, philosophical issue regarding sharing of risks emerges in every cotenancy clause

3 negotiation. Has a tenant entered into a lease for space in the shopping center with an iron-clad guarantee of full operation of all major department stores and all other tenants as a condition to such tenant's obligation to operate, or, has the tenant entered into a lease for the right to operate within a shopping center market created by the landlord but with the attendant risks of discontinued operation of major department stores and/or certain other retail tenants? It is important to note that the success or failure of major department stores and other retailers within the shopping center is often not a function of the operation of the specific shopping center, but rather of the marketplace generally, and the ability of the department stores and satellite stores to operate within the marketplace. From a landlord's perspective the risk of department stores or other retailers closing is, therefore, a marketplace risk, and not necessarily a developer risk which should be borne exclusively by the owner of the shopping center. From a landlord's perspective, the chain retailers most capable of negotiating strong cotenancy clauses are also those retailers who are often financially stronger than the owner of the shopping center itself and are capable of analyzing the demographics of any retail market and the trends within that market. Therefore, their obligation to operate should not be dependent (or co-dependant) upon the continued operation of their neighbors. Tenants often highlight the hundreds of thousands of dollars invested by them in improvements and merchandise. The landlord, in response, may point to tens and hundreds of millions of dollars expended in development of the shopping center. Both the landlord and the tenant share the desire to see the shopping center become a successful development. From where a landlord sits, however, to ask a tenant to risk ten or a hundred thousand dollars in a shared risk with the landlord's ten or hundred million dollar risk does not appear unreasonable Modifying the Covenant to Operate from a Tenant's Perspective. The argument that the closure of a department store is a "marketplace risk" rather than a developer risk is based upon a rather feeble theory. When the landlord induces a tenant into a center, it is the retail environment created by the center and the department stores that the tenant has responded to, with the demographics of the marketplace being an extremely important but secondary influence. If all a tenant were concerned about was the marketplace, it would not need to go into the landlord's shopping center. It could find a street location in that marketplace with only the minimum rent and taxes to worry about -- no percentage rent, no CAM charges, no central HVAC, no merchant's association, no kiosks, no relocation clause, no intrusion by columns or conduits, no use clause, no tradename restriction, a free right to assign and no operating covenant. It is the retail environment created by the shopping center that a tenant bargains for (and that the Landlord held out to the Tenant), not merely the marketplace in which it is located. For the satellite tenant in an enclosed regional mall, an operating covenant for the entire term of the lease is a fact of life. Nonetheless, in order to increase his flexibility and reduce his downside risk, it is essential for the tenant to modify the operating clause with a cotenancy provision. After all, the Landlord enticed the tenant into his mall by projecting an image of a community of quality named retailers3

4 4.05 Negotiating for a Cotenancy Requirement Negotiating For A Cotenancy Requirement. Assume that the business representatives of the landlord and tenant have agreed that the tenant's operating requirement is to be tied to a department store and a certain percentage of mall tenants. A landlord will sometimes submit a clause like the following: Figure 4-5 Tenant's Requirement to Operate - Cotenancy Tenant shall be required to operate during designated days or hours provided that the ABC department store (or its successor) is required to operate and 75% of the tenants (including Tenant) are required by their leases to be open during such days and hours. (Emphasis added) To the tenant, such a clause is a travesty of the agreement between the business people and a mockery of the tenant.4 From a tenant's perspective, such a provision should be modified in accordance with the following principles. Elements of The Cotenancy Clause - Discussion The Department Stores and Their Successors. The tenant should not permit the anchors to be designated merely as "ABC or its successors or replacement" or "the occupant of the space initially intended to be occupied by ABC"; this is totally unacceptable from a tenant's point of view. The principal and procuring cause in inducing the tenant into the center is who the anchors are and where he is in relation to them. Thus if ABC is a department store of known and desired quality -- exuding a high drawing power -- then, replacing ABC with a lower-end operator lacking the same drawing power for the same type of customer frustrates the tenant's legitimate business expectations. To make matters worse, most landlords have departed from the use of the word "department stores" in their lease forms and now attempt to create classes of "Major Tenants" or "Anchor Stores" who are merely large space users and may not even be department stores at all. Such "Anchor Stores" are simply defined in terms of square footage without any name recognition tied to the definition but they are nevertheless intended by the landlords to satisfy the operating cotenancy requirements. Some leases define such stores as small as 15,000 or 20,000 square feet; they may even presume to call them "department stores"!5 In such a case, a satellite tenant may find that his operating covenant is tied to the sporting goods store, the toy store or the furniture store rather than to a Penney's or Macy's. In order to protect himself the tenant must insist that the concept of "anchor store" be specified to mean a "department store" and that the term "department store" in turn be carefully defined to encompass only those retail operations commonly accepted as "true" department stores. The definition of a "true" department store is comprehensively discussed in Appendix - I of these materials.

5 "I Can't Control The Department Stores". Many landlords have resisted even including the department stores as part of a cotenancy requirement on the grounds that department stores often have only a limited operating covenant in terms of years or sometimes none at all; therefore, they cannot control them. This is particularly true where the department store owns its own parcel, having purchased it from the landlord. However, when the tenant approved the deal, he was buying into the concept of a synergistic retail environment, anchored by department stores. In fact, the presence of specifically named department stores was one of the key selling points the landlord used to induce the tenant into the center. The landlord cannot now turn around and completely discount those considerations as unimportant to the tenant. If the landlord chooses to parcel out portions of the tract to the department stores, fine, but he cannot then pretend or ask the tenant to pretend that they no longer exist for purposes of the lease. The issue is not whether the landlord is at "fault" or whether he can control the department stores; the only thing that matters to the tenant is whether the named department store is open or not "Actually Open" vs. "Required to be Open". Predicating a tenant's requirement to be open on the majors being "required to be open" rather than "actually being open" is still a position taken by many landlords. However, to state the condition in terms of being "required to be open" is discounting the tenant's prime motivation. The presence or absence of an operating covenant in the department store's lease or REA is not the controlling factor for the tenant. Again, the only thing that matters to him is: "Is the department store open or not?" When applied to the satellite stores, the "required to be open" test is especially problematic. It is unlikely that the condition could ever fail because every satellite lease contains an operations covenant, even if it is coupled with a cotenancy provision. Indeed, if these tenants went dark in violation of their leases, the landlord would still have met the test simply because there was a clause in their leases requiring them (in some form or another) to be open, whether or not they were actually open. The only thing that matters to the tenant is how many other retailers are actually open, regardless of what their leases say. That is what the tenant bargained for when he signed the lease. Landlords frequently offer the tenant a covenant that the landlord will use all reasonable efforts to enforce the operating clauses of those other leases while insisting that the tenant accept the "required to be open" language. From a tenant's perspective such efforts are not especially helpful because specific performance is difficult to obtain and termination of the other fellow's lease does not increase the number of other stores that are open Percentage of the Satellite Cotenancy. The phrase "75% of the tenants (including Tenant) are open..." in Figure 4-5 is a problem for the tenant because if the shopping center is only 80% leased then the landlord's requirement is diluted to merely 75% of 80% or 60%. This provision would allow the landlord not to require an operating covenant in 40% of his leases while still requiring the tenant to operate. The cotenancy requirements must be tied to a percentage of the gross leasable area of the center being open, not just a percentage of the tenants the landlord happens to have.