Daily Development for
Thursday, April 9, 1998

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

Today's Daily Development is an essay on recent developments in the area of implied covenants on continuous operation. There have been hundreds of appellate decisions on this issue over the years. Although it is fair to say that the results in many cases are driven by specific facts before those courts, there clearly are issues of law and predispositions of theory that have a major impact on outcome.

The editor has studied at least the vast majority of appellate cases on this issue, and ventures a guess that the trend of cases favoring the tenants' position versus those favoring the landlords' position is about 3 to 1.

Yesterday's DD on "going dark aggressively," of course, identifies a special case, where tenants must be cautious not to invite judicial hostility for overreaching conduct. But where a tenant simply elects to shut down its location, even when it relocates nearby, even when the tenant pays percentage rent and even when the tenant is an anchor tenant, the courts usually do not find a breach of any implied duty to continuously operate. The primary consideration appears to be that the parties to these leases were "big boys" who certainly knew how to craft a continuous operation covenant, and should be be viewed as implicitly agreeing to one when the lease is silent.

Of course, landlords frequently argue that some other part of the lease - usually the "use clause" - imposes the duty of continuous operation. And they point to other aspects of the lease, such as a relatively low base rent, the fact that the landlord constructed the building when the tenant moved in, the fact that the landlord agreed to an "exclusive clause" or even a "radius restriction," and restrictions on assignment and subletting to militate for a construction of the use clause as an agreement for continuous operation. As indicated, however, they lose more often than they win.

The editor recently updated his survey of these cases (client's property, so can't share - sorry) and here reports some interesting recent cases. Three good tenant's results, one good landlord's result, and two interesting remedies cases, and one group of "crazy cases."

The editor also cautions that there has been a trend to take these cases to federal court, where federal district judges write and publish opinions that often are extremely strong in their language. Such opinions, however, are not necessarily as relevant for precedent as the conclusion of an appeals court panel, either state or federal.

I. Good Tenant's Results:

An important tenant's case is Rothe v. Revco D.S., Inc., 976 F.S. 784 (S.D. Ind. 1997). The tenant executed a renewal option and moved to a nearby location less than a year later. The tenant had generated substantial percentage rent over the years, was protected by a radius clause, and was limited in its sublet and assignment rights. The court found no implied duty to operate.

There are two important aspects to the opinion. On the issue, vital in many decisions, of whether the base rent was "substantial," the court said: "Although [Landlord] may be able to reasonably argue that the base rent was insubstantial, the issue of substantiality of the base rent may not be reached until the court has a need to construe the contract beyond the facial provisions." Knowledgeable tenant's lawyers will dance around the room when they read this.

In Hamilton West Development, Ltd. v. Hills Stores Co., 959 F.S. 434 (N.D. Ohio 1997), the lease provided that the tenant "agrees to use . . . Premises as a department store or a supermarket (and for no other purpose) and to operate its business in the Premises . . . on all regular business days except legal holidays, at least eight hours each day between 9:00 A.M. and 10:00 P.M. except for reasons beyond Tenant's control." The court held expressly that this language did not constitute a continuous operation covenant. The editor disagrees with the conclusion that this language, standing alone, did not express an understanding of an operating obligation; but the editor agrees with the conclusion that there could be no damages awarded in the case because the clause went on to say that in the event the tenant did violate this clause the landlord had the express right to terminate the lease.

Another good tenant's case, albeit involving an express covenant, is In re Ames Dept. Stores, Inc., 136 B.R. 357 (Bkrtcy. S.D. N.Y. 1992), where the court held that six month's down time while the tenant looked for an found an assignee was not a breach of an express continuous operation clause. The court stated this as an intepretation of the lease as well as an application of bankruptcy policy.

The court also discredited an important prior Indiana federal case, Mass Mutual v. Associated Dry Goods, 786 F.S. 1403 (N.D. Ind. 1992) - one of the strongest cases in the tenant's arsenal, since it ordered specific performance of an implied continuous operation clause for an anchor tenant in a major mall. The court points out that the Mass Mutual case no longer reflects Indiana law.

Note also that the injunction issued in the case was suspended on appeal. The Mass Mutual parties apparently settled pending appeal, so the injunction never went into effect.

A third good tenant's case, albeit involving an express covenant, is In re Ames Dept. Stores, Inc., 136 B.R. 357 (Bankr. S.D. N.Y. 1992), where the court held that six month's down time while the tenant looked for and found an assignee was not a breach of an express continuous operation clause. The court stated this as an intepretation of the lease as well as an application of bankruptcy policy.

II. Good Landlord's Case:

Lagrew v. Hooks-SupeRx, 905 F. Supp. 401 (E.D. Ky. 1995) is as close to a "slam dunk" as a landlord's lawyer is going to get. The landlord had good facts, as the tenant had renewed its lease on a dark premises and moved one mile away. Still, most of the "earmarks" weren't there. The base rent was a substantial element of the landlord's return throughout the lease, especially in recent years. Percentage rent had rarely been more than fifty percent of total rent. The tenant had a general right to sublet (subject to some exceptions) and there was no exclusive use protection, factors which usually are associated with no operating duty. Further, the tenant did offer to sublet, but to a "discounter," which landlord rejected, pursuant to a specific right in the lease.

The court cited the "six factors test" that some courts have used to analyze whether there is an implied operating covenant, and purported to apply it, but began with the "presumption" that the parties did intend an operating duty simply because they elected to use a percentage rent formula. Percentage rent, according to this court, is the landlord's "hedge against inflation."

In light of this presumption, the court could quite handily brush aside those inconvenient aspects of the six factors that don't contribute to the court's foregone conclusion that the tenant gets wiped out here, such as the tenant's right to sublet, that there was no exclusive use protection, and that there was no language in the lease itself that suggested the parties intended to impose such a burden on the tenant. Congratulations to the landlord's lawyers here, who apparently persuaded this court that most all long term percentage leases reflect an intent of the parties that the tenant has a continuous operation duty. If only you could bottle that and sell it!!!

III. Remedies cases:

A. "Fair Market Value" Damages:

Several recent decisions have determined, sometimes even regardless of an implied operating covenant, there exists an implied covenant to pay fair rent.

One case in which this seemed an intelligent compromise result was Pequot SpringWater Co. v. Brunele, 698 A.2d 920 (Conn. App. 1997), where a long term lease provided for rent of a spring and bottling facility based upon the amount of water bottled. Tenant sold out to a competitor and closed the plant. The court concluded that the parties, who provided for no minimum rent, intended that the tenant pay a minimum rent for the premises, and remanded for a determination of that rent.

Although this makes some sense where there is no minimum rent at all, what about when the parties do provide for a "base rent" against a percentage? In Lagrew v. Hooks-SupeRx, 905 F.S. 401 (E.D. Ky. 1995), the court found that there was an implied duty of continuous operation, but that the tenant had not and likely would not have generated much percentage rent. The tenant "went dark aggressively," in the court's view - renewing the lease on the dark space to suppress competition. The court held that, if the tenant's continued operation in the space would have been uneconomic, it might not have awarded an injunction that the tenant reopen, had the landlord sought that remedy. But it did hold that the landlord had the right to terminate the lease to reclaim the space and to recover, for the time between tenant's vacation and the landlord's cancellation, rent at the fair rental value rather than just the base rent.

B. "Value of the Center" Cases:

Most retail leasing mavens are familiar with Hornwood v. Smith's Food King No. 1, 772 P.2d 1284 (Nev. 1989) where the court held that a landlord could show that a tenant's breach of an express or implied operating covenant could result in a damages recovery based upon the loss in value of the shopping center, not just for injury to the leased premises or loss of rent from that premises.

Tenant's lawyers have been hoping this case would just go away. But now we have Pleasant Valley Promenade v. Lechmere, Inc., 464 S.E. 2d 47 (N.C. App. 1995), where the court followed the lead of Hornwood and permitted a special damages recovery for loss of value to the center in addition to a recovery for lost rent. The trial jury had awarded the landlord $8 million in damages, but the appeals court, although it upheld the remedy theory, reversed and remanded because the trial court had not treated the damages claim as special damages, as opposed to general damages, and had not ruled whether the landlord had adequately pleaded them as a separate element of damages.

III. "Crazy Case:"

In TOC Retail, Inv. v. Gulf Coast Oil Co., 886 F.S. 1306, 893 F.S. 622 (E.D. La. 1995), the lease provided that the premises would be used for a service station, storage of petroleum products, "and at lessee's option for the conduct of any other lawful business thereon." A casino was built nearby, and the tenant tore down the old service station buildings and built a lighted parking lot. The landlord objected (perhaps because the landlord saw its own opportunity to lease to the casino), that the tenant's actions were inconsistent with its lease obligations. It pointed out that the landlord was to get the buildings when the lease ended, even though the tenant had the right under the lease to raze the existing buildings "for purpose of constructing more modern improvements at Lessee's sole expense." This, the landlord suggested, demonstrated that the tenant was supposed to operate some sort of retail establishment using buildings (the editor assumes). The tenant responded that the construction of the lighted parking lot constituted an "improvement" under the circumstances, and that it had the right under the lease to conduct any business it wanted.

Held: Notwithstanding a general permission in a lease for the tenant to do anything it wants, there is an implicit limitation that the tenant must conduct a use "similar or related to the general scope of the described use" in the lease. The parking lot wasn't similar enough to a gas station. Tenant in breach.


Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 16, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Stacy Woodward at the ABA. (312) 988 5260 or woodwars@staff.abanet.org

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