Thursday, July 17, 2008

Replacement Tenants and Remedies in Co-tenancy Clauses

An important aspect of a co-tenancy clause can be the types of replacement tenants that are deemed satisfactory to a tenant if the initial co-tenant ceases operations, particularly if the co-tenant has the right to cease operations under its lease, or is not otherwise bound by an operating covenant. A landlord that does not have the express right to replace co-tenants can be in an untenable position if a named co-tenant, or the co-tenant in a required category goes bankrupt or otherwise ceases operating, and often the specific named co-tenant is less important to a tenant than having a quality retailer that will continue to draw foot traffic into the shopping center. The replacement tenant concept is most likely to be acceptable to a tenant in an ongoing co-tenancy clause; tenants, as business people, generally understand that the landlord cannot control a tenant’s business model and can’t prevent a tenant from going dark or bankrupt. As the goal of a co-tenancy clause is mainly to keep the tenant in an active center, a replacement retailer bringing in comparable foot traffic should be acceptable. A clothing store co-tenant should be easily replaceable with an alternate clothing store of similar quality. With respect to a named co-tenant, the acceptable replacement co-tenants may not be in the same general category. A landlord would not want to be bound to replace a co-tenant Lowe’s only with Home Depot as the business reasons causing the first tenant to close will often be applicable to another retailer with such a similar concept. Instead, particularly with ‘big box’ tenants, landlords try to negotiate the right to break up large spaces and replace co-tenants with general categories like “national retailers” so that a Lowe’s can be replaced by 3 or more 20,000 square foot national retailers in any category.
With respect to remedies for co-tenancy failures, the standard ones are alternate rent and termination remedies. The loss of a co-tenant typically has an economic impact on the tenant so some adjustment or abatement of the tenant’s rent is the most direct way to compensate for the loss. A co-tenancy failure will often have more of an impact over time, so it is not unusual for there to be a ‘grace period’ before an alternate rent would be payable. This gives the landlord some time to exercise any remedies available against the co-tenant causing the failure and/or to seek a replacement co-tenant and mitigate the effect of the failure. An alternate rent remedy may allow a tenant to reduce base rent by a certain percentage, or to pay a percentage of gross sales in lieu of base rent during the continuance of the co-tenancy failure. In some cases, particularly if a co-tenancy failure continues for an extended period of time, a tenant may negotiate full rent abatement as a remedy. Landlords may require a tenant to show that the co-tenancy failure caused an economic impact by comparing gross sales prior to the failure to gross sales after the failure. Tenants generally resist such requirements. Whatever alternate rent structure is agreed upon, landlords often insist that a tenant continue to pay any CAM charges or bill backs for services that are owed as the tenant will still be taking advantage of shopping center services. If a co-tenancy failure continues for an extended period of time, tenants will argue that the business deal has changed substantially and it should have the right to terminate its lease. This is often the ultimate remedy on an escalating scale of remedies over the course of the co-tenancy failure. The tenant has had the opportunity to operate during the co-tenancy failure and can generally judge whether the impact has been great enough to require an exit from the center. In most cases, the landlord will want the tenant to exercise its termination right as soon as it has accrued, or waive it - a thirty (30) day window to exercise such a right is typical. If the co-tenancy failure has been ongoing for some months, the tenant has had time to evaluate the economic impact, and if the tenant elects not to exercise a termination right, the tenant has presumably determined that the location remains profitable. Under this theory, the landlord will require a tenant to revert to full rent if a termination right is waived. Similarly, if the tenant exercises a renewal option during a co-tenancy failure, a co-tenancy clause may deem that exercise a waiver of any remedies for the failure.

Sample Co-Tenancy Clause

-Connie Simmons Taylor
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