Commercial Lease Co-Tenancy Clauses: California Supreme Court Weighs In
The California Supreme Court weighed in on the validity of commercial lease co-tenancy provisions with its recent opinion in JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC. A commercial lease co-tenancy clause conditions a retail tenant’s opening for business or continuing operations upon another tenant (usually an anchor tenant) opening for business or continuing operations at the same property.
First, some background, and then a summary of the Supreme Court’s ruling.
The two-step inquiry established in 1974
When the California Supreme Court last addressed commercial lease co-tenancy clauses more than fifty years ago in its 1974 opinion Blank v. Borden, it established a two-step framework used by courts to assess whether a specific co-tenancy provision is valid.
First comes the “realistic and rational choice” test to determine whether the co-tenancy provision substantively establishes methods of alternative performance or instead provides for liquidated damages. Where the provision clearly reserves to the owner the power to make a “realistic and rational choice” in the future with respect to performance of the contract, a “valid alternative performance” provision will be found. If so, the second step is skipped and the provision is enforceable.
On the other hand, where the contractual “choice” is reasonably construed as a mere “threat to induce performance” instead of a viable alternative, the provision will be deemed a penalty or liquidated damages clause, and the analysis requires a second step applying the standards governing liquidated damages set forth in Civil Code section 1671.
Court of Appeal’s opinion in Grand Prospect Partners
In the 2015 opinion Grand Prospect Partners, L.P. v. Ross Dress For Less, Inc. the Fifth District Court of Appeal held that a co-tenancy provision was an unenforceable penalty.
In that lease, the tenant’s obligation to open a store and pay rent was conditioned on the anchor tenant operating a store in the shopping center on the lease commencement date. Before the lease term started, the anchor tenant (Mervyn’s) filed for bankruptcy and closed its store. The tenant 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.
The Court of Appeal agreed with the trial court’s holding that the rent abatement provision constituted an unenforceable penalty. The court determined the shopping center landlord had no realistic and rational choice due to a lack of control over the anchor tenant Mervyn’s because Mervyn’s “owned its own building” and the landlord was not Mervyn’s landlord.
The Grand Prospect Partners opinion was covered in a Money and Dirt post here.
Court of Appeal’s opinion in JJD-HOV Elk Grove
In the 2022 opinion JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC the Third Appellate District upheld a co-tenancy clause, emphasizing the “general rule that courts enforce contracts as written.”
Under that lease, the shopping center was required to have either three anchor tenants or 60 percent of the space leased. If the shopping center fell below both of those thresholds, then the tenant (Jo-Ann) was allowed to pay a lower, “substitute” rent. The normal lease rent started at $36,458 per month with increases every five years. The “substitute” rent was set by a formula negotiated into the contract — the greater of 3.5 percent of Jo-Ann’s gross sales or $12,000 per month.
After two anchor tenants closed, the tenant started paying the substitute rent, and the landlord (JJD) sued, arguing the co-tenancy provision was an invalid penalty under the 2015 Grand Prospect Partners opinion. The Court of Appeal affirmed the trial court’s ruling that the co-tenancy clause was valid because it simply established a condition precedent based on the shopping center’s reduced occupancy, which, when triggered, resulted in the alternative performance of substitute rent.
The JJD-HOV Elk Grove opinion was covered in a Money and Dirt post here.
The California Supreme Court granted review.
The Supreme Court’s opinion
The Supreme Court affirmed.
The opinion started with historical perspective: “Historically, when interpreting cotenancy agreements, courts have applied the general principle that, absent unconscionability or significant public policy concerns, contracts should be enforced as written and agreed upon by the parties.”
The Court held that the co-tenancy clause at issue was properly analyzed “as a form of alternative performance. The cotenancy provision allocates risks and benefits between the two parties and provides JJD a realistic choice between accepting lower rent or taking additional efforts to increase occupancy rates or secure replacement anchor tenants.” The Court noted that anchor tenants “greatly impact the economic viability of other retail tenants in a shopping center by attracting customers” and that no retail tenant “wants to be stuck in a shopping center filled with vacant stores.” When an anchor tenant disappears, the other tenants receive “less value for the leases they are locked in to” and therefore “it is reasonable for the parties to agree to lower rent payments for the reduced value of services.”
The Court also observed that commercial co-tenancy provisions “are not negotiated in a vacuum” and both parties are usually “sophisticated and well-represented.” “While a cotenancy provision standing alone may seem disadvantageous to one party or the other, its inclusion in the lease may be the result of one party acquiescing to less-desirable terms elsewhere in the lease.”
Since the lease offered rational alternative performance to the landlord, the liquidated damages analysis of Civil Code section 1671 did not apply. Likewise, the anti-forfeiture provisions of Civil Code section 3275 did not apply. “Section 3275 does not apply to this case, because adhering to the cotenancy provision is a form of compliance with the contract and thus does not constitute a breach-induced forfeiture.”
The Court held that the Grand Prospect opinion was distinguishable on its facts due to the landlord’s complete lack of control over the shopping center’s anchor tenant, and expressed “no view on the validity” of the holding in that case.
Ultimately, the concept of freedom of contract prevailed: “Contracts exist to allocate risk between parties. … Cotenancy provisions benefit both parties; they allow the landlord to court tenants, and they protect tenants should the landlord provide a reduced level of service. … It is not the place of courts to invalidate a contractual term when one party benefits or suffers commercial harm.”