The California Court of Appeal for the Third District recently declined to extend the ruling of Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. (2015) 232 Cal.App.4th 1332, a co-tenancy case previously decided by the California Court of Appeal for the Fifth District which upended common understanding of co-tenancy clauses in the industry.  At the time of the Grand Prospect ruling, we described it as “remarkable” and wrote that it “will likely come as a big surprise to many in the retail industry given that the co-tenancy clause in this case is a fairly common one that has come to be accepted by many as standard in the industry.” (see here).  As it turns out, we were not alone.  In JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC (2022) Case No. C094190, the court held that the co-tenancy clause calling for reduced rent is enforceable because, unlike the conclusion reached in Grand Prospect, it is not liquidated damages or a penalty that results from a breach of the lease.  Rather, it is an alternative rent structure that is triggered by the failure of certain contingencies (i.e., reduced occupancy).  Therefore, given that the parties freely negotiated and ultimately agreed to such clause, it is enforceable.

Background

In 2003, JJD-HOV Elk Grove, LLC (“Landlord”) and Jo-Ann Stores, LLC (“Tenant”) entered into a lease in which Tenant leased approximately 35,000 square feet of space in Landlord’s shopping center. The fixed minimum rent was $42,292 per month at the time of the co-tenancy violation.  The co-tenancy clause required Landlord to have at least three anchor tenants (or suitable replacements) or 60% of the leasable floor area of the shopping center open and operating. In the event the co-tenancy provision was not met, Tenant had the right to pay, in lieu of fixed minimum rent, the greater of 3.5% of Tenant’s gross sales or $12,000 (“Substitute Rent”).

On July 5, 2018, Tenant informed Landlord it intended to start paying Substitute Rent because the co-tenancy requirement was no longer met after Toys R Us closed, bringing the shopping center’s occupancy below 60% (the decision implies that the shopping center also did not have three anchor tenants open). Tenant paid Substitute Rent for approximately 20 months before Landlord was able to increase the occupancy levels above the co-tenancy requirements, at which point Tenant reverted to paying the fixed minimum rent.

Grand Prospect

Landlord did not dispute the facts; however, Landlord sued Tenant and argued that the co-tenancy provision was an unenforceable penalty in light of the decision in Grand Prospect, where the court held that a co-tenancy clause in a retail lease that allowed the tenant to avoid paying rent is an unenforceable penalty. There, a lease between the owner of the shopping center (“Owner”) and Ross Dress for Less (“Ross”) contained a co-tenancy provision that required Mervyn’s to be open for business on the date Ross’s lease commenced, and if it was not open, Ross was not required to open for business or pay rent – the court referred to this as the “rent abatement provision.”  Mervyn’s did not open, and Ross opted not to open or pay any rent pursuant to the rent abatement provision. Owner sued, and ultimately, the California Court of Appeal for the Fifth District held that the rent abatement provision was an unenforceable penalty. In reaching its decision, the Grand Prospect court compared the actual rental loss to the landlord to the range of harm or damages that the parties anticipated would be caused to the tenant as a result of the co-tenancy violation, and explained that if the actual rental loss bears no reasonable relationship to the range of the anticipated harm, the condition will be deemed an unenforceable penalty. The Grand Prospect court reasoned that there was no reasonable relationship between the value of the property forfeited by Owner ($39,500 per month) and the anticipated harm to Ross ($0 per month) given that Ross testified that it did not anticipate any damage (i.e., lost sales or profits) resulting from Mervyn’s failure to open.  At the time of the decision, we wrote, “What is factually unique in this case, however, is the trial court testimony by Ross executives who stated that they did not anticipate or believe that the Mervyn’s closure would cause Ross any harm.  This testimony would prove to be Ross’s downfall.”

Trial Court

In JJD-HOV, the trial court ruled in Tenant’s favor and held that Grand Prospect was distinguishable. It held that, contrary to the analysis in the Grand Prospect court, the co-tenancy provision did not impose damages for breach of contract that would require compliance with the rules governing liquidated damages.  Instead, it simply provided for a different rent structure or alternative rent payments in the event certain contingencies occurred. If the shopping center met the co-tenancy conditions, then Tenant owed $42,292 per month, and if not, then the rent would alternate to Substitute Rent, without there being a breach of the lease by Landlord.  Landlord appealed.

The Appellate Court Decision

The appellate court also declined to follow Grand Prospect. The court agreed with the trial court and reasoned that the Grand Prospect court relied on a statute governing the enforceability of liquidating damages for breach of contract, and here, there was no suggestion that reduced occupancy in the shopping center resulted in Landlord’s breach of the lease.

Further, the lease’s co-tenancy provisions did not reflect ‘damages’ but instead reflected terms for a different rent structure (e.g., fixed minimum rent or Substitute Rent) in the event certain contingencies occurred (e.g., whether three anchors or 60% of the leasable floor area were open and operating).  Consequently, the enforceability of the co-tenancy provision is not governed by the liquidated damages statutes.

Once the court found that the rule in Grand Prospect was inapplicable, the court held that the parties’ co-tenancy provision was valid and enforceable, as the parties were generally free to contract as they pleased and established what was ‘fair’ and ‘just’ within the lease.  All of the terms were actively negotiated by the parties – they agreed to two different rental rates based on different types and levels of occupancy in the shopping center; they agreed the co-tenancy provision could be satisfied by either three anchor tenants or 60% of the shopping center’s space leased; they agreed if the co-tenancy provision was not satisfied, Tenant could pay Substitute Rent; they agreed that Substitute Rent would be the greater of $12,000 or 3.5% of sales. The parties thus considered the risk of reduced occupancy in the shopping center and agreed Tenant would pay Substitute Rent if that risk occurred.

Conclusion

The court concluded that the parties’ contractual intent, when reduced to writing, should be controlling and enforced, particularly as applied to the commercial leasing market in arms-length negotiations and transactions. Thus, Landlord received the Substitute Rent it agreed to receive and the court found no basis for relieving Landlord from the burden of its agreement.