Exclusive Deals

January 2013

by Nadav Ravid


Reprinted with the permission of Los Angeles Lawyer.

In the aftermath of the Great Recession of the late 2000s, many retailers shuttered their stores, went out of business, and, in some cases, filed for bankruptcy. As for the retailers that survived, many imposed an immediate freeze on their expansion plans, opting instead to wait and see how and when the market would recover. Gradually, over the last few years, the expansion freeze has been thawing, and sanguine retailers have warmed up to the notion of reentering the market. But their return comes with new demands. Aside from lower rents, retailers are demanding protections in their leases that once only the big anchor tenants could obtain. Now, tenants of every size are clamoring for these anchor protections, and landlords, still reeling from the recent economic collapse and a paucity of new deals, are reluctantly acquiescing.

One significant demand is the exclusive right to sell certain products in a shopping center. This concept, while easy to understand, is relatively difficult to draft in a way that is enforceable and that addresses each party’s concerns. From a tenant’s perspective, the provision should prohibit the landlord from allowing another tenant to compete with its business. On the other hand, landlords want the flexibility to lease space in their centers to a diversified tenant mix without unduly excessive or unintended restrictions.

Defining the Exclusive
With that in mind, the first and primary issue to consider is how to define the scope of the exclusive. Some exclusives focus on restricting a type of business, such as a “drug store,” while others focus on restricting certain types of products, such as “groceries.” In either case, problems can arise. For example, an exclusive right to operate a “drug store” has been held to prevent other tenants from selling prescription drugs, but not health and beauty products,1 which many people likely expect to find in a drug store. The exclusive right to operate a furniture store has been held to preclude a competitor from selling carpets, rugs, and linoleum,2 products that many people do not consider to be furniture. An exclusive for a martial arts studio has been held to preclude a fitness facility featuring boxing and kick-boxing.3 An exclusive right to sell groceries has been held to prevent the sale of food and beverage items, but not alcoholic beverages, paper products, or household cleaners.4

In one recent case, Winn-Dixie Stores, Inc. v. Big Lots Stores, Inc., the court analyzed over 100 of Winn-Dixie’s leases spanning the states of Florida, Alabama, Georgia, Mississippi, and Louisiana, and determined that an exclusive on “groceries” was ambiguous.5 Winn-Dixie sued the family of companies operating under the trade names Dollar Tree, Dollar General, and Big Lots. The defendant argued that “groceries” should include only food items but not any beverages, snacks, or candy, while Winn-Dixie argued that “groceries” should include all food items and all beverage products, as well as nonfood items such as paper products and household cleaners. In rejecting each side’s interpretation, the court arrived at its own definition to include only food items and beverages but not alcoholic beverages. Interestingly, the federal court in Winn-Dixie declined to follow a Florida state court’s interpretation of the identical exclusive provision prohibiting the sale of groceries.6 The state court concluded the term “groceries” should be interpreted to include more than just food.7 In distinguishing the two cases, the federal Winn-Dixie court explained that the leases it analyzed dated back to 1957, while the single lease analyzed by the state court was from 1986. This led the court to determine that while “groceries” may have been intended by the parties to cover nonfood items in the 1986 lease, the term “groceries” in the 1957 leases was not intended to cover nonfood items. The court based its decision on its determination that the offerings of groceries have evolved over time. Although the court’s analysis may appear to be making a distinction without a difference, the lesson learned is that it is imperative to define the restricted products with as much specificity as possible, or a judge may decide on the definition instead.

Exclusive Carve-Outs
Second, most exclusives that focus on the type of products sold (as opposed to focusing on the type of business operated) include carve-outs allowing other tenants to sell a certain percentage of the excluded products without such sales being deemed a violation. A common distinction is the sale of the restricted products on an incidental basis (which is permitted) versus on a primary basis (which is prohibited). As the Winn-Dixie court concluded, however, the terms “incidental” and “primary” may be too ambiguous to enforce.8 Does “primary” mean 51 percent of the total gross sales, or does it require more? What if a tenant’s most popular product amounts to 30 percent of its total sales—would that product be considered primary to that tenant’s business and thus a violation of another tenant’s exclusivity? To avoid these types of questions, it is a better, but still problematic, practice to specify an actual percentage of gross sales that would not be considered a violation. Often, the parties agree to allow other tenants to sell the exclusive product in an amount somewhere in the range of 10–25 percent (depending on the product) of such other tenants’ gross sales without such sales being deemed a violation.

Tying a carve-out to a percentage of gross sales, however, raises other concerns, such as landlord audit rights, measuring periods, and damage claims. First, a landlord should provide itself with the right to audit its tenants’ gross sales—a provision that is sometimes omitted from leases that do not require the payment of percentage rent. When audit rights are included in a lease, consideration should be given to whether the tenant should be specifically required to maintain its accounting records by separating out different product lines. Not all tenants structure their accounting in a way that allows easy verification, however, so drafting a lease provision to require it may not work. It is doubtful that a tenant will change its company-wide accounting methods to accommodate a single lease requirement. If that issue is resolved, however, the next question is what measuring period to use. Should the tenant count its sales on a daily, monthly, or annual basis? Most leases are silent on this issue. What if there is a restriction on selling 15 percent of an excluded product but the offending tenant’s gross sales of the restricted product are 12 percent in one month and 17 percent in another month? Should the tenant be allowed to average the two months and thus avoid being in violation of the exclusive? An argument can be made that the sales should be measured on an annual basis, since that is the typical measuring period for percentage rent in leases. If the sales are measured annually, however, it effectively means that a tenant that bargained for an exclusive may have to wait 12 months before it can demonstrate that another tenant is violating the exclusive.

To avoid these practical issues, some tenants prefer to measure a violation by the amount of sales floor area used to sell a restricted product. For example, a lease could provide that a tenant will not be considered to be in violation of the exclusive if it uses less than 10 percent of its sales floor area to sell the restricted product. But measuring floor area is not always straightforward either. In Winn-Dixie, Big Lots argued that only the footprint of the display unit should be counted toward the carve-out, while Winn-Dixie argued that in addition to the display unit, half the aisle space should also be counted toward the sales area.9 The court agreed with Big Lots and concluded that aisle space should not be included. To remove these types of uncertainties and avoid leaving it up to the court to decide, parties should expressly specify whether the calculation of the offending floor area should include aisle space in addition to the floor area taken up by the display unit itself.

Remedies
Once all of the issues with respect to defining what constitutes a violation of an exclusive use are addressed, next up is determining the remedies for the tenant in the event of such a violation. Many landlords are willing to protect a tenant when the landlord is directly to blame for a violation by, for example, knowingly signing a lease with a competitor. If the violation, however, is caused by what is referred to as a rogue tenant (one that does not have the right to sell the exclusive products under its lease but does so anyway), landlords are reluctant to provide a tenant with remedies. A landlord does not want to be considered to be in breach of its lease if it has not directly done anything wrong. Most tenants recognize this and are willing to make a distinction between these two types of violations by negotiating different remedies for each type of violation. For instance, if the landlord is directly to blame, the tenant’s remedy applies right away. If the violation is caused by a rogue tenant, on the other hand, the landlord may require notice along with an opportunity to cure the violation by pursuing an injunction against the rogue tenant to force it to stop the violation. In the case of a rogue tenant violation, tenants are usually willing to give the landlord a reasonable period of time to cure the violation, after which the tenant will expect to get some sort of relief.10

If a violation is established, it is possible that a tenant could terminate its lease and be relieved of all of its future obligations, as shown in Medico-Dental Building Company v. Horton & Converse, in which the court held that a landlord violated a tenant’s exclusive right to sell drugs when it leased other space in the building to a pharmacist.11 The court held that the tenant’s exclusive was a material part of the consideration that induced the tenant to enter into the lease, so the covenant to pay rent and the restrictive covenant were interdependent.12 Consequently, the landlord’s breach of the restrictive covenant allowed the tenant to vacate the premises without further liability for rent. Under some circumstances, a tenant may also recover lost profits,13 although many landlords require tenants to waive rights to recover lost profits for a landlord’s breach. Proving damages, however, may be a difficult and cumbersome task, and in some cases, too speculative for a court to determine.14

Liquidated Damages
To provide certainty, many landlords and tenants insert liquidated damages provisions providing the tenant with a fixed amount of damages following a violation of the tenant’s exclusive. Under California law, there is a presumption of validity for liquidated damages clauses in commercial leases, unless the party seeking to invalidate the provision shows that the provision was unreasonable under the circumstances existing at the time the contract was made.15 The reasonableness of the provision must be judged “at the time the contract was made and not as it appears in retrospect.”16 Thus, the validity of a liquidated damages provision is not dependent on the amount of the damages actually suffered; rather, all of the circumstances existing at the time the contract was entered into must be considered to determine whether the liquidated damages provision is reasonable and therefore enforceable. “The amount set as liquidated damages ‘must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained.’”17

With this in mind, it is common for national retailers to request liquidated damages in the form of a 50 percent rent drop upon a violation of the exclusive.18 Tenants should be careful, however, in negotiating this remedy too aggressively, because in some jurisdictions a full abatement of rent has been ruled an unenforceable penalty.19 Some landlords seek to include a sales test so that the tenant’s rent is reduced only if the tenant can prove that its sales have dropped as a result of the violation of its exclusive. Sales tests (which are also used in other areas of retail leasing), however, raise many complications that, some tenants argue, make using them unfair. Other variables not connected to a competitor’s presence may contribute to an increase or decrease in a tenant’s yearly gross sales.

Once the parties have agreed upon a liquidated damages amount, the next matter to determine is the length of time the tenant will be entitled to such damages. It is common for national retailers to pay reduced rent for anywhere from 6 to 12 months after a violation, followed by what is commonly referred to as a fish-or-cut-bait provision under which the tenant either reverts to paying full rent in spite of the violation or terminates the lease.

Monetary Damages
Aside from recovering damages from the landlord, a tenant may also want damages from the offending tenant as well as specific enforcement of its exclusive. Whether a tenant has a right to sue another tenant for violation of an exclusive will vary depending on the jurisdiction. For example, Florida, Georgia, and Alabama allow tenants to sue other tenants directly, but Mississippi does not unless there is privity of estate between the two tenants.20

In California, there is no case law that addresses this issue directly on point; however, in several cases a tenant has successfully pursued the offending tenant, at least indirectly. In Hildebrand v. Stonecrest Corporation, the landlord agreed that it would not permit the sale of drugs, medicines, or cosmetics in the supermarket located in the shopping center.21 When the supermarket began selling these items, the tenant sued the landlord and the supermarket. The court awarded the tenant a judgment against the landlord but also entered a judgment in favor of the landlord against the supermarket in the same amount as the tenant’s judgment against the landlord.22 In Lewis v. Alpha Beta Company, a liquor operator sued its cotenant and the landlord for a breach of the exclusive right to sell alcoholic beverages.23 The landlord then filed a cross-complaint against the cotenant. The court issued a permanent injunction against the cotenant based on the landlord’s cross-complaint, which rendered the liquor operator’s suit against its cotenant moot. Nonetheless, the court determined that although formally the judgment was in favor of the landlord alone, in reality the liquor operator was also a prevailing party, and the operator was therefore entitled to attorney’s fees.24

There can be many difficulties in enforcing damage claims by one tenant directly against another. These difficulties were highlighted in Winn-Dixie when the court heard expert testimony from several economists who provided different economic models and regression analyses on all of the leases. One expert testified that whenever Big Lots opened up a store next to Winn-Dixie, Winn-Dixie suffered, on average, a 6.5 percent loss of sales at that store. Using a different approach called the “gravity model,” another expert testified that the lost sales could exceed 30 percent per store. Another expert testified that “if a loaf of bread is bought in a Dollar General store, that loaf of bread will not be bought at a Winn-Dixie store.”25 The court rejected these models and arguments on the basis that, among other reasons, they were too speculative and failed to take into account Big Lot’s carve-out allowing it to sell some groceries.26 The court determined that the experts failed to provide evidence that the loss in Winn-Dixie’s sales came from sales by Big Lots of products placed outside of its permitted floor area carve-out. This raises the question of whether damages can ever be proven if an exclusive is subject to a carve-out.

A tenant that seeks to specifically enforce its exclusive may require the landlord to agree in the lease to pursue a remedy against the offending tenant on behalf of the tenant with the exclusive. Alternatively, a tenant may simply choose to pursue specific enforcement directly against the offending tenant, as was the case in Winn-Dixie. In some cases, specific enforcement of an exclusive may be a powerful tool against the offending tenant, because the offending tenant will have likely spent considerable amounts of money in constructing its store and will not want to be in the position of having to shut down its business. But that will not always be the case. In circumstances in which a tenant is allowed to sell some of the exclusive products on a carve-out basis, and monetary damages are too speculative, the offending tenant may not have enough of an incentive to stop violating the exclusive. After all, once an injunction is issued, the tenant is merely required to stop violating the exclusive; there is no other penalty. Obtaining an injunction in these circumstances would amount to a pyrrhic victory for the tenant that bargained for an exclusive. For example, among the leases under which Winn-Dixie “won” an injunction, Big Lots was merely ordered to comply with the exclusive by reducing the size of the footprint of its grocery sales. After years of litigation, during which time Big Lots continued to violate Winn-Dixie’s exclusive, Winn-Dixie was merely restored to the position it was in before Big Lots violated the exclusive, after presumably having lost sales and having incurred substantial legal fees.

Notice
In those jurisdictions in which a tenant has the right to sue another tenant for the violation of an exclusive, notice is typically required. To satisfy the notice requirement, a tenant should record a memorandum of the lease that specifically refers to its exclusive rights. By doing this, the tenant provides constructive notice of its exclusive use to all incoming tenants of the center. Practically, however, except for some big-box tenants, it is not common for potential tenants to search the chain of title before entering into leases to determine whether an intended use will be restricted by another tenant’s exclusive. It will be interesting to see if a court refuses to impose constructive knowledge on an unsophisticated tenant, if not a big-box tenant. The Winn-Dixie court noted that the notice requirement was satisfied in that case because Big Lots was an experienced commercial tenant with over 7,800 stores in 32 states and because Big Lots was aware that Winn-Dixie typically secured exclusives. The court deemed that these facts imposed an obligation on Big Lots to inquire about the existence of an exclusive.27

To remove any doubt of whether a tenant has notice of another tenant’s exclusive rights, some landlords insert provisions in the lease to provide actual notice by informing the tenant that it is subject to existing exclusives affecting the center, and listing the exclusives on an exhibit. While this may solve the problem of notice, it may also result in the unintended consequence of alerting the tenants that the landlord is willing to grant exclusives to its tenants.

Successor Liability
It should be noted that not only will the original landlord be subject to the exclusive rights it grants to its tenants but also the landlord’s successors will be responsible for upholding a tenant’s exclusive use after the successor landlord takes over the property. For example, in Carter v. Adler, the tenants had exclusive rights for “Grocery, Delicatessen, Meats, Produce, Fish and Poultry” within a shopping center.28 The land was later purchased by a new landlord who also acquired an adjacent parcel for the purpose of combining the two parcels and developing the combined area into one supermarket. The court ultimately found that the successor landlord was prevented from operating a supermarket on the adjacent parcel because of the tenant’s exclusive.29 Although the Carter court did not directly address any notice requirement, Section 1468 of the California Civil Code appears to require that a restrictive covenant be recorded in the public records to be binding on a successor owner.

Antitrust Considerations
As a final note, exclusive use clauses have been held to not violate the federal Sherman Antitrust Act. Courts have applied the “rule of reason” contained in the act and have consistently upheld restrictive covenants when the restrictions do not have a substantial adverse effect on competition.30

Exclusivity provisions are rising in popularity with tenants of all sizes in the retail industry. Drafting these provisions requires careful thought and consideration of a myriad of issues. Without specificity, such provisions are ripe for attack and may lead to unpredictable outcomes. In light of the recent Winn-Dixie case, special attention should be given to defining the scope of the exclusive, establishing carve-outs, and identifying available remedies in different jurisdictions, such as monetary damages and injunctive relief.

1 Rite Aid of Ohio, Inc. v Marc’s Variety Store, Inc. 93 Ohio App. 3d 407, 416 (1994).
2 Kulawitz v. Pacific Woodenware & Paper Co., 25 Cal. 2d 664, 673 (1944).
3 Freestyle Martial Arts Corp. v. Soco, LLC, 2007 Cal. App. Unpub. LEXIS 8925, at *6-7.
4 Winn-Dixie Stores, Inc. v. Big Lots Stores, Inc., 2012 WL 3292001, at *6–7 (S.D. Fla.).
5 Id. at *6.
6 See Winn-Dixie Stores, Inc. v. 99 Cent Stuff-Trial Plaza, LLC, 811 So. 2d 719 (Fla. 3d DCA 2002).
7 Winn-Dixie, 2012 WL 3292001, at *6.
8 Id. at *9 and *16.
9 Id. at *7. The Florida state court in the prior case adopted Winn-Dixie’s position.
10 See Kulawitz v. Pacific Woodenware & Paper Co., 25 Cal. 2d 664, 673 (1944) (distinguishing between a landlord violation and a rogue tenant violation).
11 Medico-Dental Bldg. Co. v. Horton & Converse, 21 Cal. 2d 411 (1942).
12 See id. at 420.
13 Freestyle Martial Arts Corp. v. Soco, LLC, 2007 Cal. App. Unpub. LEXIS 8925 (2007). The lease with Freestyle contained an exclusive for the operation of a martial arts studio, but a second lease provided for the operation of a boxing and kickboxing fitness facility.
14 See Winn-Dixie 2012 WL 3292001, at *10-12.
15 Civ. Code §1671(b).
16 El Centro Mall, LLC v. Payless ShoeSource, Inc., 174 Cal. App. 4th 58, 63 (2009) (citations omitted) (upholding liquidated damages for tenant’s failure to continuously operate).
17 Id. (citations omitted).
18 See, e.g., Red Sage Ltd. P’ship v. Despa Deutch Sparkassen Immobilien-Anlage-Saellschaft MBH, 254 F. 3d 1120, 1130 (2001). See also Valentine’s, Inc. v. Ngo, 251 S.W. 3d 352, 355 (Mo. Ct. App. 2008), in which the court upheld a liquidated damages provision in the amount of $100,000, even though that amount was not directly related to any actual loss of profits that the tenant would have suffered due to the violation.
19 See, e.g., Barr & Sons Inc. of Cherry Hill, N.J. v. Cherry Hill Ctr., Inc., 90 N.J. Super. 358, 377 (1966); Mark-It Place Foods, Inc. v. New Plan Excel Realty Trust, Inc., 156 Ohio App. 3d 65, 97 (2004).
20 See, e.g., Winn-Dixie, 2012 WL 3292001, at *2; Roth v. Connor, 510 S.E. 2d 550, 556 (Ga. App. 1998); Willow Lake Residential Ass’n, Inc. v. Juliano, 80 So. 3d 226, 237 (Ala. Civ. App. 2010). See also Winn-Dixie, 2012 WL 3292001, at *4.
21 Hildebrand v. Stonecrest Corp., 174 Cal. App. 2d 158, 161 (1959).
22 Id. at 163-64.
23 Lewis v. Alpha Beta Co., 141 Cal. App. 3d 29, 32 (1983).
24 Id. at 33.
25 Winn-Dixie, 2012 WL 3292001, at *11.
26 Id.
27 See id. at *16.
28 Carter v. Adler, 138 Cal. App. 2d 63, 65 (1955).
29 Id.
30 See, e.g., Dunafon v. Del. McDonald’s Corp., 691 F. Supp. 1232, 1241–42 (W.D. Mo. 1988). But see In re Tyson’s Corner Reg’l Shopping Ctr., 83 F.T.C. 1598 (1974) (The FTC acted against approval rights for department stores.).