March 01, 2003

Does a Shopping Center Landlord Have an Implied Operating Duty? (2003, 17:02)

Does a Shopping Center Landlord Have an Implied Operating Duty?

By Patrick A. Randolph Jr.

Probate and Property, March/April 2003, Volume 17, Number 2

All leases create relationships, and the parties to a lease often spell out their expectations for the relationship in the documents. But, as with personal relationships, lease relationships often involve unstated expectations as well. The tenant, for instance, is viewed as having the implied responsibility to avoid injury to or alteration of the leased premises (waste) during the tenant’s possession. Landlords are said to warrant “quiet enjoyment” implicitly; that is, they must protect the legal right to possession transferred by the lease. These implied terms represent the court’s view of what the parties probably had in mind when they used the term “lease” to describe the relationship they created. Such implied duties often are not stated in the instruments creating the relationship, although some can be modified by those instruments. But if the parties do not expressly reject them (and sometimes even if they do), they necessarily are part of the deal.

For commercial leases, most lawyers would say that the landlord’s primary obligation is to provide space. The lease confers upon the tenant a legal right to possession unobstructed by the conduct of the landlord. Most lawyers would go on to say that in the typical commercial lease the tenant has few, if any, other expectationsconcerning what the landlord will provide and would suggest that the tenant specify any other services the tenant expects to receive.

Although it certainly is true that tenants who expect more than simply “space” would be wise to specify their expectations in the lease, the fact is that courts commonly impose further responsibilities on the landlord. For instance, landlords have the implied duty to provide a premises that meets building and safety codes, to preserve access across their own property to and from the leased property as the access existed at the time the lease was created, and to maintain their own adjacent premises in a way that does not unduly interfere with the tenant’s ability to carry out the purposes for which the lease was made. See Friedman on Leases §§ 27.5, 29.203 (4th ed. 1977).

In shopping center leases, the relationships are particularly complex because the whole purpose of the shopping center is to create a “synergy” that generates mutual profitability to all the participants engaged in the use and operation of the premises. Given this fundamental character of many shopping center developments, might we say that implied rights and duties exist in this context that might not exist in other types of leases?

Is There an Implied Promise to Seek “Synergy”?

In the case of certain types of retail shopping center leases the tenant expects, and the landlord implicitly promises, that the landlord will provide more than simply space. Rather, the landlord offers space that will have a certain value to the tenant as a consequence of what is happening in the landlord’s property around the leased space. The fundamental character of the arrangement is that the tenant will occupy an area surrounded by various other retail operators who together form a synergy that draws customers and business to all of them.

Of course, no tenant has a guarantee that the synergy will work and that the customers will come, and a tenant who desires to be assured of a certain amount of traffic, or even of a certain type of neighboring retailers, ought to bargain for language in the lease protecting these expectations. Still, it might be said that implicit in the agreement of the parties to lease space in a shopping center is an understanding that the landlord indeed will operate, or attempt to operate, the premises as a retailing center. If, for instance, the landlord, after leasing space to only one or two tenants, decides to alter the business plan radically and turn the balance of the center into a warehouse, with no other retail activity, the existing tenants certainly will argue that the landlord has withdrawn from the basic premise of their leases.

Tenants will have some evidentiary support for these basic expectations. For instance, it is likely that when marketing the space a landlord will provide information about the traffic generated by the mall, and the traffic in individual locations within the mall, perhaps even pricing space in accordance with projected traffic. A landlord will tout the attractiveness of anchor tenants and the layout of the mall’s corridors and entrances so that visitors to the anchors will pass by the premises of other tenants. Further, the landlord will stress its own expertise in marketing space to other attractive tenants and may even indicate to the prospective tenant that its presence in the mall is part of a special effort to develop a group of stores that work together particularly well to attract targeted buyers. If the landlord operates other malls, it will point to these malls as evidence of its success in creating an environment that attracts shoppers who are potential customers for the tenant. All of these considerations will have been weighed by the tenant in deciding whether to rent and how much rent it would pay.

When all is said and done, the landlord will have presented, and the tenant will have signed, a lease indicating that the tenant was relying upon no representations or promises except for those set forth in the written lease, but this statement almost certainly will not bar a court from finding some implied understandings. Such a broad “integration” clause, for instance, would not preclude the existence of an implied warranty of quiet enjoyment. It likely would not eliminate arguments concerning implied easements of access not stated in the lease. But our question is whether an integration clause will preclude any assertion by the tenant that it expected not just to receive space, but space in a working shopping mall. The author’s answer is: “Maybe, but maybe not.”

Of course, proving that the tenant had legitimate unmet expectations is only part of the battle. There is still the question of a meaningful remedy. The tenant may have considerable difficulty suggesting any kind of specific performance remedy, or even recovering damages for lost profits, because often it will be unclear exactly what the tenant expected of the landlord other than operation of some kind of retail center. Nevertheless, even though the tenant may be unable to say exactly what it expected the landlord would do, it might be able to demonstrate what the landlord clearly was not to do, that is, to depart completely from the retail center model. In the event of a landlord’s breach of this implied duty, the tenant might be permitted to terminate its own rental obligationsand even to recover consequential damages in the form of the costs of outfitting the store for a retail enterprise now rendered fruitless.

Recent examples illustrate, if they do not resolve, the question of whether the landlord has an implied duty to provide a certain kind of business environment.

The Big Box Phenomenon

Landlords of retail shopping malls recently have faced intense competition from big box retailers and power centers, large special purpose retail operations that are single destinations. The big box business model is not based on sharing customers with those drawn by neighboring retailers, but rather on drawing customers through the store’s own reputation and advertising. Big box stores seek to provide direct and convenient access to their customers, and usually they are not interested in walking their customers past a mall full of lesser retailers using the big box as an anchor. Thus many big boxes eschew shopping malls entirely.

Some owners of existing centers have concluded that their best economic interests lie in joining this trend, rather than in fighting it. As a consequence, they attempt to convert all or significant portions of their malls into groups of large big box facilities, with direct access to parking just outside their own doors. Often the conversion to this use involves a great deal of construction and, of course, the elimination of many smaller retail operations.

Although landlords can undertake these changes as existing tenants vacate at the end of their leases, it is a rare landlord that has all tenant leases terminating during any one period. Consequently, some tenants will be in the middle of their lease cycles, or will have just renewed, when the landlord commences changing the environment in which they operate to a low- or no-pedestrian traffic area. Were the landlord to obstruct customers physically from reaching its existing tenants, there would be no question that this obstruction would violate the tenants’ implied easement rights. But what if the landlord simply adopts a business practice of nonrenewal of existing retail tenants and terminates any efforts to find others? The construction of a new big box facility often can take several years, and even when it is completed, such operations may generate no potential traffic for remaining retailers from the old mall scheme.

Should the retail tenants have anticipated this development and guarded against it by provisions in their leases? Or were they entitled to expect some minimum effort to provide opportunities for other retailers to participate in the original synergistic relationship?

Office Conversions

Another example of the problem, which poses even more difficult issues, is the situation that arises when a landlord converts substantial portions of a center to office, rather than retail, uses. Portions of old strip shopping centers are used for government offices that serve the public, such as motor vehicle departments, social security offices, or military recruiting facilities. The landlords of downtown office buildings find that the properties generate more revenue per square foot if portions of the lower floor retail areas are eliminated to provide more room for office tenants who demand more space.

In fact, traditional shopping centers have always included some of these activities, and, as these uses do generate traffic—often as much or more than a retail operation would generate—an argument can be made that the tenant ought to have no objection. But what if the offices serve a population that is unlikely to provide a base of retail customers—such as those frequenting a government unemployment office or welfare office? Do retail tenants now have an argument that the implied promise of a synergistic environment has been breached?

Although the big box conversion and the office leasing phenomenon often generate similar problems for a center’s other tenants, there are some differences. Often, office conversions can be carried out with less disruption of traffic, and, what’s more, the amount of traffic may not be decreased significantly from what the tenants had enjoyed before. (Remember that these changes tend to occur only when the center had not been doing well as a retail operation.) So, in some sense, the tenant will have greater difficulty demonstrating that the landlord has altered the traffic scheme.

Unlike the big box conversion, however, when a landlord converts to offices, it departs more clearly from the original retail complex model, and thus the tenant may be in a better position to show that there has been a change in the nature of the operation, even though the big box conversion may in fact be more harmful in terms of reduction in customer traffic.

The Precedent

There is surprisingly little authority in the appellate cases, perhaps because most often, after “lining up the tanks,” the parties (at least those that have the resources to litigate to the appellate level) conclude that their best interests dictate some compromise. One significant decision is Herman Miller, Inc. v. Thom Rock Realty Co., 46 F.3d 183 (2d Cir. 1995), involving a lease for a “contract furniture showroom.” The court held that, under all the facts and circumstances of the case, a landlord had an implied duty to offer leased space only to tenants whose businesses were in “synergy” with those of the already enlisted tenant. Interestingly, however, the court did not grant rescission, even though the landlord protested that the market had changed and that it made no sense to try to create the kind of “merchandise mart” approach that it had originally conceived. The landlord had leased to a number of other tenants in the early stages of its development, and all of these leases (but not the plaintiff’s lease) included a kick out or escape clause that permitted the tenants to vacate if a certain goal was not met for enlisting other similar contract furniture operations. This fact tends to suggest that the implied duty found here was not one that the parties left out because they assumed that it was obvious, but rather represented a bargaining choice. A more conservative court might not have found an implied duty.

In an unreported Massachusetts trial court decision, a percentage lease tenant sued a landlord for damages when an anchor tenant and other smaller tenants moved out, detrimentally affecting the traffic generating scheme for which the tenant allegedly enlisted. Papa Gino’s, Inc. v. Assembly Square Mall, No. 98-04879, 1998 Mass. Super. LEXIS 608 (Mass. Super. Ct. Oct. 23, 1998). In claiming that the landlord had violated its obligations under the lease, the tenant argued that the percentage rent arrangement implied that the landlord would exercise its best efforts to maximize the traffic in the mall.

The court acknowledged that Massachusetts authority recognized the possibility that in some percentage lease situations, the tenant might have an implied duty of continuous operation so that percentage rent would be generated for the landlord (the reverse of the tenant’s argument here). The court noted, however, that no Massachusetts court had ever found such an implied duty of the landlord and in the absence of specific language in the lease, such a determination was unlikely. Based on the facts, the court stated there was no basis to believe that the parties intended to impose any kind of duty of “special effort” on the landlord. Having said this, however, the court noted a lower appellate court case, based on a specific set of facts, stating that there was a “basic assumption” of the parties as to the “continued operation of the plaintiff’s shopping center, but not a continued presence of the anchor stores.” Id. at 4. Thus the case might stand for the proposition that, although the landlord has no implied duty to maximize traffic for the tenant, the landlord may have to show some irreducible minimum of commitment to the original concept.

In a significant recent trial court decision in Indiana, a number of retail stores operated by The Limited, Inc., attempted to invoke a kick out option on the grounds that the landlord had failed to recruit tenants vigorously to the rest of its space. Glendale Centre, LLC v. The Limited, Inc., No. 49D07-0204-PL-000606 (Super. Ct. Marion County, Ind., Apr. 19, 2002). The court rejected the argument, ruling that the tenant had expressly defined its expectations as to the landlord’s duties when it negotiated the kick out clause and thus had no implied rights beyond that. It enjoined the tenant from terminating its own operations that were controlled by a continuous operation clause.

Analysis

Courts should recognize that the parties can, if they want, address in the lease specific obligations of the landlord to promote traffic in the center. The lack of such a provision should be viewed as an indication that the tenant expects to rely upon the landlord’s self-interest to promote the center in order to derive revenue from many areas within the property and not just from the tenant.

Nevertheless, the tenant can argue that it justifiably expects that the landlord’s economic decisions will be made within the context of the shopping center concept that was the basis for the tenant’s lease. Although the exact characterization of this expectation must be made on a case-by-case basis and often requires a relatively far-ranging inquiry on the part of the court, this task is no more formidable than that generally undertaken by courts in interpreting other long-term contracts. Times change, and the parties’ expectations as to what happens with change often are not spelled out expressly. Courts frequently are compelled to glean indicators of intent from many sources.

A percentage rent lease is sometimes said to impose mutual obligations on both landlord and tenant to attempt to maximize the opportunities to each. Tenants have raised this argument, for example, in cases to prevent a landlord from leasing space to competing tenants, even when the lease contains no exclusive use clause. See Friedman on Leases, supra , § 27.5, note 11.1. Because express exclusive use clauses are common in the industry, however, courts should not assume that the parties expect the duty to exist if they fail to bargain for it. More commonly, landlords have raised the implied duty when seeking to impose an implied operating covenant on the tenant under a percentage rent lease. See Friedman on Leases, supra , § 6.9. The author has been critical of implying an operating covenant on the tenant, however, because the trade practice is to specify such a duty in the lease when the parties so intend. Id. § 6.906. If the obligation is not expressed in the lease, the landlord generally relies upon the tenant’s self-interest and takes the risk that this self-interest will continue for the life of the lease.

Similarly, the landlord, defending against the tenant’s contention that it has an implied duty to continue to operate a center, could argue that the tenant in a percentage rent lease bargained in reliance upon the landlord’s self-interest, which requires that the tenant’s business thrives; consequently no further duty should be implied. However, leases rarely express any expectation concerning the landlord’s operation, and those that do, for the most part, address this concern in co-tenancy “kick out” provisions that are given only to the strongest tenants. Thus, unlike continuous operation rights and exclusive use rights, there is no industry standard for a clause imposing express operating duties on a shopping center landlord. One could say that this means that there is never such an expectation. Another conclusion, however, might be that, unlike in the case of continuous operation or exclusive use, the parties assume that the basic shopping center purpose will continue. Because this expectation is so obvious, it need not be stated in the lease.

The argument for an implied duty upon the landlord to continue operating a center is perhaps stronger in fixed rent leases than in percentage rent leases. A tenant’s rent obligation remains constant in a fixed rent lease, but its rent obligation is reduced under percentage rent leases when business is slower. Nonetheless, in both fixed term and percentage rent leases, the tenant normally must pay some basic rent and frequently is expected to make significant front-end investments in franchise fees, fixtures, stocking, and other costs that are not recoverable in any other way if the center essentially becomes a ghost town.

Remedies

As suggested in the cases above, the court most likely will not be in a position to issue an affirmative injunction because the content of the implied covenant is really too vague in terms of positive duties of the landlord. The tenant’s best remedy will be to terminate the lease based upon a claimed major breach, amounting to a constructive eviction when such theory is available, and to seek damages for unamortized, nonrecoverable investment costs.

As to a damages claim, the tenant has some real challenges. The tenant’s whole premise is that the rental value is now less than the contract rent. There is no way to estimate what the landlord really should have done to promote the tenant’s business, however, so there is no way to project lost revenues. In some cases, the tenant may argue that the loss of the lease occasioned the waste of substantial unamortized investment in the form of tenant-paid improvements or unrecoverable franchise fees. But the tenant agreed to put this investment at risk because the tenant expected a fighting chance to generate revenue and even profits within the context of the retail environment the landlord allegedly offered.

Conclusion

Many retail center relationships are premised upon mutual expectations of continued commitment to an identifiable and valuable business model. When the landlord suffers a mid-life crisis and elects to pursue other goals, courts may well conclude that the landlord implicitly promised existing tenants that the landlord would stay the original course. The sensible landlord will not attempt to pass on to existing tenants the costs of supporting the landlord through the period of change. The landlord can simply not renew some existing tenants’ leases and can buy out or modify the leases of others. The cost of clearing the field of the remnants of the old business model before starting in on a new one can be readily factored into the new business plan. This cost, at least in some cases, with justification, should be borne by the party seeking to depart from the implied commitments made earlier.

Of course, if courts do recognize the landlord’s duties here, it is likely that there will be no great disruption in business cycles. The landlord will be forced to bargain for clear and express language in shopping center leases that give it the right to terminate the existing retail model. In some cases, of course, the result of this bargain will be the tenant’s obtaining a kick out right or some other recognition that it need not sit by and pay rent when the landlord’s interests have focused on a different business model. The point is that the landlord would have to bargain at the outset or bargain at the end. The landlord would not have free rein to hold the tenant to a lease in space that is no longer in an environment that the landlord offered and that the tenant agreed to lease.

Shopping center lease relationships are not marriages; they are not even partnerships. But the landlord obtains higher rents based on the implicit value of the shopping center model and perhaps should not have a free right to depart from that model without bargaining.


Patrick A. Randolph Jr. is the Edwin E. Pierson Professor of Law at the University of Missouri–Kansas City School of Law and of counsel to Blackwell Sanders Peper Martin LLP in Kansas City, Missouri.