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LEASE LANGUAGE: Operating covenants

An operating covenant is an agreement by the tenant to continuously operate its store for a set number of months or years and for a designated number of hours and days each week. Such covenants frequently appear in leases containing a percentage rent clause designed to ensure the tenant's sales are maximized. Because of the economic interdependence of stores in strip centers and/or malls, operating covenants are important to both the landlord and the various tenants as a means of maximizing traffic flow.

An anchor tenant and a tenant occupying an in-line store frequently fare differently in negotiations concerning operating covenants. The anchor tenant typically flexes its bargaining power and insists it retain a right to “go dark.” The landlord will argue that at a minimum, a limited operating covenant must be granted so the landlord can meet its co-tenancy and/or financing requirements. The anchor tenant may in turn offer a covenant to open, provided the corollary co-tenancy requirements contained in the lease have been met, and may also agree to continuously operate for a limited time. The tenant occupying the in-line store is rarely blessed with the same leverage and frequently is required to capitulate to the operating covenant.

A poorly drafted operating covenant can give rise to litigation between landlord and tenant. For instance, if a tenant agrees to “continuously operate,” is it incumbent on the tenant to fully stock and staff the store? From the landlord's perspective, percentage rents and economic synergies in the center will not be maximized if the tenant operates at less than full capacity. The tenant needs to review the days and hours of operation and insist the clause only apply if a significant percentage of the tenants in the center are similarly obligated. A tenant agreeing to an operating covenant must be careful to negotiate for “excused periods,” which are exceptions to the covenant. Typical exceptions include events of casualty or condemnation, and down time the tenant will need to renovate or remodel.

If a tenant successfully negotiates for the right to “go dark,” the landlord will insist the tenant nevertheless be obligated to fulfill all of its monetary obligations under the lease. Further, the landlord will frequently require the tenant to keep the store lighted during all hours the center is open and/or maintain appropriate decorative window coverings. In addition, as a quid pro quo to allowing the store closure, the landlord will often retain a right to recapture the space. Of course, the tenant will want to ensure the recapture right in no way conflicts with the excused periods during which the tenant is permitted to close. In addition, the tenant will often ask for the right to resume operations within a specified period of time after the tenant's receipt of the landlord's recapture notice.

If a tenant breaches an operating covenant, the landlord's remedy is typically limited to monetary damages. Courts are loath to compel the tenant to continue to operate, because of the burden of monitoring the tenant's compliance with the continuous operations covenant. To avoid uncertainty about the outcome of the remedies available for a breach of the covenant, the parties can stipulate in the lease to a liquidated damages provision; for example, double rent. A tenant should be concerned if it fails to limit its damages, because, in addition to seeking recovery of loss of percentage rent, a landlord could conceivably make a claim for diminution in the value of the shopping center resulting from the loss of traffic attributable to the tenant's store.

If a tenant negotiates out the continuous operation covenant, they must be careful other provisions of the lease cannot be construed to create an implied operating covenant. To avoid the implication of an implied covenant, the tenant should expressly negate the continuous obligation to operate.

Jeffrey A. Leonard is a member of Cozen and O'Connor and chairs its real estate department. He works from the firm's Philadelphia office.

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