A Tenant's Duty to Operate Continuously
 
March 26, 2001
 
Martin P. "Marty" Murphy- Chicago

"To be, or not to be: that is the question" Hamlet, Act III, Scene 1

The retail development market can be very volatile.  It is often characterized by large upswings and sometimes even larger downswings.  To further complicate matters, it is often very unpredictable as these trends are difficult to forecast accurately.  Today’s market appears to be no exception.  After years of expansion, many are now forecasting slower retail development growth in the coming years due to fears of a recession and fears of the Internet capturing an ever-increasing percentage of the retail market.  However, low interest rates (with rumors of even lower interest rates), a proposed tax cut, and an excessive amount of dot-com failures may prove any fears of a slow down in this market to be unfounded.

This volatility and unpredictability within the retail development market has a great impact on retail lease negotiations.  Because of these factors, a landlord knows that it is very possible that a tenant’s economic circumstances or market strategy may change over the course of a lease term.  Therefore, a landlord will try to obligate its tenant to certain standards of operation for the duration of the lease term, so that the tenant will be required to stay the course regardless of changes in its circumstances.  Conversely, the tenant seeks to avoid or reduce these restrictions on its operations so that it may maintain the maximum amount of flexibility to adjust the way it operates over the course of the lease term.  In this regard, one of the most critical issues from both the landlord’s and tenant’s perspective, and often one of the most hotly negotiated issues, is whether a tenant is subject to a covenant to continuously operate and, if so, the extent of the terms and conditions of this covenant.

In general, there is no legal requirement that a tenant continuously operate its retail business within its leased premises in the absence of an express operating covenant.  However, exceptions to this general rule do exist and courts have found implied covenants to operate in certain circumstances.  This article will discuss both express and implied lease covenants that obligate a tenant to continuously operate its retail operation.

Express Covenants

An operating covenant to operate continuously can be as straightforward as stating that a tenant is obligated to keep its business open for certain specified hours during weekdays, weekends, certain holidays or other specially designated days.

A tenant obviously would prefer to avoid such a covenant as it would like to preserve the maximum amount of flexibility to operate (or not operate) its business within the leased premises.  A tenant may wish to shut down its operation on its currently leased site (i.e., “go dark”) to either minimize its losses in a failing operation or better maximize its profit potential by moving to a new and better location.  A landlord, on the other hand, may need such a clause if it is essential that the tenant remain operating for the entire lease term.  It is often critical for the landlord that all of the stores within its shopping center, including the tenant’s store, are operating.  If so, a shopping center will be much more attractive to customers as it provides the maximum number and range of retail shops and it presents a healthy and thriving appearance.  The landlord also may be taking this position because all, or a substantial portion, of the landlord’s rent is from percentage rent.  If so, it is important to the landlord that the tenant keep its store open and operating so that the tenant is maximizing its gross revenue which, in turn, maximizes the percentage rent payable to the landlord.

Although most retail landlords would like to include some form of express continuous operation covenant within a lease, it is not always critical or necessary.  Store front buildings, stand- alone buildings, or out-parcel buildings that do not contain percentage-rent clauses often do not need an express operating covenant because, (a) unlike the mall or local shopping center, a tenant allowing its premises to go dark within this type of store will not impact the landlord or the other tenants because either it is a stand-alone site or the tenant’s demised premises are sufficiently remote that it materially does not affect traffic to the mall or shopping center, and (b) unlike a percentage-rent lease, the gross income of the store is not critical to a landlord because it will not affect the landlord’s total rent.

If a landlord and tenant agree to include an express-operating covenant within the lease, the terms and conditions of this covenant should be negotiated carefully by both parties.  Often this covenant can be very detailed and address issues such as (a) limiting the length of time that the clause is effective, such as the first few years of a lease term; (b) requiring the tenant to adequately stock inventory and adequately staff the premises in order to maximize sales and thereby increase percentage rent; (c) conditioning the effectiveness of this clause to the extent that the balance of the shopping center stores, or at least certain important stores, are open and operating; (d) conditioning the effectiveness of this clause upon landlord fulfilling all, or certain, of landlord’s lease obligations; (e) requiring the tenant to operate under a certain trade name so that the landlord is assured that the tenant it bargained with is the actual tenant that will be operating within the leased premises; (f) allowing both landlord and tenant to adjust hours of operation in certain situations such as holidays or other critical times; and (g) requiring that the tenant operate in all or substantially all of the leased premises.

No matter what type of express operating covenant may be agreed upon, a tenant should seek to carve out certain times where it will have the right to close its operation for such customary and normal matters as taking inventory, restocking inventory, labor strikes, periodic remodeling, restoration after a casualty or condemnation, remodeling in connection with an approved sublease of the premises or assignment of the lease, and possibly a winding down at the end of the lease term.  In these periods of temporary closure, the landlord should see that the lease presumes a certain level of gross sales in order that the

Implied Covenants

Even if a retail lease does not contain an express covenant requiring a tenant to operate its retail business continuously within the leased premises, some courts have nonetheless held that, in certain situations, a tenant may be subject to an implied covenant to continuously operate.

Usually for a court to even consider whether an implied covenant exists, the lease in question must contain a percentage-rental clause.  In addition, courts will consider other factors depending on applicable state law.  For example, the United States District Court for the Eastern District of Kentucky has stated that courts usually also consider “(1) whether base rent is below market value, (2) whether percentage payments are substantial in relation to base rent, (3) whether the term of the lease is lengthy, (4) whether the tenant may sublet, (5) whether the tenant has rights to fixtures, and (6) whether the lease contains a noncompetitive covenant.”  Lagrew v. Hooks-Superx, Inc., 905 F. Supp. 401 (E.D. Ky. 1995).

Among courts considering the factors set forth by the Lagrew court, the first listed factor regarding whether base rent is below market value is often seen as the most important and a necessary prerequisite for a court to find an implied covenant to operate.  BVT Lebanon Shopping Center, Ltd., v. Wal-Mart Stores, Inc. No. 01-A-01-9710-CV00607, 1999 WL 236273 (Tenn.  Ct.  App. 1999).  A lessor must show disparity between the fixed minimum rent (i.e., the non-percentage rent component) and fair market value. 

Assuming that the first factor has been satisfied, courts considering the Lagrew factors look to the other five factors as additional indications of whether the parties intended for the tenant to be continuously operating, and therefore, an indication of whether an implied covenant exists.  These courts are more likely to find an implied covenant to operate if, in the analysis of these factors, the court finds the existence of (a) high percentage-rent payments, (b) a long lease term, (c) significant restrictions on a tenant’s ability to sublease, (d) significant restrictions on a tenant’s ability to remove its fixtures, and (e) the presence of a non-competition covenant.  However, these courts have not found it mandatory that all of these factors must be satisfied to find the existence of an implied covenant to operate continuously.

Note, however, that in general, implied covenants in leases are not favored under the laws of most states.  Rothe v. Refco D.S., Inc., 148 F.3d 672 (7th Cir. 1998).  Although some courts have found tenants to be subject to implied covenants to operate continuously in certain circumstances, such as the Lagrew case, many courts have not found implied covenants to operate continuously to exist.  See Scot Properties, Ltd. v. Wal-Mart Stores, Inc., 138 F.3d 571 (5th Cir. 1998); Oklahoma Plaza Investors v. Wal-Mart Stores, Inc., 155 F.3d 1179 (10th Cir. 1998).  The facts and circumstances of each situation need to be examined in connection with applicable state law.

Conclusion

If a landlord believes that it is essential for its tenant to operate continuously, then an express operating covenant should be negotiated and included in the lease.  This clause can have a major impact on both parties over the course of a lease term, so it is important that all relevant issues are addressed during the negotiation and drafting of the lease.  If a landlord does not include an express covenant to operate continuously in situations where it is appropriate, then the landlord does so at its own peril.  Although some courts have recognized implied covenants to operate continuously in certain instances, implied covenants are generally not favored.

Mr. Murphy is a Partner in our Chicago office.  He can be reached at 312-578-6571 or at mmurphy@hklaw.com.