In recent years, Canadians have been witness to the reshaping of the Canadian retail landscape, precipitated in large part by a difficult global economic climate resulting in increased insolvencies, restructurings and consolidations of retail businesses and the efforts of foreign retailers (particularly US-based) to expand their reach into Canadian markets. While such circumstances are unfortunate for ailing retail businesses and their stakeholders, they present opportunities for those seeking to instantly establish a significant presence, or to materially expand their existing footprint, in an increasingly crowded Canadian retail marketplace where vacancies in premier retail nodes and shopping centres are difficult to find. Whether the resulting transactions are structured as business acquisitions or simply pertain to the subject real estate interests, the transfer of retail leases raises considerations that are in many cases peculiar to this real estate asset class. This article explores some of the important considerations relevant for both sellers/transferors and buyers/transferees in the context of the transfer of retail leases.
1. Consent Requirements
Under most leases, the transfer of a tenant’s interest in a lease (whether directly by assignment or indirectly via a sale of shares or a merger involving the existing tenant) will require the consent of the landlord. Many sophisticated retail tenants will negotiate exemptions from some of the consent requirements and accordingly one of the first tasks in a proposed transaction will be to analyze the leases to see which of them require landlord consent. While principally part of the transferee’s due diligence, it is generally prudent for a transferor to take the necessary steps in order to understand its portfolio and anticipate (and verify) the questions/issues that may be raised by the transferee and the landlord. To the extent the landlord’s consent is required, the analysis should also extend to the parameters within which the landlord is required to consider the consent request and to grant the consent. Questions to consider in this regard include: May the landlord unreasonably or arbitrarily withhold consent? Does the consent request trigger a right in favour of the landlord to recapture the leased premises and terminate the lease rather than consent? What conditions may the landlord attach to such consent and what are the consequences thereof?
2. Use Considerations
- Permitted Uses. If the transferee proposes to change the use of the subject premises from that which is set out in the lease, this will generally require the consent of the landlord (a notable exception being leases for anchor/big box tenants who often have the negotiating clout to provide for flexibility in this regard). Such use provisions may contain specificity beyond the general permitted use in regards to the banner under which the business may be conducted, the type of goods which may be sold, the required merchandising mix and the days and hours of business that must be maintained by the tenant.
- Prohibited Uses. Retail Leases will generally prohibit the tenant from undertaking uses which constitute a nuisance, are immoral or inconsistent with the status or quality of the shopping centre or are competitive with other tenants thereof. It is also possible, particularly in the context of premises within an unenclosed mall or power centre, that additional use and operational restrictions to which the transferee will be bound are found within instruments registered against title to subject lands (such as restrictive covenant agreements, reciprocal easement and operating agreements and municipal development agreements). Accordingly, in certain circumstances a search of title to confirm the existence and application of such instruments to the leased premises in question would be prudent.
- Zoning & Municipal By-Laws. When determining the appropriate scope of due diligence, consideration should also be given by the transferee to the review of applicable land use and zoning laws and by-laws. Whether such investigations are advisable will depend on the proposed use (or change in use) of the leased premises and their location and type. Given their nature and configuration, particular care should be given to considering standalone street front retail locations and parcels within an unenclosed mall or power centre. Recent media stories in Toronto highlight the importance of conducting zoning reviews. They followed the plight of an entrepreneur who commenced operating an arcade/pinball-themed café at a street-front retail location, only to find that the municipal zoning by-law deemed such use to be a prohibited gaming establishment. Other common zoning issues concern exterior building signage, outdoor and sidewalk sales and storage and expansions and alterations to premises (particularly in the context of heritage-designated premises where most alterations are prohibited absent approval from the applicable heritage conservation authority).
- Continuous Operation Covenants. If a lease contains a continuous operation covenant, both the transferor and the transferee must be cognizant of the potential breach of this covenant should the contemplated transition of the premises between them involve any “dark” periods. If so, consideration should be given as to how this should be addressed with the landlord in light of the fact that it may be entitled to various remedies during the dark period (such as per diem penalties, forfeiture of tenant rights and an entitlement to reclaim the lease).
- Radius Restrictions. The transferee should also determine whether its current or anticipated future locations fall within the area of any radius restrictions within the lease and the implications thereof.
3. Personal Rights
Most sophisticated landlords will provide in their leases that certain concessions from their standard form requirements or other special tenant entitlements (such as options to renew the term and rights to lease adjacent premises) are personal to the originally named tenant and do not enure to the benefit of any transferee of the lease. The loss of some of these rights, such as renewal options at fixed rental rates, could have a material impact on the financial metrics of the transaction for the transferee and accordingly it is incumbent upon the transferee to identify such personal rights and consider the implications of failing to secure the landlord’s agreement to have the benefit of such rights survive the subject transfer.
4. Consent Responsibilities and Associated Costs
One of the transaction points to be negotiated amongst the parties will be the extent to which the transferor must go to secure any required landlord consents and the allocation of risk and responsibility for the satisfaction of any conditions thereto. This may well be dependant upon the parties’ agreed upon requirements for a valid consent, as landlords, sensing any leverage in a situation, may insist on receiving something in return for a consent which it may otherwise not be obligated to reasonably consider (for example, consents to a change in use or retention of personal rights). The required concessions and conditions for the grant of a consent may be expressly contemplated by the lease or raised as part of the negotiated settlement to secure it. An important lease provision in this context is the entitlement of the landlord to escalate the minimum rent payable under the lease post-transfer. Common examples of rent escalation formulas found in Canadian retail leases include those based on consumer price indexes, crystallization into minimum rent of averaged percentage rent payments and increases based on fair market rent determinations. Other consent conditions might include forfeiture of special tenant rights, required remodelling of the premises, and concessions by the transferor in respect of its other locations in the landlord’s portfolio of properties. In addition, the lease may entitle the landlord to any consideration received by the transferor for the transfer of its interests in the leases. How such risks and costs are to be borne and allocated amongst the parties will be the subject of negotiation and the permutations will depend on the creativity of the parties and their negotiating leverage.
5. Consent Thresholds
Where the subject transaction involves multiple leased locations, the parties will need to consider what the critical mass of required consents must be before either party wishes to proceed. The transferee will need to be comfortable that it has a critical mass of the desirable stores such that it is able to implement its proposed use and business plan. similarly, the transferor will need to be satisfied that it will not be saddled with undesirable locations that will otherwise be difficult to individually divest. The appropriate critical mass may take any number of forms depending on the particulars and economics of the transaction. For example, if the acceptable threshold is 35 of a possible 50 leased locations, such threshold might be set as a mutual condition of closing. Within this category, each of the parties may specify locations which it views as crucial to its intended goal with the transaction and accordingly the transfer of such locations must form part of the aforesaid 35. A different approach would be to place the entirety of the consent risk on the transferee. This approach would generally only be commercially tenable in those circumstances where the allocation of risk is priced into the transaction and the transferee can reasonably be expected to be a desirable tenant to landlords. This scenario will have issues of its own in that the transferee will not have a legal right to occupy the premises without such consent and that the transferor will continue to be obligated to the landlord notwithstanding the assignment and could face recourse for this breach.
6. Inability to Secure Consents
In circumstances where the parties have agreed to close the transaction with less than all of the landlord consents in hand, the parties will need to consider the question of what do in circumstances where the balance of the consents have not been obtained for closing. Some permutations could include removing from the deal any lease for which consent is not obtained with (or without) a corresponding “release” value for each such location by which any consideration paid by the transferee to the transferor is reduced. Where the transferor’s intention is to divest itself entirely of the portfolio of leases concomitant with the disposition or wind up of a chain of stores this will not be a preferred approach. Accordingly, the transferor may, as noted above, insist that the transferee take all such locations notwithstanding the lack of consent and principally bear all associated risks.
7. On-Covenant Obligations
It is common for retail leases to provide that despite an assignment of such lease, even where the landlord’s consent is obtained, the original tenant is not released from its obligations therein. Accordingly, the landlord may look to the transferor for restitution in the event that the transferee does not fulfill its obligations. Absent exceptional circumstances, it would be atypical for Canadian landlords to release the transferor upon assignment of the lease. Accordingly, this consideration will need to be factored into the transferor’s analysis of the transaction and the prospective transferee with whom it will remain linked for many years. To the extent the transferor is concerned with the covenant of the transferee (particularly where it is a special purpose entity), this will need to be factored into its risk analysis of the transaction and it may wish to secure a parent indemnity or other covenants to address all or part of its concern. If the transferor is especially uncomfortable with the covenant of the transferee and a release from the landlord is not available, one possibility would be to sublet the premises to the transferee as opposed to an outright assignment, such that the transferor may reclaim possession of the premises in the event of default by the transferee therein.
8. Long Term Leases
The transfer of leases with lengthy terms and renewal options raise unique issues. In Ontario, the transfer of a lease with a remaining term (including options to renew or extend) that may exceed 50 years is generally subject to land transfer tax, calculated generally at the approximate rate of 1.5% of the fair market value of the subject premises. If the premises are located in Toronto, a similar municipal land transfer tax will also be exigible in addition to the aforesaid provincial land transfer tax. Also, leases (generally other than leases of parts of a building) with a term and renewals that may exceed 21 years require consent of the applicable authority pursuant to the subdivision control provisions of the Planning Act (Ontario). Absent such consent the term of the lease generally may not exceed 21 years less a day or the lease may be void altogether should it not contain the statutorily mandated savings language which expressly limit the term to maximum length permitted by the Planning Act. While there is no uniformity across the provinces in this regard, careful consideration should be given to such issues in each province within which the assignment of a long term lease is being considered.