Be Careful What You Wish For: California Court of Appeals Holds Co-Tenancy Clause Unenforceable

January 2015

The California Court of Appeals for the Fifth District just issued a remarkable ruling in favor of a shopping center landlord holding that the co-tenancy clause in a retail lease that allowed the tenant to avoid paying rent is an unenforceable penalty. The decision in Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. 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. During lease (and letter of intent) negotiations, retailers often argue that their success in a particular center is tied to other retailers being open for business, generating foot traffic, and providing other synergies to the center—no one wants to operate in a ghost town. In fact, several other notable retailers, including The Gap, Bed Bath & Beyond, H&M, Petco, and VF Outdoor, filed amicus curiae briefs in support of the tenant in this case. And they all lost. But not entirely—the court did rule partially in favor of the tenant by enforcing a second and critical part of the co-tenancy clause that allowed the tenant to terminate the lease after 12 months of a co-tenancy violation. Perhaps recognizing the gravity of its holding and the potential ripple effect on thousands of leases, the court clarified that the opinion “does not establish a categorical rule of law holding cotenancy provisions always, or never, are enforceable. Instead . . . [the outcome] . . . depends heavily on the facts proven in a particular case.” So, what are the facts?

The Parties

In April of 2008, after several years of negotiations and multiple drafts, a lease was executed by Ross Dress For Less—the nation’s largest retailer of off-price apparel and home fashion with more than 1,000 stores nationwide—and a limited partnership landlord consisting of two individuals, each with over 30 years of experience in real estate, and whose general partner helped develop over 60 shopping centers. Under the lease, Ross expected to take possession of the premises in February of 2009.

The Co-Tenancy Clause

The lease contained a co-tenancy clause providing that Ross was not required to open its store for business or pay rent unless, among other conditions, Mervyn’s was operating in the shopping center on the commencement date of the Ross lease (the “No Rent Clause”)—a fairly common provision. The co-tenancy provision went on to provide that if Mervyn’s (or a suitable replacement) did not operate within 12 months of the Ross commencement date, then Ross would have the right to terminate its lease (the “Termination Clause”)—another fairly common provision. 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.

Mervyn’s Bankruptcy

Mervyn’s filed for bankruptcy in July 2008 and closed its store in the shopping center on December 31, 2008—long before the commencement date of the Ross lease. When the landlord learned in October 2008 that Mervyn’s was going to close its store, the landlord contacted Ross to re-negotiate the lease. Ross responded, “We negotiated hard for the Mervyn’s co-tenancy because it makes a huge difference to us financially. Without Mervyn’s, we will open very soft and it will take much longer for Ross to get established in Porterville.” With that as the backdrop, Ross proposed amending the lease to require it to open its store (notwithstanding the co-tenancy failure) in exchange for reduced rent. But the parties could not agree on new terms and despite Mervyn’s closure, Ross took possession of the premises on February 9, 2009. However, Ross never opened for business, never paid rent, and eventually terminated the lease when the landlord failed to replace Mervyn’s within the required 12-month period.

The Trial Court

Right before Ross terminated its lease, the landlord sued Ross and argued that the No Rent Clause and the Termination Clause were unconscionable, or alternatively, were unreasonable penalties and therefore unenforceable. The trial court agreed with the landlord on both theories and awarded the landlord damages of $672,100 (the total rent abated during the period from commencement date until termination), plus $3.1 million in other damages arising out of Ross’s termination of the 10-year lease, plus over $900,000 in attorneys’ fees and costs, for a total of $4.7 million. Ross appealed.

The Appellate Court Decision

First, addressing the landlord’s contention of unconscionability, the appellate court found that the co-tenancy provision was a product of lengthy negotiations by sophisticated parties. Due to the facts that the landlord was given the opportunity to negotiate the terms of the lease, the parties went through multiple drafts of the letter of intent and the lease, the landlord had years of experience in the development and management of shopping centers, and that the landlord was under no pressure to enter into the lease, the appellate court found that the co-tenancy provision was not procedurally or substantively unconscionable. Therefore, the court rejected the unconscionability argument.

The appellate court then turned to the landlord’s argument that the No Rent Clause and the Termination Clause were unenforceable penalties. The court explained that because (1) the No Rent Clause existed regardless of whether Ross subsequently exercised its option to terminate the lease, (2) each right was triggered by different, albeit partially overlapping, conditions, and (3) each provision resulted in different consequences to the landlord-tenant relationship, the validity of each provision required a separate analysis.

The No Rent Clause

In California, a contractual provision is an unenforceable penalty if the value of the money or property forfeited or transferred bears no reasonable relationship to the range of harm anticipated to be caused by the failure of the provision’s requirements. In other words, a provision will be deemed unenforceable if the punishment doesn’t fit the crime. Here, the No Rent Clause allowed Ross to avoid paying $39,500 per month (potentially throughout the entire 10-year term)—this is the value of the property forfeited. As for the anticipated range of harm, the court concluded that, based on the trial court’s findings and the testimony of Ross’s executives, that amount was ZERO.

The appellate court stated that the trial court “explicitly found ‘Ross did not anticipate any damage, i.e., lost sales or profits, if or because Mervyn’s would not be open on the Commencement Date.’ The [trial] court also found ‘the presence of Mervyn’s was not a condition material to Ross under the Lease . . . .’” Ross did not challenge this finding, and the appellate court noted that such a challenge would have failed anyway, because Ross executives testified during the trial that “no study or analysis was done to determine the impact of Mervyn’s traffic on Ross’s potential sales or, alternatively, the impact of Mervyn’s closure on Ross’s potential sales. Furthermore, in October 2008 after the Ross executives learned of the Mervyn’s closure, they held the view that the Porterville Marketplace remained a desirable location for a store. McGillis [Ross’s group vice president of real estate] testified that he was unable to state, one way or the other, whether the closure of Mervyn’s stores in shopping centers where Ross was present adversely effected Ross’s sales.” The appellate court determined that, “As found by the trial court, no harm was anticipated to result from the Mervyn’s vacancy.” Thus, the court concluded the No Rent Clause was an unenforceable penalty and struck it down.

The Termination Clause

Next, in analyzing the Termination Clause, the appellate court, relying on two cases dealing with casualty provisions, noted that “California courts have developed a specific rule that applies to termination provisions in commercial leases.” The court stated that when a commercial lease contains a termination clause based upon the occurrence of contingencies that (1) are agreed upon by sophisticated parties and (2) have no relation to any act or default of the parties, no forfeiture results from the exercise of the termination clause and the clause is therefore not deemed an unenforceable penalty. The court stated, “This specific rule of law controls over the general test usually applied to determine if a contract provision is an unenforceable penalty.” Put another way, the penalty analysis applied to the No Rent Clause is not applicable when analyzing termination clauses; if sophisticated parties agree to a termination right based on the failure of a certain condition to occur regardless of any default (e.g., if it rains on Saturday then this lease will be terminated), then such provision will be upheld.

Here, the Termination Clause was based on conditions that were agreed upon by sophisticated parties; both parties had substantial experience in real estate and negotiating leases. Furthermore, the conditions that triggered Ross’s right to terminate had no relation to any act or default of the parties because when the lease was made, neither Ross nor the landlord could control whether Mervyn’s continued to operate in the shopping center. Thus, the appellate court found Ross’s right to terminate the lease was valid and Ross could rely on it to terminate the lease.

Conclusion

Based on the court’s analysis, the No Rent Clause was struck down (meaning Ross owes the landlord the rent that it failed to pay ($670,000)), but the Termination Clause was upheld, allowing Ross to terminate the lease and avoid the lease termination damages ($3.1 million) awarded by the trial court.

Update on Case

Not surprisingly, both sides have appealed the decision, presumably with Ross arguing the No Rent Clause should be upheld, and the landlord arguing that the Termination Clause should be struck down. In our opinion, one of them is right! It does not make sense to end up with two different results in analyzing the remedies in the co-tenancy clause. Either the entire clause is an unenforceable penalty or it is not.