When a court of appeal announces that it is tackling a new commercial lease issue for the first time ever in a published decision, it’s wise to pay attention.
In a recent decision by the California Court of Appeal (Fifth District in Fresno) — Grand Prospect Partners, L.P. v. Ross Dress For Less, Inc. — the court weighed in on the enforceability of commercial lease “co-tenancy” clauses.
Co-tenancy clauses are increasingly popular in commercial leases, and generally require other stores in a shopping center to be occupied by operating businesses as a condition to other lease obligations.
The co-tenancy clause at issue
Grand Prospect Partners, L.P. owned and operated a shopping center. Grand Prospect leased a portion of the center to Ross Dress For Less, Inc.
The 10-year term lease conditioned Ross’s obligation to open a store and pay rent on Mervyn’s operating a store in the shopping center on the lease commencement date. Ross also had the option to terminate the lease if Mervyn’s ceased operations in the shopping center and was not replaced by an acceptable retailer within 12 months.
The co-tenancy condition fails
The opening co-tenancy condition failed because Mervyn’s filed for bankruptcy and closed its store.
Ross took possession of its space, but (relying on the co-tenancy clause) never opened for business, never paid rent, and terminated the lease after the 12-month cure period expired.
Grand Prospect sued Ross, claiming Ross was obligated to pay rent for the entire 10-year lease term. Grand Prospect argued that the co-tenancy clause was entirely unenforceable because the clause was either: (1) unconscionable; or (2) an unreasonable penalty.
The trial court sided with Grand Prospect on both theories, holding that Ross breached the lease by failing to pay rent and by terminating the lease. The trial court entered judgment for $672,100 in unpaid rent (for the period Ross occupied the property) plus $3.1 million in other damages (mostly unpaid future rent) caused by the early termination.
The court of appeal’s opinion
The court of appeal modified the judgment to award damages only for unpaid rent.
The court held that the co-tenancy clause was not unconscionable because both parties were sophisticated and experienced in the negotiation of commercial leases for retail space, and in fact thoroughly negotiated their lease without any sign of duress.
As to Grand Prospect’s “unreasonable penalty” argument, the court of appeal analyzed the rent abatement and termination provisions separately.
The court held that the termination provision was not a penalty. California law generally allows termination of a commercial lease upon the occurrence of contingencies that are agreed to by sophisticated parties and that have no relation to any act or default of the parties (such as the Mervyn’s bankruptcy/vacancy in this case).
But the court of appeal agreed with the trial court’s holding that the rent abatement provision constituted an unenforceable penalty. (Under California law, a contractual provision is an unenforceable penalty if it results in a forfeiture bearing no reasonable relationship to the range of harm that would be anticipated by a breach.) Critically, there was no evidence that Ross anticipated it would suffer any actual damages from the Mervyn’s vacancy. Further, the amount of monthly rent forfeited by the landlord ($39,500) bore no reasonable relationship to the actual anticipated harm ($0).
The court of appeal struck the $3.1 termination damages portion of the judgment, but left intact the $672,100 unpaid rent damages.
The court of appeal made clear that its opinion “does not establish a categorical rule of law” regarding the enforceability of commercial lease co-tenancy clauses. The court acknowledged that “there is no standard form of cotenancy requirements” and that each case “depends heavily on the facts[.]”
This is a relatively new, and evolving, area.
But one lesson is clear: the enforceability of commercial lease co-tenancy clauses depends, in large part, on how wisely the remedies are selected (and supported by evidence).
- Termination remedies will generally be enforced as long as they are agreed to by sophisticated parties and have no relation to any act or default of the parties.
- But other remedies, such as rent abatement, need to withstand “penalty” scrutiny — they must be supported by evidence showing that the rents forfeited by the landlord bear a reasonable relationship to the harm anticipated from a failure of the co-tenancy condition. Ideally, support for the chosen remedies should be expressed and documented as part of the lease.