Smart - And Not So Smart - Ways to Write a Lease Exclusive

Smart – And Not So Smart – Ways to Write a Lease Exclusive

In order to win attractive tenants, landlords often agree to grant exclusive rights at a particular property. A retail landlord may grant a restaurant the exclusive right to sell hot dogs at a shopping center, or an office landlord may promise a law firm that it will be the only law firm in the building. Landlords must be careful when drafting an exclusivity provision in a letter of intent or lease.

As with many areas of the law, the devil is in the details, and many potential pitfalls can trap the unwary. This article points out some of those pitfalls, with a focus on bankruptcy-related headaches, and suggests some practical and easy-to-implement ways to avoid them.

Narrowly Drafting the Exclusive

Tenants may like broad statements in exclusives, but broad statements can create problems and unfairly benefit a tenant even after that tenant vacates. Landlords can best protect their interests by thinking ahead and by drafting as narrowly as possible.

For example, Landlord X desires to lease a large portion of its building to the prestigious law firm of Jones & Smith or, if you prefer, Landlord X desires to lease shopping center space to Bob's, a famous hot dog chain. In either case, the tenant is willing to sign a long-term lease, but only if the landlord promises an exclusive: Jones & Smith wants to be the only law firm in the building; Bob's wants the exclusive right to sell hot dogs.

Landlord X may make that promise, but a smart landlord will carve out certain exceptions:

1. Unless this is the first lease for the property, the landlord must make the exclusive subject to all existing leases. Another law firm or restaurant may already occupy space in the building. Existing leases are not likely to have a prohibition on law firms or hot dogs, so the landlord will not be able to stop a tenant from using its space for the prohibited use or assigning or subleasing to someone who will engage in the prohibited use.

2. The tenant should only be entitled to the benefit of the exclusive if the tenant is not in default under the lease, the lease in is effect, and the tenant is actually leasing and occupying the entire premises for the permitted use. A landlord will be gnashing its teeth if the landlord is legally bound to honor an exclusive for a tenant that is not paying rent, has moved out, or is using the premises for something entirely different than the exclusive use.

3. The exclusive should only benefit the tenant that signs the lease. Landlord X may be willing to grant an exclusive to prestigious Jones & Smith or famous Bob's, but if Jones & Smith or Bob's assigns its lease or subleases to a different company, exclusivity may not be warranted.

4. Consider whether to carve out future anchor tenants from the exclusive. Significant tenants have enough swagger to take the position that they will not lease space at a property unless they are permitted to conduct ""any lawful use"" at the center. Landlords should not put themselves in a position in which they may lose a future large deal in order to make a more modest deal.

Particularly with retail exclusives, scope must be narrowly defined. Using the hot dog example, the exclusive ideally should only prohibit other tenants whose primary use is the sale of hot dogs. An alternative would be for the exclusive to permit other tenants to sell the exclusive item in a small portion of the other tenants' stores. Disputes arise, for example, where a hardware store sets up a hot dog cart, where a drugstore installs an ATM next door to a bank with a bank exclusive, or where a coffee shop starts selling sandwiches next to a sandwich chain store.

The scope of an exclusive also should be precisely defined. Would Bob's business truly be injured if the landlord leases other space to a gourmet restaurant that sells a gourmet hot dog made of Kobe beef for $45? If Bob's is a counter service restaurant without wait staff, Bob's arguably does not compete with any table service restaurant; the exclusive should be drafted accordingly.

Stated more broadly, landlords should tightly draft use provisions in all leases for properties where exclusives are expected; a lease should list a tenant's specific permitted uses and then conclude the list with ""and for no other use or purpose whatsoever.""

Tenants often ask landlords to withhold consent to another tenant's assignment or sublease request if the request will violate the first tenant's exclusive. A landlord should only promise a tenant that the landlord will withhold consent if the other tenant's lease permits. Ideally the landlord's form lease should provide that the landlord may withhold consent to an assignment or sublease request if the proposed transferee intends to use the premises for an unpermitted purpose or if, in the judgment of the landlord, the assignment or sublease would violate any agreement of the landlord involving the property or any other tenant's lease.

Bankruptcy Hazards

Tenant bankruptcies may create new problems for landlords that have granted exclusives. A debtor (the Bankruptcy Code uses the term ""trustee"" to include debtor-in-possession; I use the term ""debtor"" to include a trustee where one has been appointed) must maximize value in all its remaining assets for the benefit of its creditors.

An unexpired lease in a good location may be a valuable asset. Can a bankruptcy court permit another tenant to lease that space for a different use? Bankruptcy Code §365(f) provides that notwithstanding any prohibition, restriction or condition in a bankrupt tenant's lease, the debtor may assign its lease to someone else through the bankruptcy process, as long as the lease is assumed and adequate assurance of future performance by the assignee is provided. Bankruptcy Code §365(b)(3), however, contains special rules for shopping center leases.

Landlords spend much time and effort assembling a fruitful tenant mix at shopping centers. The Bankruptcy Code respects that. Bankruptcy Code §365(b)(3)(C) requires that, in any assignment of a shopping center lease, the assignee must comply with existing use and exclusive provisions in the lease.

No such provision exists in the Bankruptcy Code for non-shopping center leases, such as an office lease. While this does not necessarily mean that the converse is true, namely that an office lease may be assigned through bankruptcy to a new tenant that will cause exclusivity problems for the landlord, the answer to the question of whether an office lease exclusive will be enforced is less clear and depends on applicable bankruptcy law in the jurisdiction where the bankruptcy is filed. To be safe, rather than promising a tenant that ""no other law firm will lease space in the building,"" office landlords should promise that the landlord will ""not voluntarily lease space in the building to another law firm."" That way, if an accounting firm tenant later files bankruptcy and its lease is assigned to a law firm, the landlord will not be in default.

Careful drafting can ensure that landlords grant tenants fair exclusive rights, while still protecting against potential pitfalls.