The Center is Failing: What Are Your Rights?

The Summary: In today’s financial climate, it is hard to keep up with the changes happening in shopping centers across the country. Retail space in shopping centers is staying vacant for several months or longer. Landlords are converting retail space to non-retail use or closing entire wings or floors of shopping centers. Landlords are even closing operations entirely at shopping centers to redevelop the property. What are a retailer’s rights when a mall begins to fail? Some retailers have favorable co-tenancy provisions in their leases that provide immediate rights under these circumstances. While co-tenancy provisions are the most obvious protection when a shopping center fails, tenants often have other protections under the lease and under the common law.

When faced with a failing shopping center, a tenant should follow three steps to evaluate its rights against the landlord.

First, a tenant should determine whether there is a co-tenancy provision in the lease, and if so, a tenant should monitor the landlord’s compliance with the co-tenancy requirements regularly. In the event of a co-tenancy failure, a tenant should assert its rights under the lease as quickly as possible.

Second, a tenant should evaluate whether there are other provisions in the lease that might offer protection. More general obligations and covenants in the lease may also offer grounds for relief against the landlord.

Third, a tenant should think beyond the lease language. State common law may offer additional protection to a tenant when a shopping center fails.

Step 1: Does The Tenant Have Co-Tenancy Rights Under The Lease?
Some tenants are in a position to negotiate co-tenancy provisions in their leases, such that if certain key stores or a percentage of stores in the center fail to operate, the tenant is entitled to relief. These provisions vary and should be closely scrutinized in this market, so that those tenants that are lucky enough to have them are enforcing them against their landlords.

Enforcing A Co-Tenancy Provision
A typical co-tenancy provision states that if one or more key stores (or anchor stores) at a shopping center is not occupied by the existing tenant or similar tenant, or if a certain percentage of the retail stores are not occupied by retail tenants, the tenant may pay reduced rent (often referred to as “alternate rent”) or terminate the lease. While co-tenancy provisions generally are enforceable, disputes relating to co-tenancy provisions may not be easy to resolve. Language in co-tenancy provisions can be ambiguous, which means that lawsuits regarding these provisions are sometimes subject to a trial rather than more efficient resolution by a judge. See Rathbun v. Cato, 93 S.W.2d 771 (Mo. Ct. App. 2002) (holding the term “similar type and size business” in a co-tenancy provision was ambiguous and its meaning must be determined based on evidence of the parties’ intent outside of the lease); Jo-Ann Stores, Inc. v. Property Operating Co., LLC, 91 Conn. App. 179 (2005) (holding term “first class retail purpose” in a co-tenancy provision was ambiguous).

Issues that often arise with co-tenancy provisions are when and how co-tenancy rights are triggered. For example, does the landlord have an obligation to notify the tenant when the co-tenancy requirements are not met, or is the tenant required to monitor the shopping center to confirm compliance with the co-tenancy requirements? This question is often governed by the specific lease language. For example, the lease may require the landlord to notify the tenant in the event of a co-tenancy failure. If the lease does not require notice, the tenant should periodically request information from the landlord regarding the occupancy of the key stores and other retail space. Even if the landlord provides such information, it is advisable that the tenant conduct its own inspection of the center and record occupancy levels.

“Making An Election” vs. Condition Precedent
Some co-tenancy provisions state that in the event of a co-tenancy failure, the tenant is entitled to “make an election” to pay reduced rent. How does this language affect a tenant’s rights? When the tenant has the right to “make an election” of remedies upon a co-tenancy failure, the landlord will argue that the tenant’s failure to make the election after a co-tenancy failure waives the tenant’s right to reduced rent or reimbursement of overpayments. Where a co-tenancy requirement is based on a certain percentage of leasable square footage, however, a tenant most likely will not be able to determine precisely when a co-tenancy failure occurs unless the landlord provides additional data. While a tenant should be vigilant about monitoring the shopping center’s occupancy and compliance with co-tenancy requirements, a tenant should take the position that it is the landlord’s obligation to provide the tenant with information relating to co-tenancy failure before the tenant is obligated to make an election of remedies.

Other co-tenancy provisions more simply state that if the co-tenancy requirements are not met, then the tenant is not required to pay full rent. This language creates a “condition precedent.” If the condition (the co-tenancy requirement) is not met, the tenant’s rent obligations are reduced automatically. This language is preferable to the “election” language as described above. Where there is a condition precedent, if for some reason the tenant continues to pay full rent after a co-tenancy failure, the tenant has a stronger argument for reimbursement of prior overpayments.

Step 2: Does The Tenant Have Other Rights Under the Lease?
If a lease does not include a co-tenancy provision, a tenant still should closely review the lease to identify other provisions that may provide rights when a center begins to fail. In many leases, the landlord covenants to do something for the benefit of the tenant. For example, the landlord may covenant to maintain common areas consistent with a first class shopping mall; conduct marketing and promotional activities; or provide security or other services. If the shopping center is failing, and as a result, the landlord fails to maintain it properly or comply with its marketing or security obligations, the landlord would be in breach. The lease will often set forth the remedies available in the event of such a breach.

Further, landlords may covenant in a lease to provide certain things to the tenant, such as a first class shopping center or regional retail development. A lease may include a specific description of the shopping center or attach a map of the center and its individual retail stores. If the shopping center no longer fits the description as set forth in the lease, the landlord may be in breach and subject to a claim for damages.

Even language relating to the tenant’s obligations in the lease may be of use when the center is failing. For example, a tenant may agree that its sales practices will be consistent with standards and practices generally acceptable in “enclosed first-class, full-retail-price regional shopping centers.” If the landlord has made changes to the center such that it is no longer operating a “first-class full-retail-price regional shopping center,” the landlord may be in breach of the lease.

These types of provisions and covenants demonstrate that the parties intended the shopping center to be more than the collection of leasable space. Rather, the parties intended the shopping center to be a destination in and of itself, and in entering into the lease, the tenant was agreeing to lease space in the shopping center as it existed at the time of the execution of the lease. A substantial change to the center could be a breach of the lease entitling the tenant to relief.

Step 3: Does The Tenant Have Common Law Rights Outside of the Lease?
Although a tenant typically cannot rely on state common law to assert rights contrary to the language of the lease, a tenant can use common law to bolster arguments based on the lease or to fill in gaps not addressed in the lease.

For example, if changes in a shopping center cause a landlord to breach a specific provision in the lease (e.g., co-tenancy requirements or covenant to provide center with specific characteristics), a tenant can file a lawsuit for breach of contract and seek damages. If the changes to the shopping center are so significant that the tenant cannot operate its store as contemplated under the lease, a tenant may have a right to terminate its lease based on the common law principles of constructive eviction, failure of consideration or impossibility of performance. See Causeway Partners 1, Ltd. v. Kinney Shoe Corp. T/A Foot Locker, No. 01-00-01280 (Tex. App. April 25, 2002) (unpublished) (rejecting landlord’s claim for breach of lease and holding tenant was constructively evicted when mall’s occupancy rate dropped well below 20% and there was no foot traffic). In addition, if the landlord has done something to undermine the tenant’s value in its lease, such as open a competing center nearby, the tenant can argue that the landlord has breached the covenant of good faith and fair dealing, which is a covenant implicit in every contract.

Further, a tenant should identify facts that might support a tort claim against the landlord. A landlord cannot lie to the tenant to induce the tenant to enter into or renew a lease. If a landlord misrepresented occupancy rates or that specific tenants would be leasing space at the shopping center, then the tenant may have a claim for fraud. The tenant should be careful to retain all records relating to the landlord’s representations. Even if the tenant can prove that the landlord misrepresented facts to induce the tenant to lease the space, the tenant will have the additional hurdle of proving that the lease agreement does not supersede any prior promises by the parties.

Conclusion
Retailers cannot avoid entirely the downturn in the economy, but they can take action to assert their rights against landlords when shopping centers begin to fail. First, a tenant should read the lease to determine whether there are specific provisions in the lease that set forth the tenant’s rights when the center undergoes changes. Second, a tenant should review the lease for more general provisions that may be breached by the landlord when the center begins to fail. If the landlord is not complying with its covenants in the lease, the landlord is in breach. Third, a tenant should consider common law claims. If the changes to the center are so substantial that the tenant cannot reasonably operate its store, the tenant may have a right to terminate the lease or seek damages based on constructive eviction, failure of consideration, impossibility of performance, breach of the covenant of good faith and fair dealing or possibly fraud.

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Splintered Decision Fails to Settle Questions About FTC's Burden in Blocking Mergers

Case: Federal Trade Commission v. Whole Foods Market, Inc., No. 07-5276 (D.C. Cir. 11/21/08)

The One Sentence Summary: The Federal Trade Commission sought a preliminary injunction to block the merger of premium supermarket chains Whole Foods and Wild Oats; after the trial court denied the injunction and the merger took place, a sharply divided three-judge panel of the Court of Appeals for the District of Columbia Circuit reversed the trial court's order, possibly signaling a lower threshold for the FTC to obtain a preliminary injunction to block potential mergers.


What They Were Fighting About: There were two key issues in this case: (1) the standard the FTC must meet in order to show it is entitled to preliminary injunction to block a merger; and (2) what role customers' particular preferences play in determining what is a "relevant market" (the market in which competition takes place) for purposes of antitrust analysis.

Before their merger, Whole Foods and Wild Oats were the largest operators of what the FTC called "premium, natural and organic supermarkets" (or "PNOS"). In February 2007, they announced they would be merging, a move the FTC alleged would create monopolies in eighteen cities where Whole Foods and Wild Oats operated the only PNOS. The FTC sought a temporary restraining order and preliminary injunction to stop the merger while it conducted an administrative proceeding to decide whether to block the merger permanently under the federal antitrust laws. The FTC argued that in order to assess the anticompetitive effects of the merger, the "relevant market" included only PNOS. The defendants disagreed, arguing that PNOS compete in a larger market including other grocery stores and supermarkets and, accordingly, that the merger did not pose antitrust concerns.

The U.S. District Court for the District of Columbia denied the injunction, holding that the FTC failed to meet the standard required to obtain a preliminary injunction under the Federal Trade Commission Act, 15 U.S.C. section 53(b). Specifically, the District Court held that because PNOS compete with regular supermarkets and grocery stores, PNOS were not themselves a distinct market in which Whole Foods and Wild Oats would actually have market power. Thus, the District Court reasoned, the FTC was not entitled to an injunction because it could not show that it was likely to succeed on the merits of its case.

Although the merger actually took place in August 2007, the FTC nevertheless appealed to the U.S. Court of Appeals for the District of Columbia Circuit, arguing that the District Court applied the wrong legal standard. On July 29, 2008, a three-judge panel of the Court of Appeals reversed, sending the case back to the District Court for further proceedings. Although it first appeared that there was a majority opinion filed by Judge Janice Rogers Brown, the Court of Appeals subsequently issued an amended opinion on November 21, 2008 that made it clear that Judge David S. Tatel concurred in the judgment only, not Judge Brown's opinion. Thus, although two Circuit Judges formed a majority in reversing the decision of the District Court, there were three separate opinions filed: Judge Brown's opinion, Judge Tatel's opinion concurring in the judgment, and Judge Brett M. Kavanagh's dissenting opinion. Accordingly, it is difficult to know what weight will be given to the decision of the Court of Appeals and its reasoning in future cases.

Both Judge Brown and Judge Tatel stated that section 53(b) set a lower threshold for the FTC to obtain a preliminary injunction than, say, a private litigant seeking an injunction would face. Both also concluded that the FTC will usually be able to obtain a injunction by raising questions as to the merits "so serious, substantial, difficult and doubtful as to make them fair ground for thorough investigation. . . ."

Judge Brown characterized the proper analysis as to whether a merger should be enjoined as a "sliding scale" under which a court should balance the FTC's likelihood of succeeding on the merits of its case against the "equities" resulting from an injunction. Under this sliding scale test, Judge Brown determined that the District Court had erred by underestimating the FTC's likelihood of succeeding on the merits of its case. Specifically, the District Court had considered only "marginal consumers" -- those who would switch to other non-PNOS stores in response to a price increase by PNOS. According to Judge Brown, the District Court should have also considered "core customers" of the PNOS -- those who were committed to natural and organic products, health and ecological sustainability. Judge Brown seemingly concluded that because these core customers were unlikely to switch to standard grocery stores should prices increase, the relevant market could be limited to PNOS. Moreover, the FTC's evidence suggested that although Whole Foods and Wild Oats competed with other grocery stores on prices of "dry goods," they did not compete with regard to the natural and organic perishable goods that made up the bulk of their business.

Judge Tatel relied on evidence presented by the FTC suggesting that customers did not consider the products of PNOS reasonably interchangeable with those of other stores. He also cited evidence that Whole Foods and Wild Oats could sustain "statistically significant non-transitory increase in price," including evidence that indicated that defendants raised their prices when they operated the only PNOS in particular cities.

Notably, the majority rejected defendants' arguments that the issue was moot because the merger had been consummated. The majority noted that if a preliminary injunction issued, the status quo could be preserved (for example, by preventing future actions taken to close additional stores).

Although the majority held that the District Court erred, the Court of Appeals remanded for further proceedings because the District Court had not yet examined the "equities" involved in granting a preliminary injunction. Thus, the Court of Appeals directed the District Court to examine and weigh those equities against the FTC's likelihood of success.

Judge Kavanagh strongly dissented, accusing the majority of diluting the requirement that the FTC show a likelihood of success on the merits. Judge Kavanagh further criticized the majority for relying on older cases such as Brown Shoe Co. v. United States, 370 U.S. 294 (1962) while ignoring more modern cases such as Munaf v. Geren, 128 S. Ct. 2207 (2008), which Judge Kavanagh argued rejected the "serious questions" standard cited by the majority.

On November 21, 2008, the same day the revised opinions were issued, the Court of Appeals denied Whole Foods' petition to have the entire Court of Appeals rehear the appeal en banc. In denying the petition, two Circuit Judges expressly stated that the judgment set no precedent beyond the facts of the case.

Key Points:

• Although there is no majority opinion, both Judge Brown and Judge Tatel suggested that the FTC should be entitled to a presumption (which defendants could rebut) that an injunction should issue if the FTC can establish that there are "serious, substantial, difficult and doubtful" questions as to the merits.
  
• The opinions also indicate that even if a merging businesses compete for customers in a larger market, a court may consider whether they have "core," dedicated consumers that prefer their specialized or premium products even when prices increase.
  
• Because there is no actual opinion of the Court of Appeals stating the bases for reversing the District Court's denial of an injunction, it is unclear what weight the D.C. Circuit, let alone other federal courts, will give to the reasoning set forth in Judge Brown's and Judge Tatel's opinions.
  
  

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