Shopping center lease covenant to operate continually reviewed.

Developers and landlords can take comfort that the courts have held that a clause obligating a tenant to operate continuously in a specific business is valid and enforceable. A recent case on this issue is Western and Southern Life Insurance Company v. Crown American Corporation, 877 F.Supp. 1041 (EDKY 1993).

In this case, Western and Southern Life Insurance Company was the owner of the Florence Mall in Kentucky. The mall had four anchor stores, including one known as Hess' Department Stores, Inc. Hess was owned by Crown American Corporation.

Western had each of the anchor tenants sign "operating agreements" and "supplemental agreements". Section 8.1 of the operating agreement required each anchor store to "continuously operate... a two-level retail department store..." The supplemental agreement in the ease of Hess obligated Hess to operate continuously for 20 years under the same name, and an additional 10 years as a "comparable retail department store with no requirement as to name." There was also a transfer restriction clause, which is the subject of this article.

Section 25.2 of the operating agreement prohibited transfers to anyone other than a corporate "affiliate," and that such affiliate must agree to be bound by all of the covenants and obligations of the operating agreement.

Hess' department stores began to fall upon hard times and was losing money at the Florence Mall location. Hess sought to close its doors and sell its property interests to another anchor store, Lazarus, Inc., which is a subsidiary of Federated Department Stores, Inc. Western brought an injunction seeking to enjoin Hess from closing its doors and prohibiting the sale to Lazarus. It was undisputed that Lazarus did not qualify as an "affiliate" within the meaning of the operating agreement.

The court denied the request for injunctive relief and ruled that Section 8.1 was enforceable through the recovery of money damages, but not an injunction, and ruled the transfer clause at Section 25.2 unenforceable as a restraint upon alienation.

In construing the continuous operation clause, the court noted that an injunction was an "inappropriate" remedy in that it was impractical and "on balance will result in hardship to Crown." The court also relied upon testimony that Hess was on the verge of failure and was operating under a requirement by its creditors to "down-size" and eliminate unprofitable stores.

Yet, since the court found that Section 8.1 was a valid clause, the court held that Hess breach of the covenant to operate continuously would entitle Western to money damages. Specifically, the court stated that Hess is not excused from its duty of performance of the operating covenant simply because "it decided to close the store for financial reasons."

On the transfer restriction clause, the court found it unenforceable on the grounds of (i) changed circumstances and (ii) the clause constitutes an unreasonable restraint on alienation. The changed circumstances noted by the court was the "near financial failure of Hess"; Hess' liability and monetary damages for not operating continuously, for which damages were mounting on a daily basis; and also that there was clearly "no affiliate in the Crown/Hess corporate family to assume the anchor store agreement."

The court found the clause to be an unreasonable restraint because "the practical effect of this restraint is to take the real estate out of the ordinary stream of trade or commerce." The clause would have the effect of leaving the site "dark," which would cause economic waste, contrary to the policy disfavoring restraints on alienation."

In holding that Hess was free to transfer the property rights to anyone, the court also required the new entity to assume Hess' obligations under the operating and supplemental agreements. The court was perplexed and unable to resolve the question of what would constitute a "retail department store" to be operated continuously. Nonetheless, the court stated it accepted testimony that such phrase contemplates a "wide range of departments, including a general line of family apparel, household products, furniture, appliances, electronics, etc." The court was left with suggesting that Western and Southern look to how Hess and the other anchor stores implemented their contract requirements in order to determine how to interpret the clause.

Although this is not a New York court decision, it is probable that under the same circumstances, a New York court would follow the same rationale. This Western case accordingly gives the owner/developer guidance in drafting tenant retail contracts and some indication as to when litigating with a financially troubled tenant will be advisable.

(Peter Goetz is a founding member of the law firm of Goetz, Fitzpatrick & Flynn. Mr. Goetz and the firm devote a substantial portion of their practice to representing the real estate industry, including developers, landlords and builders in connection with property acquisition, leasing, construction and related matters. The firm does extensive litigation, arbitration and mediation in these fields.)