What Should A Landlord Carve Out From A Tenant Exclusive?

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Don’t expect cut and paste clauses today because we’re only going to do some conceptualizing. Once it is settled that a tenant will get the benefit of an exclusive use right, its landlord needs to make sure that its own ability to make a living isn’t imperiled. We’re not going to discuss whether landlords should grant exclusive use rights because sometimes that just what needs to be done to get the rent for an otherwise empty space.

To all get on the same page, let’s try to agree that the legitimate objective of an exclusive use right is to protect a tenant’s core business (i.e., the reason its customers come to the store in the first place) against cannibalization from competing tenants at the same property whose customers come to the property, in part, because the very same “protected” tenant is at the property. Tenants with sufficient bargaining power can stretch that protection to nearby properties owned by the landlord or by affiliates of the landlord, although the rationale is a little weaker. Perhaps the strongest economic argument (or more likely, emotional argument) is that the protected tenant doesn’t want its landlord to use that tenant’s rent money to invest in nearby properties occupied by the “protected” tenant’s competitors. Ruminations may return to that subject in the future, but that’s the last you’ll read of “off-site” restrictions today.

Basically, a landlord has to be careful not to “overpromise.” It can’t let itself get in the position where the exclusive use right is violated by existing tenants who, under their own leases, are rightfully selling or displaying the “forbidden” goods or services. That’s not a full expression of the “problem,” so we’ll expand on that later. Also, landlords have to be careful not to get in a position where they can’t lease to a whole range of new tenants who, while not trampling over the “protected” tenant’s legitimate commercial interests, happen to sell a few items that fall within the “protected” tenant’s exclusive use rights. A non-controversial example might be based on an exclusive granted to a book store promising that no other occupant at the property will sell books. [We’re not going into the question of what, in the 21st century, a book might be.] Would a hair salon’s display and sale of a dozen books on hair styles really harm the bookstore?

Here’s what Ruminations is thinking. Landlords (and their to be “protected” tenants) should concentrate on these categories as the basis for exceptions or “carve-outs” to exclusive use rights:

Existing Occupants

Existing Leases

Specific Premises

Certain Types of Occupants

Certain Levels of Activity

As to “Existing Occupants,” whether under a lease or not, should (or can) the exclusive use right apply to them. This isn’t only a question of whether an existing tenant’s lease would otherwise permit sale or display of the “forbidden” goods or services. It includes whether the fact of a new lease to the “protected” tenant should change the landlord’s relationship with existing tenants. Also, should such occupants be permitted to have the “unfettered” ability to choose to sell (or not sell) the “forbidden” goods or services, even if they sign a new lease, expand their existing spaces or move to other spaces within the property? Think about the occupant (tenant) untethered from its existing lease (or about a month-to-month arrangement).

As to Existing Leases, if such a lease would permit the tenant thereunder to sell or display the “forbidden” goods or services, its landlord can’t allow itself to be in violation of the new “protected” tenant’s lease right out of the box. That is pretty obvious, although we’ve seen a fair share of leases that have overlooked that situation. In such cases, landlords have to look for court protection. Though the probability of getting a favorable court decision is reasonably high, the costs to get that ruling are also reasonably high. What is more, is that no one thinks about the countless settlements of such disputes that invariably cost the landlord money. Most likely, the reason this situation arises is because landlords looked at what their current tenants were actually selling or displaying (and usually not all that carefully), but didn’t look at what the existing leases will allow. Don’t fool yourselves; the problem doesn’t only arise out of “any lawful retail purpose” use clauses.

Even if a landlord carefully confirms that no existing tenant’s lease contains a permitted use clause that would allow the competing activity, would it also look at whether another lease provision, perhaps the assignment or subletting provision, allows a tenant to change its use with the landlord’s consent, often (by default or express language) with such consent not to be unreasonably withheld? Would it be unreasonable for a landlord to withhold its consent because it had later given away an exclusive use right to another, newer tenant? How would a court balance the equities between a landlord and its “old” tenant? Did the landlord breach its existing tenant’s reasonable expectations when it granted the exclusive use right now in controversy, when most other landlords would have preserved a prior tenant’s expectations under such circumstances? We won’t predict the outcome because of the uncertainty of result related to the particular facts in play and the jurisdiction involved, but we have no uncertainty about the cost of the litigation.

When we write about “existing leases,” we’re not talking about “existing tenants.” That’s because protecting an existing lease means protecting the rights of the named tenant and all of those who hold under that tenant, typically assignees and subtenants, but also concessionaires, licensees, and others so situated. To make that clear, the “carve-outs” might spell that out, if only to avoid later, unpleasant threats from the “protected” tenant.

With an existing lease, we also need to think about possible future amendments (including new leases disguised as “restated” leases). An amended lease is the same lease as before, only changed. “Protected” tenants need to be sure that the amendments don’t serve to defeat their legitimate expectations as to the “protection” they bargained for in the first place. For example, suppose the new “protected” tenant accepted the fact that an existing tenant had a significant business selling the “protected” product, but was willing to move into the property anyway knowing that the existing tenant would be leaving at the end of its lease, two years later. How happy would the “protected” tenant be if it discovered that an even stronger competitor would be moving into the existing tenant’s premises, not under a “new” lease, but under an amended and restated version of the existing tenant’s lease (the one with the “any lawful retail purpose” clause), the only remnant of the existing lease being a passing reference to its existence? Does every “replacement lease” need to indulge in the fiction of being an amended and restated lease? Essentially, the “protected” tenant would see an amended and restated lease saying: “the old lease is hereby amended by deleting all of its text and replacing that text with the following… .”

Further, what about expansions of space under the existing lease? How should the parties with the possible expansion of an existing tenant’s premises from 6,000 square feet to 21,000 square feet?

Clearly, if an existing lease gives its tenant the right to extend (or renew) the lease term, there isn’t anything a landlord can do to avoid such an extension or renewal. Or, is there? Landlords might want to specifically carve out such extensions (or renewals) from the “protected” tenant’s exclusive use right specifically to avoid the following kind of controversy. Imagine, and it shouldn’t be difficult to do so, that the existing tenant’s right to extend or renew its lease is conditioned on that tenant not being in default under its lease. Can the new “protected” tenant argue that the landlord should have rejected an attempted lease extension? You be the judge.

What about when the existing lease is at the end of its term with no additional renewals available as of right. Can the landlord agree to extend the lease term? You might counter that Ruminations has already raised this question when it wrote about lease amendments. Fair enough (maybe). But, what is the status of a holdover tenant? Does that existing tenant go from being covered under the “carve-out” to where it now violating the exclusive use right?

Dealing with carving out “Specific Premises” from the scope of a later-granted exclusive use clause implicates some of the same issues raised above when the existing lease is still in effect, but what about after the tenant under that existing lease moves out? Here’s an example. Suppose a nail salon signs a new lease with an exclusive use clause that recognizes the existence of an existing hair salon with two manicure work stations. If that existing hair salon closes and the landlord finds a replacement hair salon tenant, should that new tenant be allowed to have any manicure work stations? There is no easy answer because we don’t know how the negotiations over the exclusive use right handled that question. Did the nail salon move to the property despite the two manicure work stations because it didn’t consider them to be main stream competition, or did it expect to tolerate the competition until the existing hair salon eventually closed. In the real world, you’d see the original hair salon sold and the buyer negotiating a replacement lease with an extended term, additional renewal options, and other changes. Should this be treated any differently than amending the “old” tenant’s lease and then consenting to a lease assignment? Critical from the landlord’s point of view would be “how important is a hair salon” to the tenant mix at the property? Ruminations offers no answers, only questions. If, however, the answer is that any specific premises already housing a competitor may always house a competitor or may do so if there is no intervening non-competing tenant in that same space, then the “protected” tenant’s lease should say so. At least, that way, the landlord and its “protected” tenant won’t have to fight the amended and restated lease battle.

What about “Certain Types of Occupants”? An exclusive use right barring the sale of milk shouldn’t keep a landlord from subsequently leasing to a drug store or a restaurant or a supermarket. Readers can add to this list of examples. Yes, the carve-outs to a new tenant’s exclusive use rights should contemplate that certain kinds of tenants will be unaffected by the grant of those exclusive use rights. Basically, certain classes of tenants are both: (a) too important to a landlord to lose as potential occupants; and (b) really aren’t direct competitors of the “protected” tenant (in almost all cases). Basically, a “protected” tenant is getting the exclusive use right because it is “known” for that kind of goods or services and customers come to it for the breadth of its selection and expertise. If a general merchandise store is truly a “competitor,” then the “protected” store has no legitimate interest to be protected because lots and lots of merchants “all over town” are its competitors. What difference does it really make that the supermarket sells paperback books? Argue about the “over-broadness” of what we’ve just written, but then do yourself a favor and step back from your current set of clothes (and paycheck) and look at the forest. At a minimum, we think you’ll need to grant that Ruminations hasn’t gone over the deep end.

We’ve left the most commonly written carve-out for last – “Certain Levels of Activity.” This is commonly expressed as allowing an exception for “incidental sales,” however that might be defined. This concept would cover the hair salon that displays and sells a dozen hair styling books in the face of a bookstore’s exclusive use rights. It would allow for the infant apparel store to do the same. The concept is simple – if another store offers a narrow and limited range of competing products and such activity would really harm the “protected” tenant, the “protected” tenant isn’t unique enough in the customer’s eye to deserve protection. Potential customers have to want to shop at the “protected” tenant’s store, not be going there because it is owned by Hobson*.

Incidental sales can be defined by floor area limitations, by gross sales limitations (absolute dollar levels or, more commonly, as a percentage of total sales). Each approach has its benefits and limitations. One can limit the floor area of the displays themselves or (typically) you can count half of adjacent aisle space in a floor area limitation. In those cases where an exclusive use right covers more than a single group of related products, say raincoats and shoes, the “carve-out” might set separate limits for each category or might deal with them in the aggregate. Those are the theories. The devil being in the details, and with Ruminations declining, in this instance, to offer sample lease provisions, that’s all we’re going to say.

If we’ve left out any “conceptual” approaches, let us and our other readers know. If you’ve come across any really clever approaches, please do the same. Comments are best left by clicking the “leave a comment” link just above this blog entry.

                                                                        

* We’re told that Hobson owned a horse stable and, to buy from him, you had to accept “Hobson’s Choice.”

[We cite to Wikipedia]:

According to the Oxford English Dictionary, the first known written usage of this phrase is in The rustick’s alarm to the Rabbies, written by Samuel Fisher in 1660: “If in this Case there be no other (as the Proverb is) then Hobson’s choice…which is, chuse whether you will have this or none.”

It also appears in Joseph Addison’s paper The Spectator (14 October 1712); and in Thomas Ward’s 1688 poem “England’s Reformation”, not published until after Ward’s death. Ward wrote: “Where to elect there is but one, / ‘Tis Hobson’s choice—take that, or none.”

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Comments

  1. Ira, all good points. Regarding the pre-existing tenants, the concept I pursue is that the prior tenant’s rights, as they existed at the time that the lease with the exclusive holder was signed, will be respected. If the pre-existing lease is amended to (i) grant the prior tenant the right to engage in the protected use, or (ii) expand or enlarge the pre-existing tenant’s right to encroach into the protected use, including an expansion of the prior tenant’s space, then that tenant would be subject to the exclusive (or subject to exclusive to the extent of the enlargement, however that works). As to extensions, their lease rights would be honored if the prior tenant had an option to do so that was contained in the prior tenant’s lease at the time the lease with the exclusive holder was signed. If an exclusive holder only intended to tolerate the prior tenant’s existence until its lease expired, then the exclusive should say so, except as provided in the previous sentence. Some landlords try to preserve the exemption even when a altogether new tenant enters the picture who is engaged in the same use, arguing that the competitive climate has not changed. This rationale is not acceptable. It is the prior tenant’s lease rights that are being exempted, not the exemption of that use in perpetuity.

    As far as measuring an incidental carve-out, I find that use of a sales test is extremely hard to administer, although most exclusives are written this way. How does the tenant know when it has exceeded the permitted percentage until the lease year is over and then the total sales are determined (and the percentage incidental carve out is calculated). But by then it is too late isn’t it? And even if the tenant knew when it was about to hit the percentage threshold, what does it do then? Rip the merchandise out of the customer’s hands who is standing in line to pay and tell him to come back at the beginning of the next lease year? Your post is rich with other issues and it would take many more paragraphs to address them all.

  2. Jim Henegan says:

    When negotiating an exclusive I always ask the tenant “Who are you trying to exclude?”

    I try to draft the exclusive to exclude the type of entities that the Tenant is concerned about competing with them.

    The size of the competing tenant can be an issue. Most developers don’t want a small tenant to keep them from doing a deal with a large tenant. A “large tenant” could be anything from 15,000 to 60,000 minimum square feet.

    With restaurants, do you want a fast food or fast casual restaurant to keep out a sit down restaurant? How do you protect a restaurant who has a broad menu? I usually like to list examples of competing restauants that are prohibited and those that are permitted..

    You would not want an Italian restaurant to keep out a Cheesecake Factory that sells some Italian food. You would not want a take out Chinese restaurant to keep out a sit down restaurant., but what if the sit down restaurant has a take out business.

    If you limit the protection to primary business – How do you define “Primary Business”? Often it is percentage of sales. Sometimes it is number of linear feet of shelf space.

  3. I just discussed this issue today at length and we got majorly hung up on the LL remedies. The Tenant wanted three days free rent for every one day the exclusive was violated.. We suggested 50% rnet until cured up to one year.. then the tenant could terminate or go back to original rent. They would not accept this… has anyone any suggestions or experience? thanks!

    • Mark Mitchell says:

      Janet. What you have suggested is, in my experience, a reasonable tenant remedy for small to average size tenants, and is one that I often see agreed to by landlords and such tenants. When representing smaller retail tenant clients obtaining an exclusive and this remedy is proposed, I do attempt to obtain an extended period of time in which to potentially terminate the tenant’s lease after the rent reduction period has ended due to the expiration of the one year time period, and perhaps you might throw this out as a potential compromise, although a reasonable response to a request for such an extended time period before loss of the termination right is that the one year time period during which base rent has been reduced (presumably what you have suggested) is a reasonable time period for the tenant to determine if the effect on its business caused by the exclusive use violation is damaging enough to warrant exercising the termination right.

      Was your suggested remedy (i.e., rent reduction and potential termination right) the sole and exclusive remedies for the tenant in the event of an exclusive use violation? Also, does this remedy arise immediately upon any violation or does the landlord have to get notice of the violation and then have an opportunity to cure the violation? Depending on your answers to these questions (which I don’t need to know; just wanted you to consider them), there may be some more room to compromise with the potential tenant, although if this is not a tenant with much negotiating leverage, having the remedies you have suggested as the tenant’s sole and exclusive remedies for exclusive use violations is, as noted above, a reasonable approach and one that, in my opinion, the parties should agree to without much further negotiation.

      It probably goes without saying that what your prospective tenant has requested is quite “aggressive” and seems to me to be disproportionate to the actual damage to the tenant due to the exclusive use violation. It’s not just verbal jousting to suggest that a provision such as this may well have a negative impact on the landlord’s ability to sell or finance the property in the future. I know that if I represented an existing lender and a borrower submitted a lease with such a provision in it along with a request for non-disturbance rights, I would advise my client to condition the granting of such rights in the lender-prepared SNDA on this provision not being applicable post-foreclosure. That said, if a particular deal is attractive enough, this landlord would not be the first landlord to chose to agree to a potential remedy that is disproportionate to actual damage to a tenant, in which case the landlord’s attorney better be hyper-vigilant to proper exclusions to the exclusive (perhaps only an intentionally landlord-caused violation of the most important aspects of the tenant’s exclusive should warrant 100% or more rent reduction) and fight hard for ways for the landlord to protect itself from having this remedy arise.

    • Jim Henegan says:

      I think the question of damages should be related to the expected impact that the competitor has on the tenant who has the exclusive. If you bring in a direct competitor – say a second hair salon – the tenant has a real complaint with you.

      If you bring in a sit down Thai restaurant that violates an exclusive for Noodles and Co or Panda, maybe that isn’t such a big deal

      If your exclusive is drafted narrowly so that only a direct competitor can violate it, then I think you can be more generous with your remedies.

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