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Supreme Court Upholds Co-Tenancy Clause in Retail Lease
Opinion Says Provision Allowing Tenant to Pay Reduced Rent When Shopping Center Falls Below Certain Occupancy Standards Is Valid as Alternative Performance, Not Unreasonable Penalty
By a MetNews Staff Writer
The California Supreme Court held yesterday that a co-tenancy provision in a commercial retail lease—which allows the tenant to pay a reduced rent when the shopping center falls below certain occupancy rates or fails to retain a specified number of so-called “anchor stores”—is an enforceable contractual clause and not an unreasonable penalty for a breach.
At issue is a commercial lease between JJD-HOV Elk Grove LLC, the owner of a shopping center located in a Sacramento suburb, and craft supplier Jo-Ann Stores, LLC. The co-tenancy provision requires the shopping center to maintain three anchor tenants—large retailers that are attractive to a broad range of shoppers—or operate with 60% of the space leased in order to retain the right to the full $42,292 monthly rent.
If JJD falls below either of these thresholds, Jo-Ann is contractually permitted to pay reduced “Substitute Rent,” calculated as the greater of 3.5% of Jo-Ann’s gross sales of certain goods and services at the location or $12,000.
Jo-Ann informed JJD that it intended to start paying “Substitute Rent,” effective July 1, 2018, due to the closure of two anchor stores in the center. The retailer paid the reduced rent until May 2020, when the occupancy terms were again fulfilled.
Complaint Filed
JJD filed a complaint against Jo-Ann for declaratory relief and breach of contract, arguing that the co-tenancy provision was an unenforceable penalty under the 2015 Fifth District Court of Appeal decision in Grand Prospect Partners LP v. Ross Dress for Less Inc.
In Grand Prospect, the co-tenancy provision provided that no rent would be due if the anchor retailer, a department store that owned the building in which it operated, closed. Reasoning that the landlord had no control over the anchor store—which ceased operations after filing for bankruptcy—the court viewed the provision as requiring unreasonable liquidated damages as a penalty for breach in violation of Code of Civil Procedure §1671.
The section provides that “a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”
Summary Judgment Motions
Jo-Ann filed a cross-complaint against JJD, seeking a judicial declaration that the co-tenancy provision is valid and enforceable. The parties filed cross-motions for summary judgment.
Then-Sacramento Superior Court Judge Shama Mesiwala (now a Third District Court of Appeal justice) ruled in Jo-Ann’s favor, finding that the provision did not impose damages for breach of contract but instead provided for alternative performance in the event of certain contingencies came to pass. Mesiwala found Grand Prospect distinguishable and inapplicable.
The Third District Court of Appeal, in an opinion authored by then-Justice Laurie M. Earl (now presiding justice), agreed and affirmed the judgment in favor of Jo-Ann.
Justice Kelli Evans wrote yesterday’s opinion for a unanimous court, saying that “we affirm the judgment of the Court of Appeal and uphold the [co-tenancy] provision in this case as reflecting the parties’ agreement regarding acceptable alternative performance of agreed upon contract obligations.”
Alternative Performance
Evans said that “[w]e hold that the JJD court properly analyzed the [co-tenancy] provision as a form of alternative performance” and explained that a “two-step inquiry” governs whether a provision is in fact an unenforceable liquidated damages penalty.
Under the inquiry, courts first apply a “realistic and rational choice test” which asks whether the contract reserves to the owner a real choice in the future concerning performance. She noted that “[i]f the provision establishes methods for alternative performance, the inquiry ends, and the provision is valid” but if not “the provision provides for liquidated damages [and] courts apply section 1671.”
Applying the standard to the clause in question, she opined:
“The [co-tenancy] provision ‘clearly reserves to [JJD] the power to make a realistic and rational choice.’….JJD can choose to provide a higher level of service (i.e., a mall with anchor tenants or specified occupancy levels) and receive a higher rental amount, or alternatively, to provide a reduced level of service (i.e., a mall with reduced anchor tenants or occupancy levels) and receive a reduced rental amount. Because tenants are receiving less value for the leases they are locked in to, it is reasonable for the parties to agree to lower rent payments for the reduced value of services.”
Inducements to Attract
The justice continued:
“If JJD wishes to avoid receiving a lower level of rent, it can choose to make inducements to attract additional anchor tenants or raise the overall occupancy rate. These efforts may include offering favorable lease terms, providing additional amenities to tenants, or renegotiating important leases. The totality of the relevant economic circumstances here belies JJD’s characterization of the clause as a penalty….JJD has a credible choice between two alternative methods of contractual performance, which are clearly designated in the duly negotiated contract.”
She added:
“Moreover, [co-tenancy] provisions are not negotiated in a vacuum. The parties—who are often sophisticated and well-represented—consider such provisions alongside other lease terms during an arms-length negotiation process. The bargaining power of the parties, their ability to rigorously negotiate contract terms with the assistance of counsel, their understanding of the real estate market,…all inform what it means for the parties to have made a ‘realistic and rational choice’ in entering a lease agreement in light of economic realities.”
Turning to the Grand Prospect decision, Evans remarked that “we express no view on the validity of Grand Prospect’s holding” but said that the case was distinguishable. She pointed out:
“The [co-tenancy] provision condition at issue here did not condition the level of rent on the continued occupancy of a specific anchor tenant whose actions the landlord had no ‘opportunity to affect.’….As the owner of the space and the anchor tenants’ landlord, JJD had ‘control’ over which method of alternative performance to pursue.”
Unreasonable Forfeiture
JJD also contends that it is being punished for taking a discretionary act under the contract causing it to suffer an unreasonable forfeiture under Code of Civil Procedure §3275, which provides that “[w]henever, by the terms of an obligation, a party thereto incurs a forfeiture, or a loss in the nature of a forfeiture, by reason of his failure to comply with its provisions, he may be relieved therefrom, upon making full compensation to the other party.”
Evans concluded that JJD “failed to raise the argument in the trial court or to meaningfully develop it in the Court of Appeal” but said that the claim was “meritless.”
She acknowledged that “[u]nder section 3275, a party that incurs a forfeiture by failing to comply with a contractual provision can, in some cases, raise section 3275 as an ‘equitable defense’ to enforcement,” but declared:
“Section 3275 does not apply to this case, because adhering to the [co-tenancy] provision is a form of compliance with the contract and thus does not constitute a breach-induced forfeiture. And, even if it did, JJD does not claim that it has provided the ‘full compensation’ to Jo-Ann that would entitle it to relief under the statute.”
Evans wrote:
“It is not the place of courts to invalidate a contractual term when one party benefits or suffers commercial harm. As the Court of Appeal below succinctly stated: ‘[T]he parties considered and agreed to allocate the risk of reduced occupancy to JJD, and agreed JJD would receive substantially reduced rent if that risk occurred. JJD has received precisely the Substitute Rent it agreed to receive.’….We decline to alter that agreement.”
The case is JJD-Elk Grove LLC v. Jo-Ann Stores LLC, 2024 S.O.S. 3730.
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