Can A Tenant Enforce A Rent Abatement Penalty? Here, A Court Says: “No.”

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What would you think if Ruminations told you that it is perfectly fine in California for a tenant to terminate its lease if a co-tenancy condition isn’t met, but not to exercise a rent waiver, even if it hasn’t opened its store? Well, we’re telling you that based on our seeing a January 12 court decision from a California Court of Appeal. The case is Grand Prospect Partners, L.P. v. Ross Dress For Less, and the decision can be seen by clicking: HERE.

Uncharacteristically, we’re aiming for a “short one” today. [We’ve missed.] So, lawyers and law buffs should certainly take a look at the court’s opinion. It is rich with “real” legal analysis, though we think it is far short when it comes to the court’s understanding of commercial reality. What is more, the court’s analysis doesn’t seem to be limited to co-tenancy remedies; it could be equally applicable to agreed-upon remedies for violation of exclusive use rights or access violations.

The keystone to today’s blog posting, and to the court decision that led to it, is the legal concept of an “unreasonable penalty.” We’ve written about this before in the guise of what is known as a liquidated damage. Search Ruminations using “liquidated damage” as a search term. But, now, to the story.

Part of a shopping center project was owned by a developer and part was owned by a traditional department store. A discount department was open and operating in 87,000 square feet of space on the developer’s portion; the traditional department store was open and operating in 76,000 of square feet of space on its owned parcel. A clothing retailer was interested in leasing a 30,000 square foot store from the developer. We’ll call the clothing retailer, “tenant” and the developer, “landlord.”

From the onset of negotiations in the Fall of 2005, the tenant was insistent that its lease include both an “opening co-tenancy” and an “operating co-tenancy” provision. Though the case that triggered today’s posting implicated only the “opening co-tenancy” provision, the reasoning behind its outcome would apply to an “operating co-tenancy” provision as well. It would also apply to typical remedies for a landlord’s violation of a tenant’s exclusive use rights or site plan control rights.

Between the time negotiations started and when the lease was signed in the Spring of 2008, the discount department vacillated about remaining at the property, but eventually elected to stay and even to expand its store to 126,000 square feet of space. All the way through, and finally into the lease itself, the tenant insisted that its obligation to actually open for business and to begin paying rent would be contingent on the discount department store being open and operating in its entire space. Likewise, the traditional department store would have to be open and operating in its entire store.

The lease gave the landlord the opportunity to replace the required “co-tenants” with qualified replacements and it also gave the tenant the right to terminate its lease if either co-tenant’s store was still “dark” after a year.

Everything was fine when the landlord began improving the tenant’s store. Along the way, however, the traditional department store filed for bankruptcy and closed its store. The landlord offered a lower rent to the tenant and made some other offers to the tenant in order to avoid the consequences of the now “dark” space, but the tenant was unmoved. The space was completed and the tenant, after reminding the landlord of the opening co-tenancy contingency, accepted delivery of the leased space. It never readied the store for its business; it didn’t open; and, it didn’t pay rent.

The landlord bought the department store’s parcel so that it now owned (and controlled) the entire shopping center. It marketed the vacant department store, but didn’t re-let the empty store within the year after it delivered the eased space to its tenant. The tenant exercised its right to terminate the lease.

[The procedural history of the lawsuit overlaps the “story” we’ve just related, but that’s of no relevance to the outcome.] What is relevant is that the landlord asked the court to rule that remedies it negotiated with the tenant to cover the opening co-tenancy contingency failure were unconscionable and also an unreasonable penalty. It was talking of both the rent abatement remedy and the termination remedy.

The lower court agreed with the landlord, holding that both remedies were unenforceable and finding that the tenant was liable for the unpaid rent as well as for damages suffered by the landlord until it could re-rent the tenant’s space. It also seems that the tenant was ordered to pay for some of the work the landlord had done to the space for the tenant.

Of course, the tenant appealed. It was only partially successful. The Court of Appeal held that the tenant could rightfully terminate the lease after the 12 months, but that the rent abatement agreement was an unenforceable penalty. That’s where the outcome now stands. Whether there will be a further appeal (by either or both sides) or whether the outcome will change if there is an appeal is yet “unwritten.”

Basically, the Court of Appeal was asked “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.” To the court’s credit, at least it ruled (without direct analysis) that its opinion did “not establish a categorical rule of law holding cotenancy provisions always, or never, are enforceable.”

Interestingly, as to the termination right, the court felt bound to a rule established in 1915 by the California Supreme Court. In reversing the lower court’s ruling that the termination provision in the lease before it was an unenforceable penalty, the Court of Appeal summarized California law as to a lease terminating contingency. What it wrote was: “… [W]e conclude that when a commercial lease contains a clause terminating the lease upon 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. This specific rule of law controls over the general test usually applied to determine if a contract provision is an unenforceable penalty.”

For Ruminations, this leaves us with a great urge to deal with both the “unconscionabilty” issue and the rent abatement as an “unenforceable penalty” issue. We promise to Ruminate over unconscionability in a soon to be published posting, but today’s focus will be on how and why the court deprived the tenant of its negotiated remedy as an unenforceable penalty.

So, what makes a particular remedy unenforceable as a penalty? The California “rule” is pretty much the same rule as found throughout the country. As stated in the court’s opinion, “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. … In other words, an unenforceable penalty ‘bears no reasonable relationship to the range of actual damages the parties could have anticipated would flow’ from a breach of a covenant of a failure of a condition.”

Ruminations takes no issue with the legal principle that even agreed-upon “remedies” can be penal and, if so, can be unenforceable. We’d be rightly assaulted if we took exception. So, what makes this particular case interesting? One factor is a pretty technical legal issue – the distinction between a “condition” not being satisfied and a “direct statement” that if “x” happens (or doesn’t happen), one party will pay the other an agreed-upon sum. The opinion we’re working with does a nice job of saying that it doesn’t matter (at least in California) how you write your contract; the court will look through the “legal” structuring and focus on the outcome. We leave it for readers for whom such a legal analysis would be of interest to look at the opinion itself. [More about the opinion later.]

Translated for the situation in front of us, the Court of Appeal set out to compare the loss to the tenant if the opening co-tenancy was not satisfied to the landlord’s loss if the rent was abated. It found zero impact on the tenant. It also found that the landlord was harmed to entire extent of the abated rent. That’s: Tenant – $0 loss; Landlord – $672,000 loss. Yes, according to the court, the tenant suffered nothing because the traditional department store wasn’t open and it wasn’t fair that the landlord wouldn’t be paid rent.

Two things about the facts in the case appear to have gone on. For one, it seems as if the tenant didn’t really get much on the record in the original trial (before the lower court) as to its losses. That allowed the Court of Appeal to minimize any further arguments to that effect because an appellate court doesn’t have to deal with any facts that weren’t before the lower court. Second, because the tenant never opened its store (as was its right, though the Court of Appeal didn’t seem to integrate that fact into its analysis), the tenant couldn’t show any actual damages.

For readers who are chomping at their bits, wanting to explain to this court, “how things work,” Ruminations says: “you can’t change the facts.” Here, the court liked its own analysis. A whole bunch of other retailers and the California Retailers Association all tried to “teach” (call that “help”) the court understand how retailers think the world works. They entered the case as an Amicus Curiae, as a “friend of the court,” attempting to bring information to the court that was not already in front of the court.

We know that Ruminations holds itself out as a “retail real estate law” blog. Today, we’ll weasel out of the “law” part other than for what we’ve already written. We don’t want to dilute our main message: a California appellate court has found a typical lease provision to be an unenforceable penalty. We don’t think that it has mis-expressed the law. We just think its factual analysis is a “little off.” We don’t think it is “unreasonable” for a retailer to select a location based on what it subjectively finds appealing about that location and to seek assurances that the “appeal” doesn’t disappear either before it is ready to open for business or even along the way. After all there is a “business” law that includes this phrase: “location, location, location.” Here, the retailer didn’t want to be at the property if the two named retailers weren’t there. It wouldn’t have signed the lease without them. That was clear all the way from when the deal started in the Fall of 2005 until the lease was signed in the Spring of 2008. It was induced to sign the lease based on the landlord’s “promise” that both retailers (or suitable replacements) would be open and operating. Had the lease not given the landlord a year to find a replacement tenant and had it allowed the tenant to terminate the lease as if it hadn’t signed it in the first place (because the required tenants weren’t there), the court would have been bound to protect the tenant and thus “harm” the landlord. Instead, the court said that the tenant should have paid rent (implying that it would have been smart to build-out its store, start up, and then operate its business) knowing that it would likely shut down after 12 months.

Also, it would appear that even though the court (in a legal analysis we won’t get into) rightly pointed out that courts show preference for substance over form, it would have upheld a provision wherein the tenant’s obligation to take possession of the leased space in the first place was contingent on the two other stores being open and operating. The effect would have been the same.

So, we’ll return to the situation Ruminations thinks this particular court’s ruling creates: “How much rent abatement, set out in advance in the text of the lease, will be ‘enforceable.’” Would a 10% rent reduction for a co-tenancy failure or for the breach of an exclusive use right ever be sustainable?” Wouldn’t every tenant still be required to “prove” its losses? Is that even possible? Yes, sales went up even though the co-tenant closed down. But, what would have happened if the co-tenant didn’t close? Perhaps sales would have gone up more (or fallen).

Don’t get Ruminations wrong. This isn’t the only court that ever threw out a rent abatement remedy, agreed-upon between a landlord and its tenant, in a fairly negotiated lease. This court’s opinion cites some of those case as well as ones to the contrary. Where we think the court has gone wrong is that it ignores an important factor when it comes to deciding what is “reasonable.” It ignores what an entire industry has accepted as a reasonable solution to a reasonable tenant concern. We didn’t invent that concept. If anyone is interested in such an “unreasonable penalty” analysis by an upper court, take a look at the New Jersey Supreme Court’s opinion in MetLife Capital Corp. v. Washington Avenue Associates by clicking HERE: 

All that having been said, we urge law aficionados to look at the California opinion we’ve been blabbing about. Our view is that it is a little disorganized, but that it really explains a lot about co-tenancy provisions, conditions precedent, procedural unconscionability, substantive unconscionability, unenforceable penalties, and other good things. Again, we don’t disagree with its explanation of the applicable law; Ruminations just thinks the court may not have properly applied that law to the facts. In fairness, that might be because we think the outcome is not the correct commercial one and this belief might be blocking us from appreciating the court’s wisdom. Ruminations would be really, really interested in hearing from readers who actually review the court’s decision. Did the court get it right or wrong? Why? If you want to chime in, please let us (and our readers) know what you conclude by adding your comments in the appropriate place below.

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  1. Alan Betus says:

    A couple of questions and comments. I’m curious about

    * What impact, if any, did the fact that Landlord didn’t initially own the traditional department store parcel. In other words, if the traditional department store tract was initially owned by Landlord, does the outcome change?

    * Whether or not the rent abatement clause had the typical “liquidated damages” boilerplate about the parties agreeing that damages are difficult to ascertain and as a result the rent abatement, freely agreed upon by Landlord and Tenant, are not a penalty and that rent abatement is a good faith effort to establish damages, and if so, if (and to what extent) the verbiage was considered by the court.

    • Those are good questions. I urge you and anyone else who is in this “field” to look at the opinion itself. As to the traditional department store not being owned or controlled by the developer (until after the bankruptcy, when it bought the parcel), the court takes note of that in one place and then goes on to report the subsequent purchase and the eventual lease-up with a mix of tenants [but that happened after the clothing store tenant’s lease was (rightfully) terminated.] In another part of the opinion, in what appears to be “dicta” (essentially not a basis for the court’s decision, but something like the court’s wise musings), it makes note that the landlord didn’t leave itself with an obvious way to cure the “vacancy.” It knew that when it signed the lease (that it didn’t control the traditional department store’s space) and took the risk (that’s our comment). Basically, it didn’t have any expectation that the traditional department store would ever go dark (that’s also our comment, not the court’s).

      The opinion didn’t mention a liquidated damages clause. Importantly, the parties didn’t think that saying the tenant didn’t have to pay rent until both key spaces were open and operating was a “damage” provision. That is, not until the landlord had its litigation counsel review the lease and (successfully, in part) make that argument.

  2. Ronald Neifield says:

    Ira – The lease provided that the tenant could open for business and pay no rent until the opening co-tenancy requirement was satisfied. In the first non-California case that the Court cited (and followed), it emphasized that the tenant seeking to enforce a rent abatement related to the breach of an exclusive could operate for 50 years without paying rent if the abatement provision in the lease was enforced. Although tenant in Grand Prospect Partners elected not to open, under the lease it could have opened and not paid rent until the opening co-tenancy provision was satisfied – presumably operating rent free for the entire term. Although this was not emphasized in the Court in its discussion, it seems to be a critical fact.
    If the lease was drafted so that if the tenant opened for business it would pay a reduced rent, I suspect that the tenant’s right to not open and totally abate rent may have been looked at differently.

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