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August 2009

Keeping the Lights On At Your Shopping Center: Drafting a Better Continuous Operation Covenant

Commercial leases used for shopping center tenants often contain a covenant of "continuous operation" requiring that the tenant continuously and without interruption operate and conduct business within the premises through the lease term. This is to protect against a tenant "going dark," i.e. ceasing operations which can cause the landlord to suffer significant economic loss. Percentage rental payments become impossible and customer traffic decreases. The vacancy can create a "domino" effect regarding the other tenants, and can create the appearance that the space is not viable for business, making it difficult to relet to a new tenant. The continuous operation covenant offers some protection from such economic disasters, but only if it is enforceable. A California Appellate Court recently approved a liquidated damages provision in a retail shopping center lease that enforced a continuous operations covenant and awarded the landlord $98,000 in damages for its violation. The decision, El Centro Mall v. Payless Shoesource Inc., provides shopping center owners some guidance on how to properly draft a liquidated damages provision to enforce its covenants of continuous operation.

In El Centro Mall, the landlord (El Centro) and tenant (Payless) entered into a written lease agreement for 3,300 square feet of retail space in a shopping center for base monthly rent, percentage rent, and other charges such as common area maintenance, costs and taxes. The lease contained a covenant of continuous operation, and set forth the specific hours of operation. The liquidated damages provision provided that, if the tenant failed to operate within these terms, the landlord shall collect an additional charge at the daily rate of ten cents per square feet for each day the tenant remains in breach of the covenant.

Liquidated damages clauses are presumptively valid, but may be unenforceable if challenged, as Payless did here, on the grounds that it was not intended by the parties to be a reasonable estimate of damages, but was instead a penalty.

To determine the enforceability of El Centro's liquidated damages provision, the Court first looked to the lease itself to understand the purpose of the provision. El Centro's lease stated that the purpose was to compensate it for the percentage rental it no longer received. The Court held that this was an unenforceable penalty because another section of the lease provided a readily ascertainable basis for calculating damages for loss of percentage rental, rendering the additional liquidated damages provision unnecessary.

The Court next considered El Centro's arguments that, in fact, the purpose of the provision was to compensate it for the anticipated loss of synergy, goodwill, and patronage Payless provides by continuing to operate in the retail center. Because it is difficult to estimate these types of damages at the time the parties enter into the lease, a liquidated damages provision is the best remedy. El Centro's provision, which provided for 10 cents per square feet, was found to be reasonable because it is directly proportionate to the amount of space the retail tenant utilized to conduct business in the retail center. For example, a shoe store with a floor area of 100 square feet or a small kiosk will not generate as many shoe sales as a full retail store with a floor-area of 3,3000 feet such as Payless had here. The larger store will likely carry more styles, brands, shoes, and, therefore, likely conduct more business, generating more patronage and goodwill, attracting complimentary tenants at increased rents and generating more percentage rent.

The Court held El Centro's liquidated damages provision enforceable because Payless failed to demonstrate that it was not intended for the forgoing reasonable purpose, and failed to present evidence, such as expert testimony, that 10 cents per square foot did not represent a reasonable estimate of the actual damages a retail center would suffer if a tenant like Payless ceased operations.

The "take away" here is to make sure your retail center lease contains a covenant for continuous operation, enforced by a liquidated damages clause that (1) is in proportion to the amount of space the retail tenant will utilize, and (2) expressly states that its purpose is to provide a reasonable method to calculate anticipated damages caused by the loss of synergy, good will, and patronage (and not for a loss otherwise provided for by the lease).

Real Estate

Holly L.K. Heffner


Real Estate

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