Tuesday, October 27, 2015

Fun with Percentage Rental Clauses

In 1993, Ralphs Grocery Company signed a 20-40 year lease with Midtown Shopping Center Associates for 53,000 square feet in a Los Angeles shopping center. Under the lease, Ralphs is required to pay an annual base rental rate of almost $1 million per year, plus 1.25% of gross sales over $31 million.

The lease defines “gross sales” as the amount of the sales price, whether or not for cash or upon credit, of all merchandise and goods, and the charges for services sold on or delivered from the shopping center property. The lease excludes 15 items from gross sales, including sales tax, deposits on returned items, refunds and credits for defective items, sales from other stores, interest and credit card charges, sales from lottery tickets and coin-operated devices, coupons, commercial sales of scrap materials and bulk sales consisting of inventory, fixtures and equipment.

Also excluded are “. . . discounts allowed to any customer pursuant to any customary and reasonable policy adopted by Ralphs . . .”

Ralphs created a Rewards program in 1997 intended to encourage and reward customer loyalty. In this program, Ralphs charges two prices for merchandise: (1) a higher price paid by customers who do not participate in the Rewards program; and (2) a lower price paid by customers who sign up for the customer loyalty program.
Paper transaction receipts generated at the check-out stand detail what Rewards customers would have been charged without the program discounts, and calculates their “savings.” The program has been quite successful: transactions by Rewards customers account for 97% of all transactions at Ralphs.

Ralphs provided Midtown yearly statements reflecting what it believed constituted “gross sales” from the Midtown store, using the amount Rewards customers actually paid rather than the amount they would have paid for the same items had they not participated in the loyalty program. When Midtown expressed its view that Ralphs was under-reporting “gross sales” by excluding the amounts Rewards customers could have been charged, Ralphs filed a lawsuit against Midtown.

The trial court concluded that “gross sales” was based on sales prices Rewards customers would have paid absent the program discounts. Accordingly, the court awarded Midtown $305,000.

Ralphs appealed.

The Court of Appeals determined that a reasonable, fair and just definition of “gross sales” is one that looks to the amounts Ralphs actually charges its customers, as opposed to the hypothetical amount Ralphs opts not to charge them.

The Court of Appeals also found that the Rewards program is a discount pursuant to a “customary and reasonable policy” adopted by Ralphs, as specifically contemplated by the lease even though it was created four years after the lease was signed.
The Judgment of the trial court is reversed. The term “gross sales” in the Ralphs – Midtown lease does not include amounts Ralphs never charged its Rewards customers. Consequently, Ralphs owes no additional rental.

See Ralphs Grocery Company v. Midtown Shopping Center Associates; No. B252292; California Court of Appeal, Second Appellate District, Division Two; June 17, 2015.

Lesson learned: It is difficult in commercial leasing to anticipate every issue that will occur over a 20 or 40 year lease term. Gross sales clauses are constantly being  probed and tested, as are CAM triple-net pass-through clauses of taxes since Texas franchise and margin taxes didn’t exist seven years ago. Be extra careful when you are addressing percentage-of-gross-sales and expense reimbursement provisions.
Reprinted with the permission of North Texas Commercial Association of REALTORS®, Inc.

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