Landlord has Right to be Unreasonable

April 2009

by Nadav Ravid, Esq.

In today’s unprecedented economic environment, more than ever before businesses are searching for ways to dramatically and immediately cut costs in order to succeed, and in more than a few cases, simply survive.  So it is not surprising that many companies are scrutinizing their leases in an attempt to discover any loophole to help reduce, if not altogether avoid, perhaps the biggest operating expense: occupancy costs.  Whereas in the past, minor lease violations went unnoticed or even overlooked, with this backdrop companies are now seizing any misstep as the casus belli to renegotiation, and ultimately litigation.

Meanwhile, on the other end of the spectrum, landlords, facing their own struggles with maturing debts and evanescing tenants, are towing the fine line of squeezing the most they can from their better-financed tenants and negotiating lease reductions to stave off bankruptcies from their struggling tenants.  Even the once untouchable Class A landlords, apt to schadenfreude, are focused on tenant retention.

In this issue of the Dirt Report, we review three new cases that emphasize the importance of properly negotiating and documenting SNDAs, landlord’s approval standards for lease assignments, and CAM audits.

INNOCENT TENANT LOSES BELOW-MARKET LEASE

In Aviel v. Ng, 161 Cal.App.4th 809 (2008), a lender foreclosed on a property, took over as the new landlord, and terminated a tenant’s below-market lease even though the tenant was not in default.  The parties sued one another and the lender/new owner prevailed.

In 1998, the tenant signed a lease to operate a restaurant in San Francisco, called the Grand Palace Restaurant.  The lease included a subordination clause, which stated in part, “This lease shall be subject and subordinate to all underlying leases and to mortgages which may now or hereafter affect such leases or the real property of which the premises form a part….”[1]  The lease did not provide the tenant with non-disturbance protection.

In 2000, the lender recorded a deed of trust in connection with a loan it made to the owner of the property.  In 2002, after the owner defaulted on the loan, the lender foreclosed on the property and became the new owner.  As a result of the foreclosure, all subordinated leases were terminated including the tenant’s lease.  In 2003, the lender/new owner filed an unlawful detainer action against the tenant after the tenant refused to enter into a new lease for higher rents.  The tenant filed a cross-complaint arguing, among other things, the foreclosure did not terminate the lease because the lease specifically stated it was only subordinated to a “mortgage,” but not to a “deed of trust.”

After a lengthy analysis, the court stated the distinction between the terms “deed of trust” and “mortgage” in connection with the dispute was illusory, unimportant, and meaningless, concluding, “California appellate courts have held that a deed of trust is functionally equivalent to a mortgage.”[2]

The “mortgage/deed of trust” analysis of Aviel is not particularly relevant to the landlord/tenant relationship.  What is important, however, is the fact that once again, a court has held that a non-defaulting tenant runs the risk of losing its lease, the money it spends improving its space, its good will, and other valuable assets, if the landlord defaults on its loan.  Below are key suggestions to avoid such risks.

Practical Pointers

  1. Before signing a lease, tenants should obtain a separate non-disturbance agreement from any existing lender or ground lessor to avoid being wiped out by a foreclosure.
  2. During lease negotiations, tenants should demand non-disturbance protection from future lenders as a pre-condition to lease subordination.
  3. Conversely, landlords should protect themselves, if not their lenders, by inserting an attornment provision in their leases to avoid a lease termination following foreclosure.

LANDLORD HAS RIGHT TO BE UNREASONABLE

In Nevada Atlantic Corp. v. WREC Lido Venture, LLC, No. G039825, 2008 WL 5065977, 1 (Cal.App. 4 Dist. December 2, 2008) (unpublished opinion), a landlord refused to consent to a tenant’s assignment of a lease based on a lease provision that gave the landlord the right to withhold consent for any reason in its sole discretion.  The tenant argued the sole discretion standard was unenforceable and the landlord was required to act reasonably.  The court disagreed and ruled in favor of the landlord.

In 1985, the parties’ predecessors-in-interest signed a lease for waterfront property to be used as George’s Camelot Restaurant on Lido Marina in Newport Beach.  In 2001, Nevada Atlantic acquired the restaurant and lease and became the tenant.  In 2006, Nevada Atlantic sought the landlord’s consent to a lease assignment in connection with the sale of the business.

The lease prohibited assignments without the landlord’s consent, providing in relevant part, “Lessor shall have the absolute right to withhold consent for any reason whatsoever or for no reason, it being understood that the giving or withholding of such consent shall be at Lessor’s sole discretion.”[3] The landlord denied consent (no reason is stated in the court’s opinion) and the sale fell through.  Tenant sued the landlord.

The trial court ruled in favor of the tenant stating that because the lease did not contain any objective standard upon which to base the landlord’s refusal to consent, the landlord must use reasonable discretion according to Section 1995.260 of the Civil Code (as opposed to Section 1995.250), and there was no reasonable basis to deny consent.

Following an in-depth analysis of the history of consent standards in leases, the appellate court reversed the trial court’s decision and ruled for the landlord, concluding that, “a freely negotiated sole discretion clause is a permissible standard under the majority view, minority view, and Section 1995.250.”[4]

Practical Pointers

  1. It is customary for landlords to agree to a reasonable standard in approving assignments or subleases.  Therefore, during lease negotiations, most tenants should not easily give up the right to demand that their landlords be reasonable in connection with assignment/subletting.
  2. Although not discussed in this case, there is at least one significant downside for landlords who insist on having a sole discretion standard.  Such landlords lose the benefit of Section 1951.4 of the Civil Code, which allows landlords to recover future rent from defaulting tenants without regard to the duty to mitigate, normally required under Section 1951.2 of the Civil Code.

LANDLORD MUST EXCLUDE LLC TAXES FROM CAMS

In Tin Tin Corp. v. Pacific Rim Park LLC, 170 Cal.App.4th 1220 (2009), the tenants of a shopping center sued the landlord over CAM expenses.  The tenants signed “triple-net” leases requiring them to pay for the shopping center’s maintenance costs, insurance, and property taxes.  A dispute arose over whether the leases permitted the landlord to pass through the LLC taxes and fees the landlord was required to pay for the LLC that owned the property.  The court concluded the leases did not permit the landlord to do so.

The court focused on one key provision that stated the landlord could pass through “all costs incurred by Lessor relating to the ownership and operation of the [shopping center].”[5] The court concluded that even though the LLC was formed for the sole purpose of owning the property, the LLC taxes and fees were not costs directly related to owning the property, but were rather the costs of doing business in California under the LLC entity form.  In addressing this issue, the court noted such LLC taxes and fees would not be incurred if the owner merely owned the shopping center as an individual.  The court stated, “While we agree with the trial court’s statement that [the tenants] agreed to bear the costs of ownership of the property, LLC taxes and fees are not the costs of owning property but the costs of operating a business in a form that limits the personal liability of its principals.”[6] The court also concluded the LLC taxes and fees did not fall under the definition of “Property Taxes” under the lease.

Practical Pointers

  1. Landlords should include specific language permitting pass throughs of LLC fees and taxes.  Conversely, tenants should demand such fees be excluded.
  2. The dispute might have been prevented had the landlord included some commonly used protective measures such as shortening a tenant’s time period to contest CAMs to a few months following receipt of an annual reconciliation statement.  Had this time limitation been in place, the tenants would have been prevented from suing for more than one year’s worth of CAMs.  Here, the tenants objected to five years’ worth of CAMs.
  3. In today’s economy, when most tenants are looking for every angle to get out of their lease obligations, landlords should ensure their CAM statements contain only those charges permitted under the Lease.  Conversely, tenants should closely review the landlords’ statements and possibly audit landlords’ books and records to ensure the CAMs are accurate.
  4. This case involved a dispute that started in 2005 and ended in 2009.  It involved 12 tenants seeking to recover a total of $32,153.92 (or on average, $2,679.49 per tenant).  The amount of time and attorneys fees it requires to file a lawsuit, go to trial, and appeal, substantially outweighs any possible benefit any of the parties could have reasonably hoped to recover.  Before engaging in costly and timely lawsuits, parties should use their best efforts to settle “minor” disputes.

 


[1] Aviel, 161 Cal.App.4th at 813.

[2] Id. at 819.

[3] Nevada Atlantic Corp., 2008 WL 5065977 at 1.

[4] Id. at 6.

[5] Tin Tin Corp., 170 Cal.App.4th at 1222.

[6] Id. at 1231.