Enforceability of Co-Tenancy Remedies

On Jan. 12, 2015, a California Court of Appeal, in Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc., 232 Cal. App. 4th 1332 (5th Dist. 2015), held unenforceable a co-tenancy provision in a retail lease that allowed the tenant to accept possession of the premises but thereafter have no obligation to pay rent or open for business, even though the provision had been negotiated by two sophisticated parties with leasing expertise. While the court noted that the determination of the enforceability of co-tenancy provisions depends heavily on the facts of the case, the Grand Prospect decision still provides useful guidance about the likely enforceability of remedies that are often negotiated into co-tenancy and other lease provisions.

Background

In Grand Prospect, the co-tenancy provision conditioned Ross's obligation to open its store and pay rent on Mervyn's operating a store in the shopping center on the commencement date of the lease. It also granted Ross the option to terminate the lease if the co-tenancy condition remained unsatisfied for a 12-month period. The lease did not provide the landlord with the option to replace Mervyn's to satisfy the opening co-tenancy condition; moreover, at the time the lease was executed, the landlord did not own the portion of the shopping center occupied by Mervyn's.

The opening co-tenancy condition was not satisfied because Mervyn's filed for bankruptcy and closed its store before the commencement date of the lease. As authorized by its lease, Ross took possession of the space, never opened, never paid rent, and terminated the lease after the 12-month cure period expired.

As a result, the landlord sued Ross, claiming that the opening co-tenancy provision was unenforceable because it was unconscionable and resulted in unreasonable penalties. The trial court agreed with both theories and awarded the landlord over $3.7 million in damages, which included lost rent over the term of the lease.

The court of appeal reversed the lower court's decision in part, holding that the co-tenancy provision was not unconscionable, and Ross did have the right to terminate the lease. But it affirmed the lower court's decision that allowing Ross to occupy the space for 12 months without paying rent was an unreasonable penalty and therefore unenforceable. Ross was required to pay the landlord approximately 12 months' unpaid rent ($627,100.00).

Unconscionability

First, the court addressed the landlord's assertion that the co-tenancy provision was unconscionable.

Factors that establish unconscionability may include: 1) the amount of time the party claiming unconscionability was given to consider the proposed contract; 2) the amount and type of pressure exerted on such party to sign the proposed contract; 3) the length of the proposed contract and the length and complexity of the challenged provision; 4) the education and experience of such party; 5) whether such party's review of the proposed contract was aided by an attorney; and 6) the one-sidedness or overly harsh effect of the actual contract or the terms of the contract.

The court held that the co-tenancy provision was not unconscionable, because the principals of the landlord were experienced owners and operators of shopping centers with over 33 years of experience, including prior experience negotiating leases with Ross (so experienced, indeed, that they elected not to use a lawyer). Also, there was no evidence that the landlord was under any time or economic pressures that would cause it to accept onerous terms.

In addition, although Ross had more bargaining power based on its financial resources and many options for opening stores in other locations, the court found that genuine negotiations of the lease occurred between the parties. Also important was that the landlord had meaningful choices when it opted to pursue Ross ' which would pay higher rent but required a co-tenancy provision ' over other tenants that would have paid a lower rent either without a co-tenancy provision or with one more favorable to the landlord.

Unreasonable Penalties

Second, the court addressed the landlord's claim that the rent abatement and termination remedies were both unenforceable as unreasonable penalties. With respect to the termination remedy, the court had to determine whether this remedy violated a doctrine of California law that prohibits courts from enforcing a termination right if it would unfairly penalize the other party by causing it to forfeit the benefits of that contract. Relying on other California cases reflecting similar facts, the court concluded that if a commercial lease negotiated by sophisticated parties contains a clause permitting a party to terminate the lease based on certain agreed-upon contingencies, and the occurrence of the contingencies was not caused by any act or default of either party, then the termination clause would not result in an unfair forfeiture or penalty.

The court upheld Ross's exercise of its termination right because it was based on conditions agreed upon by sophisticated parties, and neither Ross nor the landlord could control whether Mervyn's continued to operate a store in the shopping center or whether that space would be occupied by the type of anchor tenant specified in the lease.

Although the court upheld Ross's right to terminate the lease, it decided that the rent abatement provision in the lease was an unreasonable penalty and thus unenforceable. The court recognized that a contractual provision is an unenforceable penalty “if the value of the money or property forfeited or transferred to the party protected by the provision bears no reasonable relationship to the range of harm anticipated to be caused to that party by the failure of the provision's requirements.”

The court found that the value of the money forfeited by the landlord was the rent under the Ross lease, which was approximately $39,500.00 per month. The court also determined that there was no evidence of any harm anticipated by Ross from the failure of the co-tenancy condition due to Mervyn's closure: Ross's executives had testified that no study or analysis was done to determine the impact of Mervyn's closure on Ross's potential sales; and further, no testimony or evidence was provided indicating whether the closure of Mervyn's stores in shopping centers where Ross had stores adversely affected its sales.

Consequently, having found that Ross anticipated no harm would arise from Mervyn's closure, the court concluded there was no reasonable relationship between the value of the property forfeited by the landlord (i.e., Ross's rent for the full the term of the lease) and the anticipated harm to Ross. Thus, the court found the rent abatement was an unenforceable penalty, and Ross was required to pay its rent under the lease.

Best Leasing Practices

1. Provide for replacement of co-tenants. A significant factor in the Grand Prospect court's decision was that the opening co-tenancy provision was virtually incurable, because it did not provide the landlord the opportunity to satisfy the opening co-tenancy condition with a substitute retailer. Whenever a tenant's co-tenancy remedies are conditioned upon specific named co-tenants operating in the center, a landlord should insist on the right to replace that named co-tenant with another, or include a longer list of possible others that could replace the co-tenant.

The Grand Prospect case should encourage tenants to agree to give a landlord a replacement right, since without it, the tenant's remedies might be deemed to be unenforceable penalties. Co-tenancy provisions should also provide a landlord with sufficient opportunity to cure before the tenant can exercise its remedies.

2. Provide for liquidated damages. In light of the Grand Prospect case, it may be prudent for tenants and landlords to agree in the lease that the rent abatement represents liquidated damages, not a penalty, and is a reasonable estimate of the amount of damages that may be incurred. However, given that some courts will look to the substance of a contract over form, tenants should also be prepared to justify the rent abatement amount in relation to the amount of damages that may be incurred.

3. Establish harm before exercising rent abatement remedies. Although the Grand Prospect case specifically involved co-tenancy provisions, the court's decision not to enforce the rent abatement could apply to rent abatement remedies in other lease provisions as well, such as late delivery of possession or a violation of an exclusive use. Before exercising a rent abatement remedy in a lease, tenants should internally document the harm they have suffered, or expect to suffer, that justifies the rent abatement. It is likely that the court in Grand Prospect case felt that Ross was taking advantage of the terms of the lease by taking possession of the space without paying rent for it, although it had no expectation that it would be harmed by the failure of Mervyn's to operate in the center.

M. Rosie Rees, a member of this newsletter's Board of Editors, is a Partner is the real estate department of the Chicago office of Pircher Nichols & Meeks. Stephanie J. Kim is Of Counsel in the same office.

On Jan. 12, 2015, a California Court of Appeal, in Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. , 232 Cal. App. 4th 1332 (5th Dist. 2015), held unenforceable a co-tenancy provision in a retail lease that allowed the tenant to accept possession of the premises but thereafter have no obligation to pay rent or open for business, even though the provision had been negotiated by two sophisticated parties with leasing expertise. While the court noted that the determination of the enforceability of co-tenancy provisions depends heavily on the facts of the case, the Grand Prospect decision still provides useful guidance about the likely enforceability of remedies that are often negotiated into co-tenancy and other lease provisions.

Background

In Grand Prospect, the co-tenancy provision conditioned Ross's obligation to open its store and pay rent on Mervyn's operating a store in the shopping center on the commencement date of the lease. It also granted Ross the option to terminate the lease if the co-tenancy condition remained unsatisfied for a 12-month period. The lease did not provide the landlord with the option to replace Mervyn's to satisfy the opening co-tenancy condition; moreover, at the time the lease was executed, the landlord did not own the portion of the shopping center occupied by Mervyn's.

The opening co-tenancy condition was not satisfied because Mervyn's filed for bankruptcy and closed its store before the commencement date of the lease. As authorized by its lease, Ross took possession of the space, never opened, never paid rent, and terminated the lease after the 12-month cure period expired.

As a result, the landlord sued Ross, claiming that the opening co-tenancy provision was unenforceable because it was unconscionable and resulted in unreasonable penalties. The trial court agreed with both theories and awarded the landlord over $3.7 million in damages, which included lost rent over the term of the lease.

The court of appeal reversed the lower court's decision in part, holding that the co-tenancy provision was not unconscionable, and Ross did have the right to terminate the lease. But it affirmed the lower court's decision that allowing Ross to occupy the space for 12 months without paying rent was an unreasonable penalty and therefore unenforceable. Ross was required to pay the landlord approximately 12 months' unpaid rent ($627,100.00).

Unconscionability

First, the court addressed the landlord's assertion that the co-tenancy provision was unconscionable.

Factors that establish unconscionability may include: 1) the amount of time the party claiming unconscionability was given to consider the proposed contract; 2) the amount and type of pressure exerted on such party to sign the proposed contract; 3) the length of the proposed contract and the length and complexity of the challenged provision; 4) the education and experience of such party; 5) whether such party's review of the proposed contract was aided by an attorney; and 6) the one-sidedness or overly harsh effect of the actual contract or the terms of the contract.

The court held that the co-tenancy provision was not unconscionable, because the principals of the landlord were experienced owners and operators of shopping centers with over 33 years of experience, including prior experience negotiating leases with Ross (so experienced, indeed, that they elected not to use a lawyer). Also, there was no evidence that the landlord was under any time or economic pressures that would cause it to accept onerous terms.

In addition, although Ross had more bargaining power based on its financial resources and many options for opening stores in other locations, the court found that genuine negotiations of the lease occurred between the parties. Also important was that the landlord had meaningful choices when it opted to pursue Ross ' which would pay higher rent but required a co-tenancy provision ' over other tenants that would have paid a lower rent either without a co-tenancy provision or with one more favorable to the landlord.

Unreasonable Penalties

Second, the court addressed the landlord's claim that the rent abatement and termination remedies were both unenforceable as unreasonable penalties. With respect to the termination remedy, the court had to determine whether this remedy violated a doctrine of California law that prohibits courts from enforcing a termination right if it would unfairly penalize the other party by causing it to forfeit the benefits of that contract. Relying on other California cases reflecting similar facts, the court concluded that if a commercial lease negotiated by sophisticated parties contains a clause permitting a party to terminate the lease based on certain agreed-upon contingencies, and the occurrence of the contingencies was not caused by any act or default of either party, then the termination clause would not result in an unfair forfeiture or penalty.

The court upheld Ross's exercise of its termination right because it was based on conditions agreed upon by sophisticated parties, and neither Ross nor the landlord could control whether Mervyn's continued to operate a store in the shopping center or whether that space would be occupied by the type of anchor tenant specified in the lease.

Although the court upheld Ross's right to terminate the lease, it decided that the rent abatement provision in the lease was an unreasonable penalty and thus unenforceable. The court recognized that a contractual provision is an unenforceable penalty “if the value of the money or property forfeited or transferred to the party protected by the provision bears no reasonable relationship to the range of harm anticipated to be caused to that party by the failure of the provision's requirements.”

The court found that the value of the money forfeited by the landlord was the rent under the Ross lease, which was approximately $39,500.00 per month. The court also determined that there was no evidence of any harm anticipated by Ross from the failure of the co-tenancy condition due to Mervyn's closure: Ross's executives had testified that no study or analysis was done to determine the impact of Mervyn's closure on Ross's potential sales; and further, no testimony or evidence was provided indicating whether the closure of Mervyn's stores in shopping centers where Ross had stores adversely affected its sales.

Consequently, having found that Ross anticipated no harm would arise from Mervyn's closure, the court concluded there was no reasonable relationship between the value of the property forfeited by the landlord (i.e., Ross's rent for the full the term of the lease) and the anticipated harm to Ross. Thus, the court found the rent abatement was an unenforceable penalty, and Ross was required to pay its rent under the lease.

Best Leasing Practices

1. Provide for replacement of co-tenants. A significant factor in the Grand Prospect court's decision was that the opening co-tenancy provision was virtually incurable, because it did not provide the landlord the opportunity to satisfy the opening co-tenancy condition with a substitute retailer. Whenever a tenant's co-tenancy remedies are conditioned upon specific named co-tenants operating in the center, a landlord should insist on the right to replace that named co-tenant with another, or include a longer list of possible others that could replace the co-tenant.

The Grand Prospect case should encourage tenants to agree to give a landlord a replacement right, since without it, the tenant's remedies might be deemed to be unenforceable penalties. Co-tenancy provisions should also provide a landlord with sufficient opportunity to cure before the tenant can exercise its remedies.

2. Provide for liquidated damages. In light of the Grand Prospect case, it may be prudent for tenants and landlords to agree in the lease that the rent abatement represents liquidated damages, not a penalty, and is a reasonable estimate of the amount of damages that may be incurred. However, given that some courts will look to the substance of a contract over form, tenants should also be prepared to justify the rent abatement amount in relation to the amount of damages that may be incurred.

3. Establish harm before exercising rent abatement remedies. Although the Grand Prospect case specifically involved co-tenancy provisions, the court's decision not to enforce the rent abatement could apply to rent abatement remedies in other lease provisions as well, such as late delivery of possession or a violation of an exclusive use. Before exercising a rent abatement remedy in a lease, tenants should internally document the harm they have suffered, or expect to suffer, that justifies the rent abatement. It is likely that the court in Grand Prospect case felt that Ross was taking advantage of the terms of the lease by taking possession of the space without paying rent for it, although it had no expectation that it would be harmed by the failure of Mervyn's to operate in the center.

M. Rosie Rees, a member of this newsletter's Board of Editors, is a Partner is the real estate department of the Chicago office of Pircher Nichols & Meeks. Stephanie J. Kim is Of Counsel in the same office.