Court rejects co-tenancy remedy as Unenforceable Penalty

Grand Prospect Partners, L.P. v. Ross Dress for Less, 232 Cal. App. 4th 1332 ((Cal. App. 5th Dist. 2015).  This January, a California Court of Appeal issued an opinion in Grand Prospect that is causing consternation in the retail world and will likely cause many retailers to reexamine the wisdom of over aggressive co-tenancy and exclusive use right remedies.  Grand Prospect involved a retail lease in a development in Porterville, California.  The lease as heavily negotiated over more than a two-years and included both an opening co-tenancy and an operating co-tenancy provision.   Under the opening co-tenancy, Ross was not required to open if two specified anchor retailers — Target and Mervyn’s (each located on parcels adjacent to the shopping center, but not owned by the landlord) — were not open and operating for business.   The operating co-tenancy specified that if Mervyn’s and Target were not open for any continuous 12-month period during the lease term following the commencement date, then Ross had the right to terminate its lease.

Landlord spent more than $2.3 million preparing Ross’s premises for delivery.  Shortly prior to the scheduled delivery date, Mervyn’s filed bankruptcy and closed its Porterville store.  As the opening co-tenancy conditions were not met, Ross elected to defer accepting delivery of its premises, although that deferment did not impact the commencement date of the lease.  Mervyn’s remained closed and was not replaced during the entire 12-month period following the commencement date.  During that period, Ross negotiated with the landlord for potential modifications to the lease to address the loss of Mervyn’s.  Those negotiations included a proposal to convert the Ross lease from a net lease to a gross lease, at a lower overall rental rate.  The landlord and Ross were unable to come to terms on a lease modification and, at the end of the 12-month period, Ross notified the landlord that Ross was terminating its lease under the operating co-tenancy provision.  At this point, Ross had never taken possession of the premises nor paid any rent under the lease (Ross’s total rent for that initial year of the lease would have totaled over $650,000).  In response to Ross’s termination notice, the landlord brought an action challenging the enforceability of both the opening and operating co-tenancy provisions in the lease and seeking both past and future rent from Ross.  The landlord claim asserted that both of the co-tenancy provisions (i.e., opening and operating) were unconscionable and constituted unenforceable penalties.

As an initial matter, the court noted that because of the wide variation between co-tenancy provisions in commercial leases, with respect to both potential triggering events and potential remedies, co-tenancy provisions are not susceptible to any categorical rule of law.  As a result, to determine the enforceability of any particular co-tenancy provision one must examine the particular facts and circumstances.  Turning to the issue of unconscionability, which can be a defense to an entire contract or to a particular contract provision, the court noted that unconscionability has often been defined as the “absence of a meaningful choice” by one party to a contract, where the contract or challenged provision is “unreasonably favorable to the other party.”   Unconscionability is a common law defense in most states, but has been codified in California (see, Cal. Civ. Code Section 1670.5(a)).  The legal analysis for whether a contract or specific provision is unconscionable has two components – one procedural and the other substantive.  The procedural aspect relates to an examination of the circumstances surrounding the negotiation and formation of the contract, while the substantive aspect pertains to the fairness or one-sidedness of the challenged contract or provision.  Unconsionability claims are analyzed based on the circumstances at the time of contract, rather than in hindsight.  In this instance the court noted that the landlord failed to prove the procedural aspect of its unconscionability claim.  Citing to the respective sophistication and bargaining strength of the landlord and Ross, along with the protracted lease negotiation process, the court determined that the landlord had meaningful choices (even though Ross was insistent on the inclusion of the two co-tenancy provisions), the lease was not a contract of adhesion and neither of the co-tenancy provisions was legally unconscionable.

The court turned next to landlord’s claim that several of Ross’s remedies under the co-tenancy provision (i.e., full rent abatement and the right to terminate) constituted unenforceable penalties.  The characteristic feature of an unenforceable contractual penalty is the lack of reasonable proportionality between the remedy provided in the contract and the anticipated harm from the breach or event giving rise to the remedy.  In this instance, the landlord had provided Ross with the right to possession of the space for over a year (even though Ross failed to take possession) and the landlord had lost all rental income under the lease for that period.  At the same time, Ross did not refute the trial court’s finding that “Ross did not anticipate any damage” flowing from the Mervyn’s closure.  As a result, the court determined that Ross’s rent abatement remedy constituted an unenforceable penalty and the court ordered Ross to pay the landlord more than $650,000 in back rent.  Interestingly, the court upheld Ross’s termination right, holding that when a commercial lease negotiated by sophisticated parties contains a termination clause that is triggered by the occurrence of an event “that has no relation to any act or default by one of the parties to the lease” (in this instance the landlord did not own or control the Mervyn’s parcel), that no forfeiture results from one of the party’s exercising its termination right.

It will be interesting to see if and how the issues in Grand Prospect are dealt with by the California Supreme Court.  In the interim, Grand Prospect serves as a useful cautionary tale for retail tenants, encouraging temperance when crafting remedies for co-tenancy provisions in a lease, keeping in mind that the these remedies will be judged based on the proportionality of the harm to the remedy.  The same caution should apply to contractual remedies applicable to the violation of a tenant’s exclusive use rights, which would be judged by the same proportionality standard.