Suitable Replacement Tenants Can Make You Sweat

October 2017

A retail tenant’s decision to lease space in a particular shopping center is driven by a variety of factors.  One significant factor is the amount and type of other tenants that operate in the center, also known as the center’s “tenant mix.” When a center’s tenant mix is important to a would-be tenant, the tenant may require the landlord to provide certain assurances that the other tenants will continue to be there after the tenant signs its lease and throughout the lease term.  These types of assurances are often addressed in co-tenancy clauses, which vary significantly from deal to deal.  Co-tenancy clauses may require specifically named tenants (e.g., Apple, Nordstrom) or a certain percentage of the overall center (e.g., 85% of the gross leaseable area of the center), or both, to be open and operating.  They may address remedies for the tenant if the co-tenancy requirements are not met.  For example, if a certain co-tenant stops operating, then rent reduces by 50%, or if the violation continues for 12 months, the tenant can terminate its lease.  Co-tenancy clauses may also give the landlord a right to replace a particular tenant that stops operating with another tenant; this is often referred to as a “suitable replacement” tenant.  Like the other co-tenancy issues, the concept of a suitable replacement raises a variety of sub-issues that need to be carefully considered and addressed to avoid unintended results.  An example of this recently came up in the case of RadioShack Corporation v. Azusa Pacific University (California Court of Appeal, Unpublished).

In RadioShack, the court examined a co-tenancy or “Excessive Vacancy” provision allowing RadioShack to end its lease early or pay reduced rent if a “Major Tenant” (defined as any tenant that occupies more than 15% of the gross leaseable area of the shopping center) discontinued operations at the shopping center and was not replaced with a “Similar Tenant” within six months. The lease defined a “Similar Tenant” as one that “has the same or higher quality of goods to be sold and equal or better customer traffic.” as compared to the Major Tenant it is replacing.  RadioShack began paying reduced rent after Big Lots, a Major Tenant, vacated its premises in the shopping center.  Big Lots was eventually replaced with Triad Fitness, a physical fitness center that sells ancillary items, such as t-shirts, energy bars, and water bottles. The landlord asked RadioShack to resume paying full rent, but RadioShack asserted that Triad Fitness’s operations did not satisfy the definition of Similar Tenant. RadioShack then sued the landlord for breach of contract and declaratory relief, arguing that an Excessive Vacancy violation existed at the shopping center because Triad Fitness did not sell the “same goods” as Big Lots pursuant to its lease and was therefore not considered a Similar Tenant. RadioShack argued that the mutual intention of the parties was to require the replacement tenant to sell “some reasonable combination or variation of furniture, appliances, clothing, electronics, packaged food items, sundries, garden supplies, linens, cookware, auto supplies, home furnishings, seasonal merchandise, and other consumer items as did Big Lots,” and that a fitness center that sells items such as water and snacks on an incidental basis is not a retailer selling the same type of goods as Big Lots.  The landlord focused on the specific language in the lease and countered that Triad Fitness did qualify as a Similar Tenant because it sold the “same quality of goods” as those sold by Big Lots.

The trial court found that Triad Fitness was not a Similar Tenant, reasoning that RadioShack entered into its lease bargaining for a specific clientele and that the lease specifically provided that the landlord would rent space to a Similar Tenant selling the “same” goods as a Major Tenant.  On appeal, the sole issue was the lease’s definition of a “Similar Tenant.” RadioShack argued that the parties’ mutual intention was that a Similar Tenant would be interpreted as a “retailer” (as opposed to a gym) selling certain goods. It further argued that a reading of the lease as a whole would support its interpretation of the parties’ intent.

The court rejected RadioShack’s interpretation as unreasonable, noting that the lease first defines an “Excessive Vacancy” with respect to the occupancy level of the gross leaseable area of the shopping center as less than 70% of the gross leaseable area being occupied by other “retail tenants.”  However, in defining an Excessive Vacancy that arises out of the loss of a Major Tenant, the lease did not use the term “retail tenant” and instead referred to “any tenant which has the same or higher quality of goods to be sold” (emphasis added). Because the parties used the term “retail” elsewhere in the lease, the court presumed that the parties intentionally left room for a successor Major Tenant to operate for a non-retail use, such as a gym. In reading the lease as a whole, the court also noted that the lease’s exclusive use clause prevented the landlord from leasing to other tenants selling specific types of goods in competition with RadioShack. The court reasoned that RadioShack’s election to spell out specific types of goods elsewhere in the lease was evidence that it intentionally chose to focus on quality of goods rather than type of products with respect to replacement Major Tenants.

The court distinguished the RadioShack lease from that in the unpublished case of Old Navy, LLC v. CTR Devs. Oreg, LLC, which was cited by RadioShack. There, Old Navy’s lease required that “the use” of the “Key Store” space in the shopping center had to be substantially the same as that of the Key Store it was intended to replace. The court distinguished the Old Navy lease from RadioShack’s by emphasizing that the language of the Old Navy lease expressly required a similar “use,” while RadioShack’s lease focused on “quality” of goods.

Interestingly, the court noted (almost as an aside) that RadioShack stipulated that its sales were not adversely impacted by the new tenant.  See Ravid Law Group’s Dirt Report article Be Careful What You Wish For: California Court of Appeals Holds Co-Tenancy Clause Unenforceable, where that fact alone rendered a rent reduction clause in a co-tenancy provision entirely unenforceable because it was considered a penalty.

Although RadioShack v. Azusa Pacific University is an unpublished case that does not constitute binding precedent, it serves as a reminder to both tenants and landlords that co-tenancy provisions require careful drafting. A lease should clearly define what constitutes a co-tenancy failure, as well as the meaning of a suitable replacement.