Daily Development for Thursday, March 10, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

LANDLORD/TENANT; COMMERCIAL; CONTINUOUS OPERATION; IMPLIED COVENANT OF CONTINUOUS OPERATION: Tenant  that “goes dark aggressively” may not be “ nice,” but is not in violation of implied covenant of good faith and fair deal; nor is there any implied operating covenant when there is no percentage rent, free assignability, and tenant built the building itself.

Oakwood Village, LLC, v. Abertsons Inc., 104 P.3d 1226 (Utah 2004)

Tenant, a grocery store operator, paid a ground rent of $1777 a month for a large plot in a shopping center, where it constructed a grocery store.  The lease term was for 25 years with eight five  year renewals.  The lease was net of taxes and provided no escalators in rent over the 65 year potential term.  There is no indication whether  there was a CAM charge, although one assumes that there was.  There were 26 stores in the center, and Albertsons was the “anchor tenant.”

The lease had a “noncompete” clause protecting Albertsons.

The lease was assigned to what was apparently a holding company, and Albertsons remains liable on the lease and the store remained an Albertsons.  Twenty one years into the lease, the Albertsons store “got a better offer” from a nearby center and “went dark,” continuing to pay rent and relocating about a block away.

The landlord argued that, despite the fact that  there was no percentage rental, Albertsons implicity agreed to operate continuously because of the long term, the nominal rent, the noncompete protection, and the language of the development agreement stating that Albertsons will participate with Oakwood in the development of the center "as an integrated retail sales complex for the mutual benefit of all real property in the Shopping Center"; and  the references in the lease to Albertsons "supermarket and other similar retail uses" and "proposed retail facilities." It noted that there are a number of cases imposing a duty on the tenant to support the “economic interdependency” that was the genesis of the original deal that gave the tenant such a great opportunity in the first place.  The tenant got space at an attractive rate because of the fact that the landlord and landlord’s other tenants clear depended upon the tenant’s operation as an anchor in order to make their own businesses succeed.

The court, however, was not impressed, noting that the vast majority of the cases in which implied operating covenants have been found have involved percentage leases. Because a percentage-rent clause is "virtually universal" in shopping centers leases (citing Friedman on Leases), the conspicuous absence of the provision from the lease at issue strongly suggests that the parties never intended the lease to bind Albertsons to operating a grocery store continuously at Oakwood Village.  Even stronger evidence lay in the fact that the lease expressly granted wide latitude to the tenant as to the use of the leased premises.  The lease stated that the tenant could use property leased in the center "to permit the construction and operation of retail facilities and parking on the Leased Premises, including supermarkets, drug and variety stores, or combinations thereof, and other similar retail uses, without conditions thereto which in Tenant's reasonable opinion would cause construction and operation to be uneconomical."  Further, the lease provided unlimited assignment and subletting rights.

The court also noted the absence of any language giving the landlord a remedy if the tenant should “vacate.”  Such language occasionally has formed the basis of a right for a landlord remedy when a tenant “goes dark.” 

The court also was convinced by Albertsons’  arguments that the lease didn’t even really require that it initially build a building at all, and certainly didn’t require it to rebuild in the event the building was constructed. 

Perhaps a more significant problem for the Tenant was the argument that going dark and “freezing” the space to prevent competition was a breach of the implied warranty of good faith and fair dealing.  Typically, this argument avails when a tenant has a series of contractual options.  The landlord argued that the tenant, had the options to operate a grocery store, assign to another grocery store, or simply to vacate, and chose the third option in bad faith.  Either of the other options would have been more consistent with the overall business objectives of the original lease.

The landlord had a valuable weapon, it thought, in an earlier Utah case, Olympus Hills Shopping Ctr. v. Smith's Food & Drug Ctrs., 889 P.2d 445, 457 n.13 (Utah 1994) (the DIRT DD 5/25/95), where the court upheld a jury’s conclusion that a tenant had a duty choosing a sublessee that would be beneficial to the landlord’s business.  Olympus Hills involved a lease between a developer and a Smith's grocery store, which contained an express covenant of continuous operation that obliged Smith's to continuously operate "any lawful retail selling business." Rather than defaulting on the lease, Smith's opened a warehouse box store in order to restrict competition with another grocery store it operated close to the Olympus Hills Shopping Center. Olympus Hills thereafter sued Smith's, claiming that Smith's had violated the covenant of good faith and fair dealing. On appeal, the Olympus Hills court concluded that the jury had properly found that the circumstances and purpose of Smith's temporary closure had been inconsistent with the parties' justified expectations of continuous operation and was, in effect, a breach of its contractual rights.

The court disagreed with the landlord that  the decision in Olympus Hills supported its claim. It concluded that Smith's operation of a warehouse box store was deemed a breach of contract because the lease contained an express covenant of continuous operation and a restriction on the nature of operations. Here, Albertsons lease contains neither a restrictive use nor a continuous operation provision and further grants Albertsons an unqualified right to sublet or assign its lease.

Comment: The editor thought Olympus Hills was incorrectly decided, and is happy to see it minimized here.  But the editor does believe that the Olymputs case is more difficult to distinguish than the court suggests.  Since the current case is from Utah’s highest court, the editor believes that the lower appeals court decision in Olympus likely has been discredited - which is a good thing.

Comment 2: The Friedman text will soon be amended to delete the statement that percentage lease clauses are “virtually universal” in shopping centers leases.  They’re certainly common, but all manner of alternate devices are used, and have been used, to lure anchor tenants in the hope that the tenants will remain and draw customers and beef up percentage rents for the balance of the center’s stores. 

But the landlord gives these incentives in order to appeal to the potential anchor tenant’s best economic interests.  It certainly is true that continuous operating covenants are quite common in shopping center lease, and virtually every shopping center landlord is well aware that it is an option it should seek if it can get it.  It the lease is silent, it is virtually impossible to conclude that the parties really intended such a covenant and forgot to include it.  Most authorities suggest that for the court to infer the existence of an operating covenant, this must be the basis. 

Comment 3:    But the editor must confess that the emphasis on the existence of a percentage rent clause as the basis for an implied operating covenant is somewhat misplaced.  A careful study of the cases, which the editor has undertaken, has convinced him that the real bone of contention in most cases involving implied operating covenants is in fact the question of the tenant’s continued presence, not the tenant’s continued generation of percentage rents.  In fact, in a few cases, the courts anomalously have based the finding of the operating covenant on the existence of the percentage rent clause, and then have awarded damages based upon diminution in the value of the center.  See, e.g., BVT Lebanon Shopping Ctr., Ltd. V. WalMart Stores, Inc., 48 S.W.2d 132 (Tenn. 2001).  (A decision the editor views as perfectly awful - holding, similar to Olympus that even an absolute right to assign had to be exercised - by implication -  in a way to generate percentage rents at the level “intended” under the original deal.)

In this case, although there was no percentage rent clause, the landlord virtually gave away the land by agreeing to a sixty five year term with no escalators at a relatively small rent.  Obviously it expected something from that.  This argument is very similar to those cases in which the tenant is given a favorable base rent with a percentage understanding.  Of course, the landlord expects something from it.  But this doesn’t mean that what the landlord expects should be turned into a contract obligation of the tenant when the landlord was unable to secure such a promise to begin with. 

Comment 4: The “good faith and fair dealing” argument is more insidious for tenants.  Does it mean, really, that the tenant has to make its business decisions with any business player in mind than itself?  Is this really how our market system is intended to work?  Here’s some useful language from the court on this issue.  (Useful for tenants, anyway):

Although we acknowledge the "dog in the manger" position that Albertsons has taken, we cannot conclude that the parties' agreement warrants finding for Oakwood. What Albertsons did may not have been nice, but its conduct in vacating the leased premises while continuing to pay rent in order to restrict competition with its new store was not unlawful under the lease.”