What’s So Gross About Sales?

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If the term “Gross Sales” had an intuitive meaning, we wouldn’t have had grist for today’s mill. And, thousands and thousands of us wouldn’t have the opportunity to write our own definition for that term. What a sad world that would make!

Percentage rent provisions are common and almost always rely on the starting concept of “gross rent.” But, while “gross rent” might have a generally understood meaning outside of the leasing community, that certainly isn’t the case inside the leasing community. If it had a common meaning, it would be an undefined term just as are most of the words and terms found in leases (and other agreements). Just think of this: we don’t define every word in our agreements (such as leases and mortgages); we rely on common understanding. That’s true even where words succumb to a choice of definitions. In those cases, many as they are, we understand those words and phrases in the context where found.

We’re not talking about “gross sales” as the number to which the “percentage” is applied because, at the end of the day, no one applies the “percentage” to “gross sales.” We apply it to an “adjusted” sales figure. Wherever we start as “gross,” you can be sure you’ll find a list of deductions or exclusions. These are two different “don’t count these” concepts, though, at the end of the day, their effect is the same. The “number” against which the “percentage” is applied is reduced by deductions and exclusions.

Some items found on a typical list are somewhat curious. For example, are sales taxes ever part of a store’s sales? Aren’t they monies collected by the store as the government’s agent? Another example is the exchange of merchandise between stores. How is that different from buying inventory or returning inventory? Nonetheless, Ruminations has to concede that these “exclusions” and others like them are necessary. That’s because our leasing industry has made them so. With almost every lease, if not all leases, with percentage rent provisions including these (and similar) items as “exclusions, it could lead people to the “wrong” conclusion that such items would be included in gross sales if they were left out of a particular lease. That’s too bad, but that train left the station a long time ago.

Another category of exclusions are “low or no margin” items, ones where paying percentage rent on their sales revenue would be too large a part of the store’s profit margin. An example might be the revenue received from the sale of lottery tickets. The typical sales commission for a lottery ticket is 5% (plus periodic “promotional” commissions). If a lottery ticket selling tenant had to pay percentage rent of 3%, its landlord would make more on the sale of a lottery ticket than would the tenant. Similar items to be excluded from gross sales might be heavily discounted sales to employees or to charities. Other exclusions might be items for which the law prohibits “sharing” such as medical services or tobacco or liquor. Those “restrictions” vary state by state, and should be investigated in each instance.

Whether and to what extent gross sales should include “sales” made at the store itself but delivered elsewhere, such as at another store, will be left for a later blog posting. Similarly, whether the revenue from merchandise sold elsewhere but picked up at the store with a percentage rent clause should be included in gross sales will be left for later. The whole subject of “internet” and similar sales will be tackled by Ruminations, but not today.

Today, we’re going to demonstrate why those of us who write leases need to understand how “business” works. We all need to internalize that what we put down in words has to be understood and applied by others. Our job is to write agreements where both parties share a common understanding of what the agreements mean. Failing to do so leaves room for mischief, hard feelings, losers, and winners. Ultimately, if parties don’t reach a settlement or common understanding, courts will impose a solution on those parties, sometimes wisely, sometimes not.

Today, we’ll tell the story of how one court reached what Ruminations believes is the right result – the one that those who wrote the “lease” should have aimed for. In our view, the California Court of Appeal in Ralphs Grocery Company v. Midtown Shopping Center Associates better understood how the concept of “gross sales” should work than did the leasing professionals who created the basis for the dispute in the first place. [To see the court’s opinion, click HERE.]

The core of the dispute in the cited case was the way the lease defined “gross sales.” Though not a common approach, it is one we’ve seen many times. Instead of understanding that “gross sales” is akin to “revenue,” the definition quoted in this June 17, 2015 decision by the court was:

“Gross sales” is “the amount of the sales price, whether or not for cash or upon credit, of all merchandise, goods and the charges for services sold on or delivered from” the rented property.

[For the few readers who may wonder why a landlord and tenant might work the definition of “gross sales” into a lease, here’s why. Many leases require rent to include or be based upon some percentage of the tenant’s “gross sales.” So, if that percentage were 2% (by way of example), a tenant might pay its landlord $20 out of every $1,000 of sales proceeds from the store. That might start at dollar zero, or more commonly be based on every dollar of sales that exceeds some threshold (usually called a “breakpoint.”)]

If you’ve been in the “business” for more than a day or two, you know the “action” in a percentage lease provision is in its exclusions – the list of items that will be deducted or excluded from “gross sales.” But, if you don’t focus on the overriding definition: “sales price” vs. “revenue,” you can’t write or understand those lists.

In the case of the lease reviewed by this California court, that list enumerated items that would either be “exclude[d] or ‘deducte[d]” from the “sales price.” Pay careful attention because “excluded” and “deducted” are not synonymous. They are found in the same neighborhood, but they are different houses.

The lease included these items on its “list” of items that were to be excluded or deducted: “sales taxes, deposits on returned items, amounts refunded or credited to customers for defective items (as well as credits received from such items’ manufacturers), sales from other stores, interest and credit charges imposed upon customers, sales from lottery tickets and coin operated devices, sales of trade fixtures and equipment, bulk sales of inventory, and sales of crates and butcher scraps to other commercial users.”

Also to be excluded from “gross sales” were certain discounts given to employees or to charitable organizations as well as the cost of trading stamps (because they were, in effect, a discount). Similarly, if a customer received a “premium or gift” based on the customer’s total purchase, the cost of that item (effectively, a discount) was deductible from the “sales price.” Another example of a “deduction” from the sales price was the value of “money-off coupons and vendor coupons.”

We’ll hold the “best,” i.e., the deduction or exclusion faced by the court, for a little later.

At this time, take a break and look at the definition this lease used for “gross sales” and think about the “whys and hows” of the agreed-upon deductions and exclusions. How would you figure out the “gross sales” during any measuring period, especially if this were 1993 when the lease was signed?

Well, the tenant took a pretty simple and common approach. Basically, it reported its net register sales. It reported what it received at the register (excluding items to be omitted, such as lottery tickets). It didn’t figure out the “sales price” of everything that passed over its check-out lines and then deduct or exclude all of the items that the lease called to be deducted or excluded.

Would the store’s “gross sales” have been different had the tenant started with the “sales prices” of what customers carried through the check-outs? Well, that’s where the landlord and tenant got into their brouhaha.

Here’s the deduction or exclusion we’ve been hiding: “the net amount of any discounts allowed to any charitable institution or organization, or allowed to any customer pursuant to any customary and reasonable policy adopted by [the tenant].”

It seems that four years after the lease was signed, the tenant “created a ‘Rewards’ program to encourage (and reward) repeat customers. Under this program, [the tenant] charge[d] two prices for certain items of merchandise: (1) a higher price paid by customers who [did] not participate in the Rewards program; and (2) a lower price paid by customers who sign[ed] up for and participate in the program (Rewards customers). Which items are dual-priced varie[d] from week to week? To drive home the savings for being a Rewards customer, the paper receipts generated at the check-out stand detail[ed] what Rewards customers would have been charged without the Rewards program discounts and calculate[d] their resulting “savings.” The program [was] quite successful: Transactions by [the tenant’s] customers account[ed] for 97 percent of all transactions at [the tenant’s store].

So, the tenant had actually kept track of the sales prices of those items passing by its registers and kept track of what its “Rewards” customers actually paid. Eventually, this fact was realized by the landlord and that’s what brought the lease and its definition of “gross sales” to the court’s attention. The landlord argued that it tenant should have been reporting the sales prices and treating the “price breaks” for its Rewards customers as the cost of doing business. The lower court agreed. You might not agree. We may not agree. But, a person who “counts” did agree. This wasn’t “theory.” It was a $260,000 dispute.

In reaching its conclusion, the lower court reasoned that “[t]he only ordinary and popular understanding of [“gross sales”] must start with the prices [the tenant’s] products [were] listed for sale for all of its customers before any discounts are applied, including the loyalty club discount.” It found that “the Rewards program did not fit within any of the Lease’s exclusions or deductions from ‘gross sales’: The Rewards program did not involve “money-off coupons,” and did not qualify as a discount pursuant to a ‘customary and reasonable policy’ because the Rewards program did not exist when the Lease was signed in 1993 and because no expert testified that such programs were [then] ‘customary’ in the supermarket industry.”

Fortunately for the tenant, the California Court of Appeals disagreed with the lower court (and, thus, with the landlord’s position).

Loyal readers of Ruminations have heard this before: In reaching its conclusion, the appellate court insisted, “[W]e must ‘consider the contract as a whole and interpret the language in context, rather than interpret a provision in isolation,” and must use the ‘ordinary and popular sense’ of words ‘unless the words are used in a technical sense or a special meaning is given to them by usage.’”

With that as its starting point, the appellate court (very wisely, in Ruminations’ view) applied common sense in saying:

“The “reasonable, fair and just” definition of “gross sales” is the one that looks to the amount [the tenant] actually charges its Rewards customers for merchandise, rather than the hypothetical amount [the tenant] opts not to the charge them. Three reasons support this conclusion. First, this definition is more consistent with the terms of the Lease. The Lease’s definition of “gross sales” and its enumerated “exclusions and deductions,” when read together [emphasis by Ruminations] uniformly look to what money [the tenant] actually collected and retained when selling merchandise to its retail customers. At no point does the Lease base “gross sales” on what [the tenant] could have charged, but elected not to charge, for merchandise. Second, keying “gross sales” to the amounts actually received by [the tenant] is more consistent with the purpose of generic and standardized percentage rental provisions like the one in the Lease. Percentage rent provisions ordinarily serve two functions: (1) they allow the landlord to share in the tenant’s commercial success; and (2) they grant the tenant some economic peace of mind by linking any increase in rent to an increase in business revenue. … When “gross sales” relies on the amounts actually collected and retained by the tenant, the landlord is able to share in that increased revenue and the tenant is given its economic security. But if “gross sales” is keyed to amount that could have been—but was not—charged, then the landlord’s entitlement to rent is keyed to a hypothetical number not related to actual increases in revenue. This outcome permits the landlord to get more rent even when the tenant is not enjoying greater revenues and simultaneously sacrifices the tenant’s peace of mind because its exposure to higher rent is no longer contingent upon higher revenue. Third, defining “gross sales” and “sales price” in [this] lease to mean the amount of money actually collected and retained by [the tenant] is more consistent with the cases interpreting those terms. In the context of percentage rent leases, the terms “gross sales” and “sales price” have consistently been interpreted to refer to the money the tenant “actually received.”

The same is true in analogous situations. The Rewards program operates like a trade discount insofar as it is akin to a ‘device used by manufacturers to offer a reduced price to certain customers.’ … As pertinent here, trade discounts are viewed as reducing the “sales price” and reducing “gross sales.” … The Rewards program alternatively functions like a tax insofar as it is keyed to revenue. Tax law looks to what is actually collected and retained. … In interpreting federal tax law, … ruled that “gross sales” under federal tax law “must be based on the actual price or consideration for which the property was sold, and not on some greater price for which it possibly should have been, but was not, sold.” … This rule “has the obvious merit of reflecting economic reality” because “[t]he seller would make no sale at the list price; only at the net price can he attract the customer. The net price is the true consideration, regardless of the parties’ bookkeeping hypocrisies.” … The trial court’s ruling that the hypothetical “list” price was “[t]he only ordinary and popular understanding of” “gross sales” did not consider any of the arguments outlined above, and cited no legal authority or portion of the trial record for support.

Does it strike anyone else that this California Court better understood the reasoning behind percentage rent and its use of “gross sales” than did those who negotiated and drafted the lease? Keep in mind that this was a supermarket lease and that almost certainly means that experienced leasing attorneys or other leasing professionals crafted it. Yet, those who worked on the lease failed to “think it through.” Undoubtedly, the same set of “rules” for determining “gross sales” appears in many similar leases. And, it is very, very likely that other landlords intuitively understood that “sales price” didn’t mean what appeared on the “price tag,” but meant the actual price each item sold for. Why, however, should that even be a question?

We are chosen to memorialize the “deal.” In doing so, our obligation is to understand how “business” works. Generalized schooling doesn’t do that. Asking questions does. Attending industry programs does. Reading industry periodicals does. Listening to the “other side” does. Let’s stop being as smug as to think that no one knows more than we do. Movie theaters need a different set of exclusions or deductions than would be found in a department store’s lease. Supermarkets get revenue from slotting fees; pizzeria owners don’t even know what they are.

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