COMMERCIAL
LEASE RESTRICTIONS:
APPLICATIONS
AND ENFORCEMENT
by John W. Steele and Anne M. Vaughan *
I. INTRODUCTION
Restrictive covenants in one form or another have been commonplace in the world of commercial leasing for decades. As the business world evolved into discrete commercial shopping centers and specialized buildings, both tenants and landlords began to look for ways to maintain property value and competitive advantage, if not survival. A landlord quickly realized that failing to limit a tenant's use of a property could result in devaluation and inability to rent adjoining space and land. Tenants realized that ensuring a viable complementary business environment, free of direct competition, was one major component of their success. Restrictive covenants were negotiated and applied to achieve these and other business goals. Sophisticated landlords and tenants have learned what is critical to their success and know how to draft and negotiate these provisions effectively. If you or your client is involved in leasing commercial real estate, you need to know how to draft and negotiate these provisions.
II. MAJOR CATEGORIES OF RESTRICTIONS
The primary manner of imposing restrictions on the tenant in a lease is through the "use" clause, which is an essential part of any lease. A well drafted use clause clearly and accurately defines the uses restricted by the tenant and either limits the use to a specific use type (e.g., office or operation of a restaurant), or carves out provisions for permitted uses. This provision will either dictate or not dictate a tenant's use of the premises. Drafting is of critical importance and ambiguous language can create significant problems. For example, a use clause that permits "any lawful use" really imposes no limit on tenant's use of the premises so long as it is a lawful use. See Warren v. Variety Wholesalers, 1995 U.S. App. Lexis 32652 (4th Cir.), aff'd 70 F.3d 1264 (4th Cir. 1995). The clause that states that tenant "may use the premises for . . ." is also not restrictive, but rather permissive in nature. Nothing is prohibited by such language.
The concerns of landlord and tenant frequently lead to drafting and negotiation of specific goal-oriented restrictions. Most of these fall into the following general categories:
A. Competition Oriented
The landlord wants to control the market for a particular type of use the sale of a particular product-type, price-point, service or use-type (e.g., restaurant, bath products, and women's clothing). Controlling the use each tenant is permitted to make of its premises provides stability and creates an environment which can both assure that existing tenants will not face undesirable competition (and thus risk a lease default or non-renewal) and provide the basis to attract new tenants looking for the security of a competition-free zone in which to operate.
B. Environment Oriented
Landlords and tenants alike seek to create the right business environment in which to operate. Some activities which may be acceptable in a neighborhood shopping center would be unacceptable in a regional shopping center. Certain types of uses create negative perceptions and/or provide reasons for customers to patronize other properties; others may create operational concerns for both tenants and landlords. These so called "obnoxious" use provisions are designed to prevent the tenant or the landlord (and sometimes both) from engaging in certain activities that will or could adversely affect actual operation of a business in this location. A typical list of obnoxious-type uses incompatible with the retail center may include mortuaries, bars, liquor sales, drug paraphernalia, manufacturing, flea-markets, fire sales, off-track betting parlors, and other potentially offensive businesses. Other obnoxious uses focus on operational concerns involving noise, distractions, parking problems and use of sidewalks. High quality centers with substantial anchors will particularly seek to prohibit certain types of uses (e.g., bowling alleys, restaurants, movie theaters, health and fitness centers, known to be large parking users) from the property or at least within several hundred feet of the premises. Other objectionable uses may involve businesses with potential environmental risks (e.g., processing, cleaning plants, and battery recycling centers).
C. Existing Restrictions
A landlord may be under an obligation due to pre-existing leases or recorded restrictions, imposed by either a prior owner or a prior tenant. If these restrictions are not imposed on the new tenant, the landlord may have no way of preventing the new tenant from engaging in an activity which, although lawful, nevertheless violates the landlord's contractual duty to an existing tenant or adjacent land owner.
D. Exclusives
Typically bargained for by a tenant, the grant of an exclusive use provision has the effect of obligating the landlord to restrict any future tenant, occupant or owner from engaging in the use-type carved out for that particular tenant. The tenant's objective in these cases is to create a competition-free zone to preserve its economic advantage to the fullest.
E. Non-Compete (Radius)
This type of restriction, typically imposed on a tenant (but sometimes imposed in reverse on the landlord), will limit the designated activities in a defined area of competition (e.g., within one (1) to three (3) miles). From the landlord's perspective, the object of this type of provision is to prevent the retail tenant from operating from an adjacent or nearby property to the detriment of the landlord. This provision is primarily of concern to a landlord where percentage rent is payable under the lease. The objective is to prevent a tenant from artificially diverting its sales (and thus the landlord's percentage rent) to other locations. When negotiated for the tenant, the radius restriction is actually a tenant "exclusive" with a larger geographic focus.
F. Approval
An "approval" provision grants to the tenant the right of approval over certain other occupants in the project/building in which the beneficiary is leasing space. Disfavored by landlords (and possibly in violation of certain state and federal laws), such a provision gives a tenant the ability to essentially control the landlord's selection and mix of tenants. A tenant refusal to grant consent can impact revenue and effectively delay, if not prevent, the landlord from entering into new leases as space becomes available.
III. APPLICATION OF VIRGINIA LAW
Restrictive covenants and use restrictions are construed in much the same way as restrictions imposed on property conveyances. They are enforced in Virginia, but subject to certain standards.
Restrictive covenants are not favored in the law. As a result, courts tend to read and interpret them strictly. Hening v. Maynard, 227 Va. 113, 313 S.E.2d 379 (1984); State-Planters Bank of Commerce & Trusts v. Standard Cary Corp., 208 Va. 298, 156 S.E.2d 778 (1967). The party seeking to enforce the restriction will carry the burden of proving the true meaning and intent of the restriction in question and establishing that it applies to the activity sought to be restricted. See Foods First, Inc. v. Gables Associates, 244 Va. 180, 418 S.E.2d 888 (1992); Mid-State Equipment Co. v. Bell, 217 Va. 133, 225 S.E.2d 877 (1976). Accordingly, much emphasis is placed by Virginia courts on ascertaining the meaning of the words used in the covenant.
Several legal maxims are typically applied by courts to focus their examination of a restrictive covenant. The major emphasis is usually placed on giving meaning and effect to the plain language of a restriction so that the words chosen by the parties are given precedence, where possible. Where terms of an agreement are "clear and unambiguous, it is the duty of the court to construe'" them as written. Kirkorian v. Dailey, 171 Va. 16, 24, 197 S.E. 442 (1938) (quoting Bossieux v. Shapiro, 154 Va. 255, 153 S.E. 667, 669 (1930)). However, to the extent that any ambiguity exists in the language, the meaning of the covenant will usually be construed to enforce the least intrusive restriction. Though the basic legal principles appear to be well established, predicting the outcome and enforceability of a poorly worded restriction is murky at best.
An example of apparently clear language which ultimately did not serve the drafter as intended is illustrated by the Foods First case. See 244 Va. 180, 418 S.E.2d 888 (1992). Foods First took over an A&P lease, which provided in part: "[I]n the event . . . [that Landlord develops a supermarket or grocery store within the shopping center,] Lessor will not erect such other building to be occupied by a supermarket, grocery store, meat market or produce store in excess of the number of square feet in the building occupied by A&P." 244 Va. at 181. The landlord did not construct a new building but renovated an existing building, which was larger than the A&P space, for use by a competing grocery store. The tenant sued for violation of the covenant. The case turned on the interpretation of the word "erect." The trial court, with the Supreme Court agreeing, found that the word "erect" means to construct and did not apply to interior remodeling of an existing building. See 244 Va. at 183. Consequently, it did not find the covenant to have been violated.
Virginia Courts have traditionally applied the legal principles noted in this article with reference to "intent," placing varying degrees of importance on examining the intent and purpose of the parties themselves in creating the covenant. Though in some cases this process seems to conflict with the concept of strictly construing the actual meaning of the words used in the covenant, the reported cases do provide useful information and some guidance for those drafting or seeking to understand restrictions in leases. A longstanding Virginia Supreme Court decision on this issue is Krikorian v. Dailey, 171 Va. 16, 197 S.E. 442 (1938). Though based in a very different time and commercial environment, the case continues to be cited in modern commercial cases. A tenant operating a "confectionary" obtained from its landlord a restriction prohibiting the landlord from leasing an adjacent property for use as a "confectionary" during the term of the lease. The tenant learned that the landlord intended to use the adjacent parcel as a drug store, which would also sell confectionary goods. Trial instructions introduced the "substantially similar business" concept. The test applied by the court was that if the new business was "substantially similar" to that of the beneficiary of the covenant, the covenant was breached. 197 S.E. at 447. The trial court, later supported by the Virginia Supreme Court, agreed that a breach had occurred. The court focused on the substance of, and the obvious reason for, the covenant which was to prevent competition in the confectionary business and concluded that giving effect to the real substance of or purpose for the covenant should not be lost in a technical construction of the words. "[T]he academic definition of words is often important, but more important still is the purpose of the covenant. Has that purpose been kept or broken." Id. at 446.
A current application of this concept is well illustrated in the recent case Providence Square Associates, L.L.C. v. Boney Wison & Sons, Inc. See 211 F.3d 846 (4th Cir. 2000). A drug store (Rite-Aid) was granted an exclusive prohibiting the conduct of any other drug store, variety store or photo finishing business or any store whose primary purpose is the sale of patent medicines, health and beauty aids, cosmetics, lawn and garden and/or outdoor living merchandise within the shopping center. The Landlord then leased a building in the shopping center to Hannaford which opened with a full service pharmacy and a drop box for photo finishing. Hannaford's signs and ads described it as a "food and drug superstore." Rite Aid protested and sued to enforce its exclusive. Hannaford argued primarily that it did not violate the covenant because 1) it was grocery store, not a drug store and 2) its photo finishing business was offsite; only drop off occurred at the store. The trial court agreed. The appellate court noted Virginia principles of law on the subject, specifically the need to determine the intent of the parties. The court noted that "if the terms are vague or ambiguous, then we may consider extrinsic evidence to interpret those provisions." Id. at 850 (citing Shoup v. Shoup, 31 Va. App. 621, 525 S.E.2d 61 (Va. Ct. App. 2000)). Like the Krikorian case, the court in Providence Square emphasized the need to determine the substance of the covenant, the real purpose behind the restriction. "[I]t is clear that Rite Aid's prohibition of another 'drug store' sought to avoid the competitive sale of prescription medicine in the shopping center." See 211 F.2d at 851. According to the court, the "clear lesson of Krikorian is that we should look to the substance not the label of the activity sought to be restricted under a covenant. . . . A 'drug store' is no less a drug store merely because it has been incorporated into a structure called a 'supermarket.'" Id. The courts reasoning and dicta suggest that in cases of commercial leases with sophisticated business entities, recognition is going to be given to the real purpose behind a restriction and to the effect of the restriction, not to a hypertechnical reading of the language.
A similar type of case, with a different result, is Marriott Corp. v. Combined Properties Limited Partnership. See 239 Va. 506, 391 S.E.2d 313 (1990). The plaintiff tenant operated under a forty-year lease, dating to 1967, which prohibited the landlord from leasing to a business operating as a "drive-in food establishment." 239 Va. at 508. Relying on cases like those noted above in this article, Marriott sought to enforce the covenant and prevent the landlord from leasing to a McDonalds by claiming that the real purpose of the restriction was to provide protection from a similar, competitive food service business. Marriott sought to establish that the phrase "drive-in food establishment" applied to today's fast food restaurants and that the covenant sought to prevent any similar type of competition. After a nostalgic look at the evolution and history of today's "drive through" fast food industry, the court concluded that its duty was to determine the intent of the parties at the time the lease was executed and doing so required interpreting the meaning of the phrase "drive in" as it was commonly used when the provision was written. In determining intent, the court's opinion claims to look to the ordinary and common meaning of the language. "[S]pecific words in a covenant will be given the common, ordinary meaning attributed to them at the time . . . the covenant was executed." 239 Va. at 512 (quoting Elterich v. Leicht Real Estate Co., 130 Va. 224, 239, 107 S.E. 735, 740 (1921)). In ruling against Marriott, the court found that the "drive in" concept of 1967 was very different from the typical fast food "drive through" concept of today and refused to enforce the restriction to prohibit a McDonalds from opening in the shopping center. Perhaps the best lesson to take from a case like this is the need to write language that is flexible enough to apply to evolutionary changes in the industry being restricted. A pertinent example is the video sale and rental business. Will prohibitions on video cassette rental operations serve to prevent the sale and rental of dvd's, laser discs and whatever future technology may be developed in that industry?
Occasionally the parties to a lease draft language which is not susceptible of interpretation under these legal strictures. In Dart Drug Corp. v. Nicholakos, 221 Va. 989, 277 S.E.2d 155 (1981), for example, Dart sought to enforce a provision limiting further expansion of the shopping center in which it leased space. The language provided in part that the location of buildings and layout of parking areas are "designated and fixed on Exhibit A,' and shall remain so throughout the term of the Lease." 221 Va. at 992. The Lease also required the landlord to maintain a minimum number of parking spaces "within the shopping center, and within any additions thereto or extensions thereof." Id. Dart naturally claimed that the first part of the language fixed the layout of the center and prohibited any further expansion. The landlord claimed that the reference to "additions and extensions" made it clear that expansion was expressly contemplated. In the end the court did what most courts do with conflicting and ambiguous language. It declared that both parties intended a reasonable construction and therefore each had a right to enforce but on reasonable terms. See id. at 993-94. This splitting of the baby no doubt pleased the landlord, because it was permitted to expand with some approval of the tenant. The tenant was probably less satisfied since its objective was no doubt to prevent a change in the shopping center layout and the development of further buildings. Use restrictions and similar covenants can be a critical asset to both the commercial landlord and tenant. As the cases reveal, they can also be a dangerous trap for the unwary. Take the time to understand what the client's goals and expectations are, whether dealing with a restriction that benefits or burdens the client. Crafting language that will give effect to the parties' business agreement is only possible if their intentions are understood and woven into the covenant with clarity. Those failing to learn from the lessons of case law may be risking their client's economic success.
*Mr. Steele is a shareholder in the Richmond office of Hirschler, Fleischer, Weinberg, Cox & Allen. Ms. Vaughan is an associate in the Richmond office of Hirschler, Fleischer, Weinberg, Cox & Allen.