Exam, Summer 1993

Contracts

Avery Katz
University of Michigan Law School
Summer 1993

Final Examination
August 23-24, 1993

DIRECTIONS

1. Your exam is due at the take-home proctor's desk 24 hours after you pick it up, or at 5 PM on Tuesday, August 24, whichever is earlier. You need not spend the entire 24 hours on the exam; it is designed to be completed in 8 hours. Please type your exam if it is convenient to do so; otherwise, please write legibly. (If you use a word processor, you are expected to take precautions, sufficient to allow you to meet the 24-hour deadline, against mechanical failure, accidental erasure, and similar misfortunes.)

2. The exam is open book; you are free to consult any written materials, and you should have available to you the assigned course materials.

3. Until the examination is completed at 5 PM on the 24th, you may not communicate with any person about the contents of the examination or about the subject of contracts, whether or not you or the other person have started or completed the exam. If during the exam you have any questions regarding its administration, you should contact the registrar's office or the dean of students' office and they will contact me if necessary; this will preserve the Law School's policy of anonymous grading.

4. There are two questions having equal weight in determining your grade. Each question has a 1500-word length limit. You may not use any leftover space from one question in answering the other. Answers exceeding the length limit will be penalized by reducing their score in proportion to the extent of the excess. I will assume for purposes of administering the limit that a typical double-spaced typed page with 1-inch margins contains about 300 standard English words when using 12-pitch type (12 words per line times 25 lines per page), or about 250 words when using 10-pitch type. Any attempts to use shorthand or nonstandard abbreviations, however, will be counted as if full words were used.

5. Please begin each essay question on a new sheet of paper, or if you are writing in a blue book, in a separate blue book. Please write your exam ticket number at the top of the first page of each essay question.

Good luck on the exam, and have a good vacation.

QUESTION 1: 50% of exam; limit of 1500 words.

You are attorney for Shady Glen Associates, a commercial real estate partnership that owns and manages three shopping centers in the state of Hutchins. In 1974, Shady Glen decided to build a neighborhood shopping center in West Arbor Township in Arbor County. At that time the township and county were relatively undeveloped (the 1970 census showed the county to have a population of 83,000 residents), but regional planners anticipated that population and economic development in the county would increase substantially over the succeeding thirty years with the growth of the city of Newburg in neighboring Fuller County. Shady Glen acquired a parcel of land at the corner of a major intersection, and began negotiating with potential tenants and with local banks for a construction loan. It found, as was common in commercial real estate development, that it could not obtain construction financing without first lining up a primary or "anchor" tenant that would draw customers to the shopping center as a whole and help attract smaller retail tenants (called "satellite" tenants in the trade). The use of one or more anchor tenants to bring in customers is a common practice in shopping center leasing, and for this reason anchor tenants typically pay a lesser rent per square foot than satellite tenants.

For the size of center that Shady Glen was planning, the typical anchor tenant would be a large supermarket. Accordingly, Shady Glen approached a few of the major chains doing business in the area, and after tentative negotiations with each of them, settled on Thrifty Mart (TM), the second largest chain in the region, as its anchor tenant. TM then signed a letter of intent which provided for the lease of space in the proposed West Arbor Plaza, enabling Shady Glen to obtain financing. During construction, TM participated in planning the layout of the plaza and selected a location on the east side of the parking lot, opposite from the main highway access. Based on this, Shady Glen was able to line up other tenants, the largest of which were a Rexall drugstore franchise and Mason's, a full-service hardware store. The drugstore, which made clear its interest in attracting spillover business from the TM, selected a location immediately adjacent to the proposed supermarket, and Mason's Hardware took the location allocated to a secondary anchor store at the west end of the parking lot. Shady Glen also signed up several satellite tenants, including a shoe retailer, a florist, a beauty salon, and a self-service laundry. The available retail area in the plaza was to total 85,000 square feet.

On June 1, 1975, TM executed a lease for the premises. The lease was prepared by TM using its standard form lease as provided for in the letter of intent, and TM considered the standard lease terms nonnegotiable. Under the agreement, TM was to lease 25,000 square feet in the shopping center at a base rent of $2500 per month, plus a variable rent equal to 1% of all retail sales above a floor level of $2 million per year. The term of the lease ran from the day TM opened its store until December 31, 1987. The lease provided various terms including an option on TM's part to renew its lease for two additional six-year terms at the same rental rate if it so wished. It also provided, in part, as follows:

"The leased premises shall be used only for the operation of a supermarket (for the sale of groceries, meats and/or other items generally sold by supermarkets). No store or building or any part of the same, now or hereafter constructed in the Center (other than the building demised to Lessee) shall be used for the sale of health foods . . ., delicatessen items, groceries, meats and/or other items generally sold by supermarkets, and no delicatessen and/or delicatessen department shall be operated in the Center without Lessee's written consent."

"Lessee TM may in its discretion assign this Lease or sublet any part or all of the leased premises for the purposes set forth in this Lease. No sublease or assignment by Lessee TM shall relieve Lessee or Lessor of any liability hereunder."

"MERGER CLAUSE. This written contract constitutes the entire agreement between Lessor and Lessee. No other promises, covenants, guarantees, pledges, or collateral understandings shall supplement this contract. The parties agree that neither relies in entering into this contract on any oral representation of the other."

The center opened in the fall of 1975 and was an immediate success. In part this was due to the growth of the township and surrounding county; the 1980 census measured county population at 151,000. In 1985 TM and Shady Glen began negotiations over an expansion of the shopping center. On February 1, 1986, the two signed a new lease that provided for the construction of a 12,000 square foot addition to the TM premises and a separate 18,000 square foot addition on the other side of the plaza. The lease superseded the 1975 lease and set a new term that ran until December 31, 1998. The parties also renegotiated the rent at this time; in 1984 TM was making annual sales of just over $5.3 million, and so had paid $30,000 per year in base rent and approximately $33,000 under the percentage-of-sales provision of the old lease. The new lease provided for yearly base rent of $45,000 plus a variable rent equal to 1% of all retail sales above a floor. The floor was set at $4 million for the first four years of the lease, $4.5 million for the second four years, and $5 million thereafter. It was anticipated that growth in sales would lead to a growth in total rent, but a low floor was chosen for the first four years to provide funds for the expansion. The new additions opened in late fall of 1986 and after some months Shady Glen was able to fill the space with additional tenants, including a video store and a bakery. TM gave written consent to the opening of the bakery.

All went well for the next five years. West Arbor incorporated as a city in 1989. The county continued to grow, and the 1990 census measured its population at 206,000. TM's annual sales grew to $6.5 million in 1991. But in early 1992, Z Brothers, a national chain of discount retailers, announced plans for and broke ground on a major regional shopping mall five miles out of West Arbor, next to the interstate highway. Z Brothers's plans included space for a so-called "superstore" grocery --- a market substantially larger than an ordinary neighborhood grocery store, and containing expanded specialty food centers including an in-house bakery, delicatessen, and seafood and meat markets. Z Brothers offered TM the opportunity to relocate its West Arbor store to its new mall, and TM commissioned a site analysis to determine the viability of relocation. The site analyst, Goebel, stated in his report that the biggest advantage of the offer would be "preventing a competitor from gaining the superstore location," and recommended relocation.

In late May 1992, Knuth, Shady Glen's managing agent, contacted TM's regional manager, Frisby, after hearing a rumor that TM was considering relocating to the new mall. In this conversation, Frisby acknowledged that TM had been offered space in the mall, and admitted that the offer was tempting. She told Knuth that if TM did not take the space, its major competitor Sun Markets would, and if Sun did that there would be severe detrimental effect on sales at the West Arbor location, and Sun would gain a major competitive advantage in the region. In order for TM to remain at West Arbor, Frisby said, the base rent on the store would have to be renegotiated substantially downward. Knuth said that he would have to check with the Shady Glen partners, but that it would be hard to renegotiate the base rent if sales were going to be depressed; a better solution might be to alter the variable portion of the rent. The next week, Knuth called Frisby back, offering to meet and discuss a renegotiation. Frisby replied that the reductions that Knuth was suggesting were inadequate, and put off his proposals for a meeting. Over the next several weeks Knuth and Frisby exchanged telephone calls and letters regarding a renegotiation, but no face-to-face meeting was ever scheduled. On August 20, 1992, TM gave written notice to Shady Glen of its intention to relocate; its notice said it might keep the West Arbor store open for an indeterminate amount of time after opening the superstore, but once the superstore was established, the West Arbor store would close.

Following receipt of this notice, Knuth contacted Frisby again. According to Knuth, in this conversation Frisby indicated that a competing supermarket chain, and in particular Sun Markets, would not be an acceptable subtenant. Frisby was careful, however, not to say so in so many words. Over the next several months TM and Shady Glen were in repeated contact regarding the West Arbor Plaza lease. Shady Glen alternatively urged TM to keep its West Arbor store open, or to sublet to Sun Markets or to another chain, Shop-n-save, both of whom according to Knuth are willing to take over the location. TM rebuffed the requests to keep the store open, although it did exchange letters with Sun and Shop-n-save regarding a sublease. According to the two competing grocery chains, however, the rents TM has so far offered in a sublease are too high to be considered seriously.

On March 15, 1993, TM opened its superstore at the Z Brothers mall, and on July 15 closed its West Arbor store. It has continued to correspond with Shady Glen and Shop-n-save (but not with Sun) regarding a possible sublease, but with no result. Beginning in April, TM began floating the idea of subleasing to Pharm-Aid, a large discount drugstore that sells household items, health and beauty supplies, and the like, instead of to another grocery. Shady Glen has taken the position that Pharm-Aid would be an unacceptable subtenant. Not only does the original lease require that any subtenant be a supermarket, but Shady Glen's lease with Rexall prohibits Shady Glen from leasing space in the plaza to a competing pharmacy. Shady Glen has privately admitted to you, however, that Rexall has been making noises about leaving the plaza. Although the current Rexall lease, which was signed in 1990 and has three years left to run, makes no specific reference to the operation of TM or other supermarket in the center, it was both parties' background understanding that TM would continue to operate an anchor store immediately adjacent to the Rexall store.

Indeed, Shady Glen's problems with satellite tenants are not limited to Rexall. Other tenants, including the hardware and video stores, have been talking about leaving, and some smaller tenants on shorter-term leases have already left, some in advance of their leases' expiration dates. Two of these -- the shoe store and a greeting-card store -- have relocated to the Z Brothers mall. Sales began to fall at the plaza as soon as the Z Brothers mall opened, and they have fallen further since the TM store went dark. Some of this lost revenue is borne by Shady Glen, which has provisions for variable rent with a number of its tenants, but the tenants are hurting as well. None of the satellite tenants' leases made specific mention of TM's operation in the plaza, and some of the leases contained merger clauses, but all the tenants benefit from having a major anchor store. In order to keep its occupancy rate up, Shady Glen has been forced to rent to some tenants it would not ordinarily choose, including a radiologist's office and a local branch of the state Department of Motor Vehicles, but these tenants do not generate much retail trade. It is also considering leasing space to a delicatessen restaurant, but without TM's permission this would violate the existing lease, as well as the analogous provision to be found in the standard lease of the groceries who are potential sublessors.

Shady Glen has just brought you its latest letter from TM, along with letters from other tenants complaining about the situation. In its letter, TM states that sublease negotiations with Shop-n-save have so far been unsuccessful, and again urges that Pharm-Aid be considered as an alternative subtenant. But what really alarms your client are two suggestions TM has not made before: First, TM suggests that if no satisfactory sublease can be arranged, it will stand by the existing lease and simply pay its base rent until 1998. Since the store is now closed, suggests TM, there are no sales against which to apply the percentage variable portion of the rent. For the last four months, in fact, TM has sent Shady Glen checks in the amount of the base rent (in the last two months the store was open, total sales were below the annualized rate necessary to reach the $4.5 million floor) and Shady Glen has cashed those checks. Second, TM states in its letter that soon after Labor Day weekend it plans to remove all specialized trade fixtures from the premises, including shelving, checkout lanes, refrigerated storage cases, and the like. These trade fixtures do belong to TM under its standard lease, but they are physically affixed to the premises and useful primarily to a tenant operating a supermarket. Once they are removed it will be significantly (but not prohibitively) more expensive for a new supermarket to open in the same location, or for TM to reopen, because it will have to install new fixtures at substantial expense.

Shady Glen asks what its rights and duties are under the circumstances. Advise it. (In your answer you should focus on doctrines and principles of contract law, and not on any special rules pertaining to landlord and tenant that you may have discussed in your Property class.)

QUESTION 2: 50% of exam; limit of 1500 words.

You have been asked to render advice to Barry and Jen, two longtime friends and college and graduate school classmates (B.A., Bennington College, 1971, M.B.A., University of Chicago, 1992). They are about to start up a new enterprise, Cosmic Crystal Products, that will produce and distribute natural and herbally based health aids and cosmetics. The goal is to apply some of the marketing and production techniques the two entrepreneurs learned in their previous jobs (after taking a variety of interesting jobs in the decade after college, Jen worked for a small chemical company for much of the 1980's, while Barry built up a successful Amway distributorship) in a more progressive setting. The business is to be operated according to enlightened principles of harmonious management: all products sold by Cosmic Crystal will be certified to be "green," or environmentally safe; none of Cosmic's products are to be tested on laboratory animals; and a portion of any profits earned will be donated to charitable causes. They may expand the business into other life-affirming products (handmade jewelry, perhaps decorative items) if it turns out to be a success.

Barry and Jen anticipate selling their products both in small shops to be opened in several towns in the state, and through a separate multilevel marketing program. They plan to recruit sales agents through a series of meetings and seminars in which potential Cosmic representatives will be introduced to the purpose and philosophy of the company; after gaining experience in the business, these representatives will be encouraged to sponsor additional recruitment meetings and to train and educate new employees and agents. Store employees will be recruited through more traditional means, but they also will be encouraged to take on similar supervisory and training roles. Once, they reach a supervisory level, employees will be able to earn commissions by wholesaling to non-supervisory personnel, and will also be eligible to earn bonuses based on their output. Exactly how this will be worked out is still at the planning stage. But, because both Barry and Jen are strongly committed to a non-alienating organizational environment in which all persons involved can achieve their human potential, management decisions will be decentralized and non-authoritarian. Cosmic employees and distributors will be given a small stake in the business, and will be encouraged to invest further in ownership shares. Barry and Jen also plan to involve employees and distributors in company decision making, and to the extent this is not feasible, to keep them informed of all important decisions affecting their day-to-day lives. They also plan to sponsor motivational seminars and calming recreational activities in the workplace (again, the planning remains to be done) as both a fringe benefit and a way of improving employee satisfaction and morale, but they are not currently sure whether they will actually require Cosmic workers to attend these events.

Both partners are wary of lawyers and the adversarial approach they bring to problems (Barry had a particularly alienating job as a paralegal for some years in the 1970's, and both had friends who had bad experiences with "the System" following arrests for recreational drug use back in college), but they have been persuaded to talk with you by some of their financial backers. Their desire is to avoid the formal sanctions of contract law, and to set up the enterprise as much as possible on principles of trust and fair dealing. Ideally, they would like to make plain their organizational philosophy through a carefully drafted set of principles and practices, which they could make available to all Cosmic employees, suppliers, and customers, who would then understand that their interests were protected by good faith and a similarity of outlook. They do not want to have to deal with lawyers or courts once the enterprise is set up, insofar as this is possible. Indeed, they would like to be able quickly to sever relations with any business acquaintance or employee who is so adversarial as to focus on legal rights and duties instead of on trust. They understand that this will not be entirely possible for all persons they deal with (for example, landlords will probably insist on formal leases for the store locations, and they understand that retail customers have some non-disclaimable rights under consumer protection law) but it is their aspiration.

Barry and Jen have asked you for advice on the extent to which they can achieve this goal, and what steps to take in order best to achieve it with regard to their employees, distributors, suppliers, and customers. They are particularly interested in your assistance in setting out a statement of their principles, perhaps in the form of a company handbook --- or for your advice in how to go about thinking about this. And, because their past experiences have made them pragmatic as well as idealistic, they also have asked you for your views on the extent to which their aspirations are realistic or sensible.

* * * * * * * *

Write an essay describing how you would advise Barry and Jen. It will help if your advice is concrete, and if you distinguish among the various types of relationships they hope to enter into in the course of their enterprise. In your essay, you should discuss:

(a) what additional information you would seek before giving advice, and why (be sure to explain why);

(b) what arrangements, if any, that you would recommend to them, and why;