Canada: Keepin' It Tight With Co-tenancy Clauses

Karsten Lee and Robert Eisenberg discuss the application of co-tenancy clauses in lease agreements, touching on the issues raised in the insolvency cases of Target and Sears in Canada, and providing tips for ensuring your agreement is tight and enforceable.

Transcript

Narrator: You're listening to season two of WeirTalking Leasing, a podcast series from WeirFoulds LLP's commercial leasing lawyers in Ontario, Canada. In these first few episodes of the season, our speakers cover topics including co-tenancies, distribution leases, and changes to construction legislation that impact leases and construction projects. Now on to the episode.

Karsten Lee: All right, welcome to the WeirTalking Leasing podcast, a podcast about everything you need to know about commercial leasing brought to you by WeirFoulds. My name is Karsten Lee, I'm a partner here at WeirFoulds, and joining me today is Robert Eisenberg, who is an associate here at WeirFoulds as well.

Robert Eisenberg: It's a pleasure to be here, Karsten.

Karsten Lee: So today, what we're going to be speaking about are co-tenancies. Now, the issues about co-tenancies are in the forefront over the past few months due to the recent retail insolvencies that have been coming through the industry. So for example, when Target or Sears went bankrupt, this raised the issues for landlords as well as many other tenants who had co-tenancy clauses, and how these co-tenancy clauses are actually triggered and how they're used, and why they're there to begin with. So Rob, why don't you tell us exactly what a co-tenancy clause is, first?

Robert Eisenberg: Well, I'd be happy to. So basically, a co-tenancy clause, it's a requirement for minimum occupancy of a development or a shopping centre or a building or something like that. And if those minimum thresholds are not met, then a tenant gets a benefit. So you know, either a right to terminate, or a right to go dark, or rent abatement, something like that. There are two major kinds of co-tenancies that we most frequently see. Those are opening co-tenancies and ongoing co-tenancies. So an opening co-tenancy usually means that something has to happen before a tenant is obligated to open for business or commence paying rent. And an ongoing tenancy is where a tenant is open, but then if something happens or doesn't happen, then the tenant gets to decide to exercise his rights or not.

Karsten Lee: So let's build on that for a second. So you're saying, in an opening co-tenancy, something has to happen. So what exactly is that something?

Robert Eisenberg: So usually an opening co-tenancy will be, I am usually not quite an anchor tenant of a centre. I'll come in, I'll be the second-tier tenant and I'll want to say, "Look, this is a new development. I don't want to be the first guy open here, because that just means I'm taking on the risk. I don't have the benefit of other people driving traffic to my store." So what I say is, "Look. Until the anchor tenant opens, whatever it is, a grocery store, a gym, whatever it is, until they open, then I don't have to open." Or you can say, "If they don't open by this date, then I might have to open, but I don't have to pay rent until they open." So it's basically a precondition before the full terms of the lease kick in.

Karsten Lee: And just to build on that, it's not necessarily just the anchor tenant or two anchor tenants opening before the opening co-tenancy kicks in. It may well be, that tenant requires, say, 75 percent of the shopping mall to be open and operating before they're obligated to open.

Robert Eisenberg: Absolutely. Then the possibilities are endless. You draw up a site plan, you can say, "Within this area, this number of tenants have to be open." You can say, "You have to have three anchors over 10,000 square feet and then 70 percent of the rest of the CRU tenants open." I mean, it's really a business decision what the actual co-tenancy requirement is. It's just, the possibilities are endless.

Karsten Lee: So that's the opening co-tenant. We don't have to open unless a certain number of tenants or a certain couple of tenants are open and operating. On the second type of co-tenancy, which is the ongoing co-tenancy, what's an example of that?

Robert Eisenberg: So the ongoing co-tenancy, the rationale behind it is a little bit different. It's there to protect tenants from being left holding the bag if things go south for the development. So let's say I'm a tenant in the centre and I'm going to say, in my ongoing co-tenancy, and it might be in addition to an opening co-tenancy; sometimes it's either/or sometimes there's both. But I'd say something like, "If at any point, less than 80 percent of the square footage of the shopping centre is open for retail purposes, then I don't have to open, or then I don't have to pay rent." Or I can say, "If at any time an anchor tenant isn't open, then I don't have to open or I don't have to pay rent."

Robert Eisenberg: And we can get into this in a little bit more detail, but that has been one of the major issues with, as you mentioned, the Target bankruptcy and the Sears bankruptcy, where other tenants had ongoing co-tenancy clauses tied specifically to those tenants, which we'll get into. But that makes it really difficult for landlords. And it's one of the biggest dangers about having poorly drafted co-tenancy clauses, is your inability to cure the default.

Karsten Lee: Okay. So before we get into the nitty gritty of the co-tenancy clause itself, why would a party want a co-tenancy clause to begin with?

Robert Eisenberg: So let me start with the tenants because I think it's a little bit more obvious. Co-tenancies are most useful in two main contexts. The first is for a new development or a new shopping centre. And having co-tenancies here ensures that you being the tenant are not the first or the only tenant left operating here. Let's say the landlord has trouble leasing out some other portions of the centre, or they decide they don't want to build as much as they originally did. We're seeing a lot of this now where construction costs have gotten very high. Landlords are deciding, "Maybe I don't want to build as much as I initially thought" or other tenants are saying, "Maybe it's not economically feasible for us to open our stores." So having a co-tenancy clause in your lease prevents you from having to open and being the only tenant open in a development where there's nobody else drawing traffic. Maybe it's not as big or as much of a destination as you thought it would be. In these situations, you usually see opening co-tenancies because once everybody's open, the idea is that, well now everybody's open, the risk to me is more minimal.

Robert Eisenberg: For existing properties, co-tenancies help protect against tenants being the ones left holding the bag and being the last man standing. If there's a lot of vacancy in a centre or if the anchor tenants leave, then the tenant in question can either get a reduced rent or cease operating, or even terminate their lease to get out of a dying shopping mall or something like that. And this is a situation where it's more common to see ongoing co-tenancies. From a landlord perspective though, landlords say this all the time, "Why would I ever give a co-tenancy clause? There's no benefit to a landlord." And that's more or less true.

Robert Eisenberg: But co-tenancy clauses, unfortunately for landlords, they're often just a cost of doing business. They're a way to share the risk with tenants and sometimes it's necessary if you want to entice tenants into a new development or maybe into a centre that you're hoping to renew or redevelop. But there are some big risks to landlords, and one of the biggest ones is, it's a risk to your financing. If there's a potential for a tenant to go dark, maybe it's one thing, but if they have the ability to pay a reduced or abated rent, or even to terminate, that could cause landlords a lot of grief with their lenders because that could mean an interruption to the income stream for the property, and a knock on effect that maybe they're going to have trouble paying their mortgages.

Karsten Lee: Well, not just that. I think a lot of the lending documents from lenders do have those provisions that say that landlords cannot agree to some sort of material changes to the lease or some material clauses. And this may well be one of those material clauses that needs the lender's consent before a landlord can agree to it.

Karsten Lee: So moving from that, let's talk a bit more about the remedies that tenants are seeking in the event these co-tenancy clauses are triggered.

Robert Eisenberg: Sure. So I think generally speaking, there are three main remedies that you see, and then there's also some other more creative ones, but they're a little less frequent. So taking the three major ones, and the first is a right to go dark. And at its most basic, that just means that the tenant doesn't have to operate. So in a lot of retail leases, as you know, there's continuous operating covenants, especially for some of the smaller tenants. But if there's a co-tenancy clause and there's a co-tenancy failure, if the tenant has the right to go dark, then they can cease operating. And generally they use that when it's less profitable to actually operate the store than it is to just sit there dark and pay their rent. Because if they're open, they have to pay their staff, they have to pay higher utilities, they've got to pay for inventory. But if they just go dark, then their only cost incurred for the store is rent.

Robert Eisenberg: The second major remedy is a rent abatement, and that could either be a partial abatement or a full rental abatement. And that, quite simply, means that if there's a co-tenancy failure, the tenant doesn't have to pay rent, or doesn't have to pay minimum rent or gross rent, or pays a lesser level of rent. And the final and most extreme remedy is a termination rate. And usually there's a required cure period for a landlord to try to cure the co-tenancy failure. But a tenant would say, "Look, if you can't fix this co-tenancy failure, I want out of the lease." And then it's an open question to negotiate, what are the terms of that termination? Does the tenant have to prove that there was a decrease in its business, or is it just an absolute right? If this happens, then I can leave whether I want to or not.

Robert Eisenberg: But there are also some other more creative remedies that you can have. And again, anything under the sun you can think up could be a co-tenancy remedy. One of the ones I've seen is where a tenant operates under a fixed minimum rent lease, they say, "Look, if there's a co-tenancy failure, you and I are going to split the risk here, landlord. I'm not going to pay my fixed minimum rent anymore. Instead, I'm only going to pay you percentage rent. So you're going to get a percentage of my sales." The idea of being there, look, there's a co-tenancy failure. I'm anticipating there's going to be a drop in traffic to the centre. There's going to be a drop in my sales, so I'm only going to pay you a percentage of what I actually sell. You're not going to get a guaranteed rent. We're going to share the hurt together here.

Karsten Lee: So from a landlord's point of view, though, when we're talking about remedies, landlords really need to think about a few things, right? They have to be able to kind of shut it down in terms of, let's say the period of time that a tenant can exercise. It's one of those things where it's got to be, from a landlord's perspective, the tenant has this right. It's either you use it within a certain period of time or you lose it. Right? And also, you can't have... Well, one thing for landlords to think about is they certainly do not want the tenant to have these rights that go on forever. Fine. You get abatement rights, and you're not paying me any minimum rent whatsoever. Well, after about a year or two, when I'm seeing that the traffic to your business hasn't gone down at all and you're still operating, you still want to. You're making money, obviously, that's why you're still there. At a certain period of time, the remedy must end.

Robert Eisenberg: Absolutely. You hit the nail right on the head there.

Narrator: You're listening to WeirTalking Leasing by WeirFoulds' commercial leasing lawyers. We're taking a quick break to tell you about part two of season two, coming Fall 2020. The episodes will cover the latest updates in the commercial leasing world in Canada. Visit weirfoulds.com/podcasts for more information and to subscribe for updates. Now back to the episode.

Robert Eisenberg: I've got a special treat for you and all of our listeners today. I am going to share with you my top five tips on how to make a tight and enforceable co-tenancy clause. Would you like to hear them?

Karsten Lee: I'd love to hear it. Top five tips to make it tight and enforceable. Go ahead.

Robert Eisenberg: Absolutely. So tip number one is, always have clear preconditions and delineation of what kind of co-tenancy you're dealing with here. So obviously number one, is it an opening co-tenancy? Is it an ongoing co–tenancy? Specify in the clause. Say one time right, or say ongoing right. I've seen clauses where there's ambiguity, and ambiguity is no fun for anybody. Question then is, does the tenant lose its co-tenancy right if it is in default at that time, if it has been in default? Is it an absolute right that it doesn't matter if a tenant's been habitually late and paying rent, but they always have this tenancy clause? Is the right personal to the original name tenant?

Robert Eisenberg: Often, landlords give co-tenancy clauses to major national tenants because they say, "Look, I know this is what I have to do to get you in to my centre." But if that tenant assigns their lease to somebody else, you might say, "Well that's not... I did that deal with somebody else specifically. That shouldn't apply to you." So be clear on that, whether it's a precondition.

Robert Eisenberg: And then the other thing which we touched on very briefly is, do the tenant sales actually have to suffer as a result of the co-tenancy failure? This is obviously applicable to ongoing co-tenancies more. Or is the remedy automatic if there's a failure, or do they actually have to prove that there was a drop in sales? And if they do, what's the mechanism for that? Do they have to give you sales reports, or do they have to show decline for the same month, year over year? How is that going to work? That's number one.

Robert Eisenberg: Number two is, be clear about what the co-tenancy requirement actually is. Do not, and I'll repeat it, do not tie a co-tenancy provision to specific tenants. When Target went under, we saw a lot of co-tenancy clauses come up that had been drafted a very long time ago. And you and I, I know specifically, saw several that were written on typewriters. And these co-tenancy clauses were not only not tied to Target, but they said, "If Zellers ever ceases to operate in the shopping centre, then the tenant has these rights." Obviously, that happened a very long time ago. Thankfully, nobody decided to insist on the strict interpretation. They said, "Oh, wow, Target. That's a great replacement. We're not going to worry about." But don't tie to specific tenants, but rather tie to a classification or something. Instead of saying a specific food store, say, "As long as a grocery store tenant" versus a specific banner. Or say, "A home improvement store" versus a specific banner.

Karsten Lee: Or say, "The tenant who's occupying the premises" outlined in red on schedule B, or whatever.

Robert Eisenberg: Sure. Yeah. You can do it that way if you do want to tie it to a specific premises, but if you also want to keep a bit more flexibility as a landlord, you might want to say, "Well no, I don't want to have to put them in that spot. Maybe I want to move my grocery store." So you could just say, "As long as I have a major national grocery store over 10,000 square feet," whatever it is.

Robert Eisenberg: So there's a lot of different ways to do it. But the key is, you got to have specificity. It needs to be clear what exactly is a co-tenancy failure. If it's a general or a percentage clause, like we talked about, 70 percent, 80 percent of the tenants in the shopping centre, then what is that 70 percent of? Is that 70 percent of square footage? Is that 70 percent of the number of tenants or the number of units available? Do you have to have specific diversity? And we've seen some times, especially in some of the older leases, where they divide tenants into different categories. There's apparel retailers, and food retailers. So do you have to have a set number of categories, or set number of tenants within each category? You just need to have some certainty there.

Robert Eisenberg: Also, really important to include a concept of replacement tenants. This gives the landlord a chance to remedy a co-tenancy default before the tenant's rights become operative. So when you're thinking about a replacement tenant, oftentimes leases will list specific tenants sometimes. But as we mentioned before, that's not always the best thing because some of these leases run 20, 30, 40, 50 years. Banners change, retailers come and go. Instead of saying a specific banner, say it's a type of tenant, a grocery retailer. Or does it have to be one tenant that fills a space, or can it be multiple tenants backfilling a space? And this is very common in the situation that you mentioned where you outlined an area on a site plan, or you say, "The premises currently occupied by Target." Well, do I have to put in a new single retailer or can I break that up and put in five new guys? So

Karsten Lee: And that's one of the big issues that has occurred since Target and Sears have gone down, is the landlords in Canada find it very difficult to backfill the space with one tenant because there's just not many retail tenants out there who want space the size of a Target box or a Sears box. So a lot of landlords are being forced to chop up that box into smaller tenants or smaller boxes.

Robert Eisenberg: Absolutely. And that's one of the key important reasons that you have to draft co-tenancy clauses carefully because that might be the market, it's just, there are no Sears-size tenants out there looking for a lot of space. And if you're a landlord and your co-tenancy clause says "No, you have to replace it with one tenant," you're going to have a big problem. You're going to have to go to that tenant with the co-tenant rate cap in hand, and you're going to have to negotiate a solution. And odds are, they're going to ask for something in exchange.

Robert Eisenberg: So my last point on that, on issue number two, is when you're thinking of replacement tenants, does it have to be a major national or regional tenant? Do they have to have a certain number of locations or can it be an independent? If you had a grocery store, do you have to replace it with another national grocery store? Can you replace it with a local or a first-to-market concept?

Robert Eisenberg: So that's my second tip. My third tip is, be clear on timelines. The first sub-point of this is, cure periods. If a co-tenancy failure happens, obviously tenants want their rights to apply as quickly as possible, but a landlord's going to say, "No, no, no. Hold on. You've got to give me a chance to fix this." So what is that cure period? And that is often a point of discussion. Usually, what I've seen is that generally tends to run for six months or so. Sometimes it even goes to a year, just because it does take that time to get a deal done. Often, these are for large spaces with bigger retailers. It's not a quick thing. You can't just throw a nail salon in there and cure a co-tenancy. So there has to be some ability for a landlord to cure it.

Robert Eisenberg: At what point does the tenant's co-tenancy right become operative? So we see in clauses a lot of the time that it's, if the co-tenancy failure happens, then commencing six months, 30 days, a year after that failure, then the tenant's rights kick in. So it's not that they get to pay an abated rent going back to the day the co-tenancy failure started, assuming it's a properly drafted clause. And I've seen some where there's a pretty good argument that the abatement starts on day one, but you got to be clear on when the rights kick in.

Robert Eisenberg: And then the final thing about timelines is, if there were multiple remedies available to the tenant, like we talked about, go dark, abatements, terminations, how do the timelines work from multiple stages? Is it after 30 days you can go dark, after six months you get a rent abatement, after 12 months you can terminate? So you need to be clear on that. And my fourth point is something Karsten, that you already spoke about, is that this can't go on forever. That would be unreasonable.

Robert Eisenberg: And that's why a good co-tenancy clause has what's called in the biz as a sunset clause. And this basically means that if the co-tenancy failure is not cured by a certain date, then the tenant has to make a decision. They either have to terminate and leave, or go back to paying full rent and reopening. The idea being that look, either this co-tenancy failure is causing suffering for the tenant, they're suffering loss of sales damages, in which case, look, this isn't working out. You can terminate. Or yeah, there's a co-tenancy failure, but it's actually not having an impact or a substantial impact on the tenant to the extent that they're pretty happy to stay. They don't mind the situation, even with the co-tenancy failure.

Robert Eisenberg: So at that point, for a landlord, you got to say, "Look, either you're hurting or you're not. Either leave, or go back to paying full rent and reopening." And my fifth and final tip is when dealing with co-tenancy as tied to anchors, be very careful that you as a landlord do not promise more than you can deliver. This is something that's very common. When you're doing a new development and you offer opening co-tenancies. Oftentimes people will say in a co-tenancy clause, "So long as tenant X is open and operating," and those are a grocery store, a gym, a big anchor tenant.

Robert Eisenberg: Those big anchor tenants, more often than not, are not going to give you a continuous operating covenant. Oftentimes what you're going to get from them is a covenant to open for one day.

Karsten Lee: If you even get that.

Robert Eisenberg: If that. So landlords need to think very carefully. And at the end of the day, it's a business decision, and it's about the risk that they're willing to take on. But if you have somebody, a tenant, coming to you and saying, "Look, I don't want to have to open until these guys are open or so long as these guys are open" and that other lease is already existing, or you're negotiating it, and you're not sure you're going to get a continuous operating covenant, you got to take that risk. Is it worth giving a co-tenancy clause to somebody else when I can't promise that this other guy is going to be open, or that he will remain open?

Robert Eisenberg: So you can think twice in your drafting in a way, and I've done this personally, is where we have co-tenants coming and asking for opening co-tenancy clauses but we have an anchor that doesn't have an obligation to continuously operate, but does have an obligation to open for one day. Instead of saying, "Is open," I'll say, "This tenant has opened for business." So there's little tricks and little ways to get around this, but at the end of the day, it's all about the allocation of risk between the landlord and the tenant there.

Karsten Lee: Okay. No, those are definitely great tips, Rob. Now, so we have this beautifully drafted co-tenancy clause. It's in the lease, lease is signed. Now, what happens if the tenant that this co-tenancy clause is tied into declares for bankruptcy? What happens? What's my rights as a tenant with this co-tenancy clause? What are my rights in those situations?

Robert Eisenberg: So our listeners, they can't see, but we're both kind of smiling and laughing here because we know very well that when it comes to an insolvency or bankruptcy, either under the BIA or the CCAA, as we've seen, the wording on the paper isn't always worth the paper it's written on. The courts have wide latitude to impress whatever orders they see fair or just in the situation. So we saw this a lot with Target. We've seen it with Sears. One of the first things the courts do is they'll institute a stay, a stay order.

Robert Eisenberg: And what that, amongst many other things in terms of co-tenancies, what that does is that prevents other tenants from exercising their co-tenancy rights. It stays. It doesn't remove them, it doesn't delete them, it just stays it. It says, "Everybody sit tight until we get a handle on this situation, then we'll figure it out." So from a landlord's perspective, and the courts often do this to help protect landlords because, if there is a major insolvency, it could take a very long time to sort out. Courts generally want to keep business moving; they don't want to create undue hardship for landlords or for shopping centres. So they say, "Look, until we sort this thing out, everybody stays open. And then once we get a handle on this, then you guys can go assert your rights."

Robert Eisenberg: This stay period can often allow the landlords a little bit more flexibility to either, if the tenant that's going through the insolvency proceeding is looking to restructure and reopen, that gives the landlord some time to fix that. Or if they've decided they're going to cease operating, then the landlord can start looking for replacement tenants. So there might be a little bit of a saving grace in there, even if your clause doesn't give you a cure period to find replacement tenants. But what happens when that stay period is lifted? That's a little bit more of an open question is, did the clock continue to run? Do tenants have their... Are they able to assert their rights going back to the day the co-tenancy failure happened, or only on a go forward basis?

Karsten Lee: And that's one of those questions that does not currently have clarity in Canada. And unfortunately, well unfortunately for us lawyers, we wanted to get an answer to that question, but the parties, at least tied to the Target co-tenancy issues, ended
up settling with each other. So the outcome remains to be seen as to what happens in the event there's a bankruptcy or a CCAA filing. But at this point, we will just have to wait and see if something else happens and it goes in front of the courts.

Robert Eisenberg: Absolutely.

Karsten Lee: So that's the topic. Thank you, Rob, for coming in today and speaking about co-tenancy clauses.

Robert Eisenberg: Thank you for having me.

Karsten Lee: That was extremely informative, and hopefully gives our listeners some ideas when they are entering into these leases with co-tenancy clauses. Thanks again for listening, and hope to have you back listening to another podcast in the near future.

Narrator: Thanks for joining us for this episode of WeirTalking Leasing by WeirFoulds' commercial leasing lawyers. Please take a moment to rate, review, and subscribe, and if you'd like to hear from our lawyers on another topic, send us an email: publications@weirfoulds.com. Tune in again soon.

Originally published June 18, 2020.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.