Arizona court recognizes implied good faith obligation to generate sales
Landlords insist on operating covenant-an agreement for the tenant to operate the business.

Arizona court recognizes implied good-faith obligation to generate sales

May 9, 2023

Owning a retail business always comes with risks. Is it the right location? Is it the right merchandise? Is there good traffic? Are the stores in the area doing well?

Is the big box down the road healthy? However, once a lease is signed, the commitment is made. Landlords, seeking to maximize income, will often insist on what is called an operating covenant-an agreement for the tenant to operate the business, sometimes including a timeframe, and sometimes even setting a minimum number of hours and days that a business must operate. Sometimes the lease will include a lease payment based upon a percentage of store sales. Sometimes, also, business conditions change. Consider a recent decision of the Arizona Court of Appeals: Ross Dress for Less, Inc. v. Westfest, LLC.

Implied covenant to operate

In 1997, Ross entered a commercial lease to occupy a certain space in a shopping center. The lease did not contain a specific occupancy clause, but provided for a certain monthly lease payment. If occupancy in the shopping center dropped, it was considered a reduced occupancy period and the tenant’s lease payment would be the lesser of the monthly rent or two percent of the tenant’s gross sales for the preceding month.

It was during such a reduced occupancy period that Ross decided to change its entire retail concept from a dress store to a discount store. Such a change obviously required revamping the store and Ross closed the store for five months while it remodeled. During this time, Ross paid nothing in actual rent, contending that it was only required to pay the lesser of its gross sales-which was $0.

The court of appeals disagreed. The court decided that where rental is determined by the percentage of sales, Arizona recognizes a good-faith duty by the lessee to ensure that the projected sales will adequately compensate the lessor for the use of the property. The court reasoned that rent based upon a percentage of sales as rent is necessarily related to the generation of sales. Ross, therefore, had an obligation to act in good faith to maintain its retail business operations if it bases its rent on a percentage of those sales.

Seeking experienced legal representation

Had the lease agreement in the Ross case contained an “excuse” clause, which could create an exception to the implied covenant to operate, the result may well have been different. The case highlights the importance of seeking the advice of an Arizona attorney experienced in commercial real estate in negotiating a lease. Such representation is equally important when business conditions change during a lease period and the ability and responsibility for continued lease payments becomes an issue.