How Big A Default Was It?

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It is pretty common for a lease or other agreement to grant a party (usually the tenant) a particular right or option and then make it conditional on the “entitled” party not being in default or never having been in default. We are “talking” about such provisions that look like the following sample, but we aren’t endorsing its particular formulation. That would be a whole ‘nutter discussion.

Provided that on both the day that Tenant gives its Renewal Notice and on what would have been the Expiration Date had the Lease Term not been extended by the giving of the Renewal Notice: (a) this Lease had not been previously terminated; and (b) Tenant shall not be in default beyond applicable notice and grace periods, Tenant shall have the option to …

In Merry Ole England, the King had a court system that heard and resolved all disputes. Well, not really all disputes, only those that fit into a limited number of “off-the-shelf” cognizable claims (lawyers, think: causes of action). These “pre-packaged” claims, called “writs,” were “designed to enable the English law courts to rapidly process lawsuits.” The writs were highly technical, and even though new ones were regularly issued to create new rights, the system just couldn’t keep up. If a claim couldn’t be fit into an existing “writ,” the aggrieved person was out of luck – “no writ, no remedy.” The law was the law and too bad!

So, the King(s), being somewhat preoccupied with other matters, such as staying alive, were overwhelmed. In response, the King’s Chancellor was empowered to hear pleas that didn’t fit within an established writ and to fashion a remedy appropriate for each such claim. Basically, the Chancellor’s job (through the Chancery court system) was to “do equity” as needed in each instance – to ameliorate the harshness of the “law courts.”

[Readers, be aware that our recitation of the history of how we wound up with a system of law courts and a system of equity or chancery courts is pretty loosey-goosey Any real historian will readily tell you so. Yes, we’ve taken some liberties. Nonetheless, Ruminations hopes readers get the “idea.”]

Why did we recite that history? Well, it was to tee up for today’s blog posting. There are lawsuits that are resolved by applying “harsh” principles of law. There are lawsuits that are resolved by a court applying principles of equity. For example, contracts generally are enforced according to “the law.” Eviction proceeding, by way of example, are governed by the principles of “equity.” Ruminations admits those are broad generalizations, especially when looked at in civil code states. But, even in those civil code states where law is dominantly by legislation and not judge-made (as it is in “common law” states), the legislatures have, for the most part, adopted equitable principles into their state’s statutes.

What difference does it make whether a court applies “law” or “equity” in a given dispute? For that, we have a 2010 Appeals Court of Massachusetts to illustrate. The case is Trinity Realty I, LLC v. Chazumba, LLC and can be seen by clicking: HERE.

In this case a tenant, a Mexican restaurant, had an option to extend the term of its lease and, as is very common, this right was only exercisable if it was not “‘in default in the performance, fulfillment or observance of any of the terms or provisions of this lease’ as of the date of exercise.”

What were its sins? It allowed a sister company (also a tenant in the same building) to make “modest use of [its] basement and utility storage” without the landlord’s permission, thus violating a lease provision restricting use of that basement for the Mexican restaurant’s business. Also, it was in arrears in furnishing its landlord with required monthly gross sales reports. The reports were for information use only, not for percentage rent purposes. The restaurant paid its rent on time and when the landlord demanded the sales reports, it delivered them on the same day.

According to the Massachusetts Appellate Court:

The [lower court] found that [the tenant] was not in full compliance with two lease covenants when it exercised the option. However, after detailed examination of the surrounding facts, the judge also determined that neither of these infractions, which she characterized as inconsequential and immaterial, was significant or prejudicial to [the landlord]. On that basis, and because [the tenant] would suffer substantial harm if it were unable to extend the lease, the judge ruled that it would be inequitable to deny [the tenant] the right to exercise the option.

Now, the lower court was looking at a contractual “condition,” one that required the tenant “not to be in default” in order to exercise its extension right. It found that the tenant was, in fact, in default. Yet, by characterizing the lease violations as “inconsequential and immaterial,” it allowed the tenant to extend the lease anyway.

The landlord cried “foul” and argued to the appellate court that the lower court judge had improperly used its “equity” powers when the matter should have been resolved as a matter of “law.”

Let’s recap. The tenant’s right to extend its lease’s terms was only exercisable if the tenant was not in default at the time of exercise. Yet, even though it was in default, the lower court allowed it to extend the lease’s term because, otherwise, it would have been “inequitable.” So, why bother including “not in default” language in the lease if it could be overridden by “it ain’t fair.” That’s why the landlord cried foul. It said something like: “Leases are supposed to be strictly construed just like those royal ‘writs,’ not like the King’s Chancellor dispensed ‘equity.” Too bad for the landlord – the appellate court said the lower court had not exercised its “equity” powers, but was following the principles of a “law court.”

What goes? Even the tenant conceded that it had been in default. Yet, it was allowed to exercise its option. Answer? – The tenant was found to be in substantial compliance with the lease and that was sufficient. There is a 1970 New York Appellate Division case that expresses this principle of law (not of equity) pretty well and it goes like this:

The defendant has cited several cases which stand for the proposition that equity will not relieve the default of a covenant [cases cited]. While this proposition has general validity, it does not touch the issue in this case. The substantial compliance rule, as it applies to the performance of a condition precedent to the renewal of a lease, is a legal rule [emphasis by Ruminations]. While it may be founded in part upon equitable principles, it is not a rule of equity which relieves nonperformance, but a rule of law which holds that substantial compliance with the covenant is adequate performance so as to maintain the covenantor’s rights under the agreement.

So, here are a few take-aways from today’s posting and a couple of strong cautions. First, and something that needs to be said over and over: “Don’t think that all you need to know when understanding a contract (such as a lease) is how to read. Contractual provisions are not written or applied in a vacuum. There is an entire body of law within which legally binding agreements are to be understood. You have to know the “law” as best as the “law” can be known. Time after time, we encounter people who insist that a given contractual provision can only be understood in one way and the outcome of their dispute is an “open and shut” case to be resolved in their favor. Briefly stated, it doesn’t work that way. And, the longer lawyers committed to understanding the law practice their profession, the clearer it becomes to them that there is more to be learned.

Another important message is that even if we absorb the “principle” as expressed above by that New York court, predicting, in any given case, what constitutes ‘substantial compliance” is difficult. For one, there is no set of rules to be applied. Secondly, the decision is that of a single judge or a panel of judges, not ours. Lastly, regardless of judicial disclaimers to the contrary, courts weigh the effect on the respective parties and try to do “justice.”

Another message for today is that while the principle of “substantial compliance exists in almost all (if not all) jurisdictions, every jurisdiction sets its “bar” at different levels in general and as to specific “rights.” For example, what would be found as substantial compliance for exercising a lease term extension right might not qualify for a purchase option in the same lease.

Lastly, courts are influenced by the social, economic, and political environment existing at the time of their decisions, and even though the trend that historically been to apply the substantial compliance principle in more and more circumstances, that can change. There can be a pull back.

For those who have made it this far, we’ll share some additional, interesting text from our Massachusetts case. It may bend the minds of those in our profession who pray at the altar of “formulistic drafting.” Try this on for size:

It makes no difference that the lease identified one of the covenants in question as a “major inducement” to [the landlord], and the other as a “material inducement,” particularly where boilerplate in this lease characterized all of the tenant’s obligations under the lease as “material,” “unique,” “extraordinary,” and “of the essence.” If such characterizations were interpreted to mean that nothing less than perfection was demanded of [the tenant] in order to retain the option to extend, the option would be virtually meaningless, as [the landlord] could seize on any number of trivial, technical violations of the lease in order to avoid it.

[Corresponding footnote: Examples given by the trial judge were the failure to clean one of the restaurant’s windows, the improper disposal of a piece of litter, or an imperfectly sealed container of food stored in [the tenant’s] basement storage area. We contrast these examples with defaults of a significant nature that go to the heart of the parties’ agreement, such as the repeated failure to pay rent on time … .]

So, what is today’s final take-away? Perhaps we should think about defining something like a “Disqualifying Default.” It could include rent unpaid for more than 10 days after notice of that unpaid rent or it could include not being open for business, each at the time an option is sought to be exercised. Our thought is that if a Disqualifying Default listed objectively determined defaults of a serious nature and the lease or other agreement required strict compliance, specifically saying that substantial compliance would not be sufficient, the parties would be striking a balance. The party holding the option right would be protected against harassment and threats from the other about the “little stuff.” In return, the rights-giver would have the predictability it deserves so that it can “move on” knowing whether the option has been forfeited.

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Comments

  1. Thanks for the interesting article.

    • This article demonstrates beautifully how intelligent, savvy, and experienced clients still need contract lawyers even if they insist “they can read”. If I had a $100.00 (sorry, inflation) for every time a client admonished me and went on their merry way interpreting what “they could read”, only to come back later explaining how the other party’s lawyer “obviously can’t read” and could I set him/her straight. No! I can’t “set them straight!” As you correctly state “it’s not that simple” and thank goodness for that. I have come to enjoy eating with a roof over my head!

  2. Marc Ripp says:

    A “Disqualifying Default” could simply be defined as a monetary breach or a material non-monetary breach. On a related subject, inartful drafting could allow a tenant to unwind its exercise of a renewal option; if the tenant exercises its renewal option and then later decides it does not want to renew after all, could the tenant deliberately commit a breach (such as paying the rent late by a few days) and then void the tenant’s renewal exercise days before the renewal term commences on the ground that a tenant default occurred? Surely, no party should benefit from is own wrongdoing. The “no default” condition should state that ONLY at the Landlord’s option may a tenant default be used as the basis to void tenant’s exercise of a renewal option.

  3. soflo real estate attorney says:

    When representing a tenant, I can usually get away with providing that there is no “default” unless and until the landlord has provided written notice of the obligation that the tenant has failed to satisfy and the tenant subsequently fails to cure such failure within the cure period provided under the lease. Only after the expiration of the cure period does such failure become defined as a default under the lease. Also, in order for the tenant to lose its renewal option, the default notice must be delivered by the landlord prior to the landlord’s receipt of notice of tenant’s exercise of the renewal option.

    This prevents the tenant from being surprised to hear from the landlord, after the tenant has exercised its renewal option, that the tenant is in default of the lease, which alleged default the tenant may have been happy to have cured had tenant known of the circumstance. It also prevents an unscrupulous landlord from fabricating a default after the tenant’s exercise of the renewal option in an attempt to deprive the tenant from the benefit of its right to extend the term upon a known rental rate. For example, in the case where the negotiated renewal term rent rate is below market.

    Furthermore, such default must be monetary (failure to pay rent) or “material” in nature.

    My definition of a “material” default is a default for which the landlord is enforcing its remedies under the lease. If the landlord is not enforcing its remedies, then the alleged default must not be very serious, the tenant apparently was in substantial compliance with the terms of the lease, and, therefore, the landlord should not have the draconian right of stripping the tenant of its right to renew the lease term.

    The right of the tenant to renew is a material deal term (from the tenant’s perspective, at least) and I will not accept anything less in negotiating a lease on behalf of a tenant client unless my client ultimately overrules my position after thorough discussion.

    I often find the landlord’s position on the issue to be a good indicator on what my tenant client can expect from the landlord after the lease is executed. Whether the landlord will treat the business relationship as a joint venture in which the landlord is going to be fair and concerned about the success of the tenant or, alternatively, the landlord is the dictatorial type who tends to treat his tenants harshly. Of course, this assumes the landlord is informed on the positions taken by his/her attorney in negotiating the lease.

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