Canada: Land Mines In Canadian Commercial Leases

In commercial leasing, there is typically a strong emphasis on pricing and monetary terms. However, the fine print of a lease agreement cannot be ignored; it can even be more important. A lease can destroy or impair the goodwill of a commercial tenant's business when it contains potentially problematic provisions – ie, "land mines". These clauses are often hidden deep within the lease agreement and may pose the risk of serious consequences for tenants.

There are three common land-mine provisions that tenants must give careful thought to before signing a commercial lease to protect themselves from potentially serious consequences during the term of the lease. These three land mine provisions relate to exclusivity, demolition, and assignment.

Exclusivity

An "exclusivity clause" in a commercial lease grants a tenant the exclusive right to provide specific goods or services within a commercial property. In doing this, the clause restricts other tenants or future tenants from also providing those goods or services in that property.

It is beneficial to a tenant to have an exclusivity clause included in a commercial lease. Such a clause ensures that the tenant will not have any direct competition on the premises, which might have an adverse effect on the success of their business. For example, if the tenant's business is a pharmacy in a plaza or at the bottom of a commercial building, that tenant will benefit from an exclusivity clause in the lease by preventing another pharmacy from opening and operating in the plaza or building and drawing potential patients and customers away from transacting with the tenant.

However, an exclusivity clause is only as effective as its wording. It is vital to examine whether an exclusivity provision truly offers exclusivity to the tenant, or whether there is a technical workaround whereby the landlord could allow a similar business to open and operate on the property covered by the lease.

In this respect, a potential issue to consider is whether an exclusivity clause uses the term "exclusive" or whether the clause instead contains qualifying words such as "primary use" or "ancillary use". The former raises a question as to whether another tenant could get around this wording by arguing that their similar business actually comes under the definition of "secondary use" because it is incidental to another business use also conducted in the premises.

For instance, using the example of a tenant with a pharmacy, imagine that another tenant has a medical clinic in the same building as the first, and the exclusivity clause in the first tenant's leasing agreement contains the words "primary use". In this scenario, the tenant with the medical clinic might conceivably be able to open a pharmacy in the clinic by arguing that the operation of their pharmacy actually constitutes "secondary use", because the primary use of their property is the practice of medicine.

In essence, when considering the importance of an exclusivity clause in a commercial leasing agreement, the crucial question to ask is whether the tenant's business goodwill is linked to the business' location under the lease. In other words, will it actually matter if a competitor opens a similar business right next door to the tenant's property that may compete with the tenant? For example, if the tenant intends to operate a business online, then it likely will not matter as much where the tenant's property is located. In general, potential clients to an online business will have no idea where a tenant is located and likely will not care.

Many tenants neglect to consider this point by solely focusing on rushing to secure a location. However, a commercial tenant actually has the most leverage before signing the offer to lease or the lease itself, to ensure the appropriate exclusivity clause is inserted. Patience and careful consideration will avoid blindly hoping that an unfavourable exclusivity provision will not apply to them.

Demolition

A "demolition clause" is the second type of potential land mine that a tenant should pay close attention to in a commercial lease. A demolition clause is a provision which gives the landlord the right to cancel the lease and evict a tenant from the premises (often on very short notice) in order for the landlord to demolish the building. Such a clause has the purpose of protecting the landlord's right to demolish the existing building in order to construct a new (and usually bigger) building on the site, which may be in the landlord's business or financial interest. The right to demolish a building and redevelop is currently very popular with landlords.

With this in mind, it is important for tenants to consider demolition provisions within a lease agreement before signing. Tenants need to consider the question of just how broad the particular demolition provision is.

A demolition provision may state that if the landlord intends to redevelop the property covered by a lease, then they need to give the tenant six months' notice, upon which time the tenant must vacate the premises. However, in analysing a landlord's intention to redevelop under a lease, there is a distinction to be drawn. First, has the landlord expressed an intention to redevelop, but not actually taken any steps towards redeveloping? Or alternatively, has the landlord actually taken steps by having applied for site plan approval and building permits and the like? When it comes to the issue of determining a landlord's intention to redevelop, a demolition provision needs to include concrete efforts and undertakings that have cost the landlord actual effort and resources.

Furthermore, a tenant needs to consider how much risk they are willing to bear in relation to a demolition provision. If the lease relates to a new building, for example, it is unlikely this new building is going to get demolished during the course of the lease. If, however, the lease relates to an old building, then the risk of demolition is higher. A tenant will need to consider how much this risk factor matters to them when it comes to signing the lease agreement, since an early termination of a lease will affect operational certainty, which may come at substantial cost and expense to a tenant. For instance, a tenant will need to determine how much effort to invest into fixturing the premises or marketing its business in the surrounding area if they may not stay in the location for long.

Assignment

An "assignment clause" is the third type of potential land mine to consider. If there are restrictions on the tenant's ability to assign their lease to another party in an exit transaction, then this reduces both flexibility and available options for the tenant during the course of the lease.

Assignment provisions in commercial leases are very important to both landlords and tenants, and are often heavily negotiated by both parties. When a tenant's interest in a lease is assigned, the tenant will essentially be transferring their entire leasehold interest – and the entirety of the leased premises – to a third party for all of the remaining term of the lease. An assignment provision is often used by tenants when selling their business which is operated from the property governed by the commercial lease.

The reason why an assignment provision may be a "land mine" is because it may sometimes contain termination rights in favour of the landlord. If and when a tenant asks a landlord for an assignment of a lease, the landlord may have the right under an assignment provision to refuse the tenant's request for assignment and opt to terminate the lease instead. In such circumstances, the assignment provision becomes a "shakedown provision", in that the only practicable way for a tenant to successfully assign a lease is to incentivise the landlord not to terminate the lease. This may come at a significant cost to the tenant, or it may adversely affect the proposed transaction by the tenant with respect to selling the business.

Conclusion

Provisions relating to exclusivity, demolition, and assignment are common potential pitfalls – or "land mines" – in a commercial lease. Whether they can be problematic for a tenant depends on how the provisions are drafted. Of course, even where such land-mine provisions exist in a particular leasing agreement, a tenant may still decide to sign it, provided that they are willing to take the risk that these provisions might be triggered during the course of the lease. Nevertheless, a tenant would be wise to adjust their expectations and operational considerations where the lease terms may not necessarily be the most favourable or predictable for them. Careful attention should be given to these risk factors before signing the lease agreement.

Originally Published by Chambers and Partners

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.