Commercial Real Estate Litigation: Are Lease Co-Tenancy Provisions Unconscionable Or Unreasonable Penalties?

Sophisticated California real estate attorneys. A national retailer. A regional shopping center developer.

Are these the parties that the California courts must jump into protect from the terms of their own heavily negotiated contracts?

In Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. (Jan. 12, 2015) —Cal.Rptr.3d —, 2015 WL 161160 (Cal.App. 5 Dist.) the California Court of Appeal addressed the issue of “whether cotenancy provisions in a lease for retail space in a shopping center are unconscionable or unreasonable penalties and, thus, not binding on the landlord.

The answer? It depends.

What Is a Co-Tenancy Provision?
A Co-Tenancy provision in a lease requires that other stores in a shopping center be occupied and operating. These provisions can be either opening or operating, meaning that the requirement is a condition required before the tenant is obligated to open for business or pay rent or it is a condition that is required throughout the term of the lease. In this case the cotenancy provision in the lease conditioned Ross’s obligation to open a store and pay rent on Mervyn’s (another retailer) operating a store in the shopping center on the commencement date of the lease. Ross could terminate the lease if Mervyn’s ceased operations and was not replaced by an acceptable retailer within 12 months.

The Facts of the Case.

In this case Mervyns declared bankruptcy and was not operating a store on the date set for commencement.  Ross did not pay rent during the ensuing twelve months and the landlord was not able to find a replacement tenant who could begin operating within the twelve month period.  Ross therefore advised the landlord that it would terminate the lease.

Proceedings in the Trial Court.

The trial court determined that the cotenancy provisions of the lease were unconscionable and were an unenforceable penalty and struck those provisions from the lease.  Ross was therefore determined to be in breach of the lease for failing to pay rent and for terminating the lease.  The jury was instructed to calculate damages and did so.  Grand Prospect, the landlord, was awarded judgment of just under $5 million.

Issues In The Case

1.  Is a Co-Tenancy Provision Unconscionable?

The Court of Appeal’s analysis first sets forth a detailed explanation of unconscionability.  The gist of the analysis is whether the contract was extremely unfair.  Of course the first question that arises in a heavily negotiated commercial transaction between sophisticated parties is why would the court get involved in the first place to substitute its judgment for that of the two consenting parties?

The court looked at whether the contract was one of adhesion, meaning that one powerful party imposed its form contract on a party with less bargaining strength and that lesser party could only adhere or reject it.  In this case the court found that this was not a form lease and that the parties went through multiple drafts of a letter of intent and five versions of the lease before reaching agreement.  It was not a contract of adhesion.  Moreover, the insistence by Ross on this clause did not make it a ‘clause of adhesion’ which transformed the entire contract into one of adhesion.

In analyzing unconscionability the Court of Appeal looked at a number of factors:

(1) Sophistication:  The parties were both sophisticated real estate professionals with both education and experience.
(2) Time Pressure:  It does not appear that Ross exerted time pressure on the landlord.
(3) Economic Pressure:  The landlord was not ‘economically vulnerable’.
(4) Pressure from Coercion or Threats:  No evidence of such.
(5)  Relative Bargaining Power: Ross had an advantage in bargaining power because it was the larger company in terms of financial resources and personnel but this did not prevent Grant Prospect from entering into real negotiations  and did not mean ‘absence of a meaningful choice’ for the landlord.
(6) Meaningful Choices:  It was the landlord who approached Ross as a potential tenant and there were other potential tenants that the landlord could have approached.  Based on all of these factors, the appellate court held that there was no procedural unconscionability in this case and this was therefore not a ground for invalidating the cotenancy provision.

2.  Is a Co-Tenancy Provision An Unenforceable Penalty?

As a legal question the Court of Appeal first held that a contract provision triggered by one or more conditions precedent can be deemed a penalty under California law.  In general a court can excuse the performance of conditions and promises otherwise agreed to by the parties.  That fact that a promise or condition will operate harshly against one party does not justify the court’s excusing its performance but the court has often prohibited the enforcement of forfeitures or penalties even though the parties agreed to them.

The court concedes that the principle is inherently incapable of precise articulation or application.  The characteristic feature of a penalty is the lack of a proportional relationship between the forfeiture compelled and the damages or harm that might actually flow from the failure to perform a covenant or satisfy a condition.

The court analyzed both the rent abatement provision as well as the termination provision.

3.  Rent Abatement

Whether a particular rent abatement provision operates as an unreasonable penalty depends upon the specific facts and circumstances of the case.  The court examined rent abatement provisions that were and were not penalties and concluded that the provision in this case was a penalty.  The court found that because the rent was $39,500 per month, its abatement was a penalty.

Generally, a contractual provision is an unenforceable penalty if the value of the money or property forfeited or transferred to the party protected by the provision bears no reasonable relationship to the range of harm anticipated to be caused to that party by the failure of the provision’s requirements.

In this case Ross had not anticipated any damage from the failure of Mervyns to open.  The court therefore held that the $39,500 per month rent abatement when compared to $0 in anticipated damages constituted an unenforceable penalty.

4.  Some thoughts

The biggest question that this case poses is why does the court need to interfere in the heavily negotiated contractual relationship between two wealthy and sophisticated parties?  If the parties agreed to these terms and neither party was coerced into entering into the contract, why does the court feel the need to substitute its positions for those expressly negotiated by the parties?