Contingencies and termination rights in retail leases

Economic realities change, businesses evolve and forces outside of the parties’ control can make a productive lease relationship impracticable or impossible

When parties enter into a retail lease, a line from the movie “Casablanca” might come to mind: “I think this is the beginning of a beautiful friendship.” Ideally, every lease strikes a reasonable balance between the interests of the landlord and the tenant, and lays the groundwork for a mutually beneficial relationship.

Things don’t always go according to plan, however. Economic realities change, businesses evolve and forces outside of the parties’ control can make a productive lease relationship impracticable or impossible. With that in mind, it’s important for both parties to expect the unexpected by incorporating certain contingencies and termination rights into a lease.

Opening and operating covenants

An opening covenant requires the tenant to open its store and operate for a specified minimum amount of time. The rationale is that if the tenant builds the space out, stocks goods and hires the employees needed to open the store, the landlord may be reasonably confident the tenant will continue to operate for some time.

An operating covenant, on the other hand, prohibits the tenant from closing its store for longer than a specified amount of time. These provisions protect the landlord should a tenant cease to operate, leaving a dark storefront in a shopping center that may deter shoppers.

Performance ‘kick-out’ rights

A performance termination, or “kick-out,” right is typically exercisable by the tenant, allowing termination of the lease if the store performs poorly. If the parties agree to incorporate a performance kick-out right, they must define what constitutes a “sale” and what level of sales will trigger the termination right.

The parties must also determine the “target period” during which sales should be measured. Since sales may start out slow and ramp up as the lease term progresses, parties should avoid setting a premature target period.

Permitting contingencies

Permitting contingencies give the parties a way out of the lease if they fail to obtain necessary approvals, such as building or operational permits. Failure to obtain such approvals could make it impossible for the parties to pursue or continue the operation they contemplated at the time of lease-signing.

If the parties agree to include permitting contingencies in a lease, they must clearly identify the party responsible for obtaining the permit in question, the timeframe for application, and the level of effort the party must expend in pursuing the permit.

Co-tenancy provisions

Under co-tenancy provisions, tenants are only required to open or operate if certain other tenants in the shopping center are also open and operating. This assures the tenant it won’t be the only store operating in an otherwise empty center.

If a landlord cannot meet the requirements of a co-tenancy provision within a specified amount of time, the tenant may have the right to pay reduced rent until the requirements are satisfied, or even terminate the lease. The landlord may wish to make this termination right mutual, so a single tenant cannot linger in a mostly empty center while paying reduced rent, preventing the landlord from putting the property to different use.

Recapture rights in connection with assignment or subletting

Assignment and subletting provisions are not explicit termination rights, but are often used by tenants seeking a way out. Assigning or subletting can be a good solution from both parties’ perspectives if the leasing dynamic or the tenants’ needs change over time.

However, landlords should consider adding a “recapture right” to the assignment and subletting provisions, giving them the right to terminate the lease and take the space back if a tenant notifies them that it intends to assign or sublet. This prevents the landlord from having to continue the lease term with an undesirable assignee or sublessee, or wait until the lease term expires to use the space for another, more productive purpose.

Casualty and eminent domain

Having a casualty or taking occur during the term of a lease can be a worst-case scenario and can fundamentally change the parties’ ability to complete their lease obligations. It is important to add termination rights, which allow the tenant to terminate if the space is not, or cannot be, repaired or restored within a specified amount of time, and which allow the landlord to terminate if repairing or restoring the space is economically impracticable.

All of these provisions are merely the tip of the iceberg. While these rights and contingencies can provide flexibility to landlords and tenants if things don’t go as planned, they must also be considered in the context of the entire lease to make sure the necessary protections and clarifications are included, and to ensure they don’t render other provisions in the lease ineffective or unfair. After all, as “Casablanca” fans will attest, everyone likes a happy ending.

Erin M. Vanden Borre, an associate in Hinckley Allen’s real estate practice in Concord, can be reached at 603-545-6118 or evandenborre@hinckleyallen.com.