Option Rights, Reasonable Expectations, And Traps For The Unwary

A few weeks ago, we included the text of a common lease extension option clause in our blog posting. We didn’t endorse it; we only used it as an illustration. An astute reader pointed out a weakness (from the landlord’s perspective) of what, at first blush, looks like a landlord-friendly aspect of the cited provision. Today, Ruminations is going to disseminate that thought and explore some other related aspects. The general theme will be what happens when it is a condition of the tenant’s lease extension option that it not be in default. So, we’ll start by republishing the lease provision that triggered today’s thoughts:

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 …

What is the weakness? It appears to allow a tenant to revoke its exercise of the renewal option by affirmatively choosing to be in default on the target renewal date. Whether a court would view the provision that way or would decide that this provision gives the landlord the right to “waive” the condition, is an open issue. If pressed to choose, we’d go for the “right to waive” selection.

Ruminations is already on record with its contention that the right to extend a lease’s term should not be conditioned on the absence of a default. To reiterate our reasoning, a landlord already has a remedy for a tenant default; it can seek to evict its tenant. It can do that before renewal notice, between the time it receives a renewal notice, or in the extension term. Basically, Ruminations believes that if it is important enough a default for the landlord to want the tenant “outta there,” it has a way to do so. We readily acknowledge that this position engenders a great deal of pushback from landlords, unless they really want or need the tenant. The argument, however, reveals something about the effect of a tenant default depending on what is at stake.

Eviction (taking away a tenant’s right of possession) is an equitable remedy. Without elaboration, think about the word, “equitable.” Automatically, you realize that it calls for a “balancing” of interests, in this case as between a landlord and its tenant. Courts will not (or should not) remove a tenant for a trivial default, and they usually don’t. On the other hand, when a right is only available if certain conditions are met (such as not being in default), it can be a whole other ball of wax. [We’re not going to venture a guess as to the origin of that idiom. Loyal readers are invited to suggest their own.] Now, when looking at a right that is subject to a condition, courts, historically, have been much stricter. They see such decisions as being “law based,” not equitable in nature. Often, the most equitable a “court of law” will be when applying a bright-line approach when determining whether a “condition” has been met is to add words of regret that it “had” to decide against the party losing the bargained-for right.

Thus far, we have exposes a fundamental, though rarely raised question – does any default, no matter how minor, count to disqualify the tenant’s renewal option?

For some kind of answer, we reached back into our library of case law (actually, into the pile on our credenza) for a pair of decisions from the 1970’s. The first decision illustrates the reasoning behind needing to know whether (or not) an extension right can be exercised. It is a 1976 Massachusetts Appeals Court case, Derman Rug Co., Inc. v. Jacob Ruderman, and can be seen by clicking: HERE. In that case, the extension option language looked like this:

Tenant may extend the Lease for an additional three (3) years upon the same terms and conditions as herein contained by notice to the Landlord delivered at least thirty (30) days prior to the expiration of the original Lease, provided that Tenant is not in default of any of its obligations under the Lease.

The tenant sent proper notice at least thirty days ahead of time, but was in default on day that was thirty days before the lease was to expire. [It owed disputed money, but paid it within the following thirty days.] The lower court read the lease’s provision to mean that the presence or absence of a tenant default was to be measured on the last day of the expiring lease term. The appellate court disagreed, instead holding that the test was to be applied thirty days before that date. Its reasoning is the point of our bringing this case up in the first place. The court ruled that a landlord is entitled to know, ahead of time, whether it will have a tenant or a vacancy when the lease would otherwise expire. Hold that thought.

Let’s jump back six years earlier and to a neighboring state – New York in 1970. There and then, the Appellate Division issued an opinion in Vanguard Diversified v. Review Company. It can be seen by clicking: HERE. As readers correctly anticipate, this case involved a lease dispute, in particular one concerning a tenant’s right to extend the term of its lease. And, as you almost certainly anticipate, it involved a dispute about an extension right that was conditioned on the absence of a default. What readers don’t yet know is, “What was the alleged default?” Drum roll … … It was in breach of this rather broad covenant it made in the lease:

Tenant at its sole expense shall comply with all laws, orders and regulations of Federal, State, County and Municipal Authorities, and with any direction of any public officer or officers, pursuant to law, which shall impose any violation, order or duty upon Landlord or Tenant with respect to demised premises or the use or occupation thereof.

Now, for those who are interested whether it really is against the law to remove the tag from a mattress, it isn’t so long as you are the consumer. For those who are interested whether the sheriff will come for you if you kill a praying mantis, apparently not. No one has been able to find any such federal or state law. [We’re not advocating that you do so, and this doesn’t constitute legal advice.] Now, back to our story (though the relevance of this digression may become clear as we proceed).

Here, there was no doubt that the tenant was out of compliance with certain laws. In fact, at the time the tenant gave its renewal notice (and on the last day it could do so), the New York State Department of Labor, Division of Industrial Safety Service had issued violations against the premises. The tenant, despite its diligent efforts to cure those violations had not done so by the last day it could exercise its option. To make the story a little more complicated, we’ll tell you that the tenant’s appeal of the violations had not yet been resolved on that date.

Holding that “substantial compliance” was irrelevant when “there being no default” is a condition to an option exercise, the lower (trial) court ruled disqualified the tenant’s attempt to exercise the extension option. It saw the tenant’s extension right as a “privilege.” Basically, it took the following New York (court decided) rule to heart:

Where the right to renew a lease depends on the performance of definite conditions or covenants, the right cannot be exercised unless there is full compliance.

The Appellate court disagreed and its written opinion frames both the question and the answer for the point Ruminations is pursuing today. Here is how it framed the question:

The question is whether this rule is unvarying, no matter what may be the circumstances. In our view, the general rule does not apply to the specific covenant in issue. Strict performance of the covenant stated in the lease is tempered under the circumstances, since the covenant relates to compliance by the tenant with regulations made by governmental authorities, and binds the tenant to maintain the general state of repair of the property. Under these provisions, imposing a burden not susceptible of precisely defined content on the tenant, the tenant’s right to renew is governed by the standard of substantial compliance.

Here is how it explained the issue:

The rationale underlying this exception to the rule of strict compliance usually accompanying leaseholds is bottomed upon a purposive approach to the law of landlord and tenant. The law does not favor forfeiture of a leasehold or of its renewal.

Here are examples it gave:

[I]n the case of a covenant by the tenant to keep the premises in good repair, the intention of the parties is fairly inferable that the tenant, in possession of the premises, should protect the landlord from loss in the value of the property from deterioration. So too with the covenant to comply with governmental orders and regulations, the landlord has required the tenant to immunize him from the actions of the authorities by keeping the premises in compliance with proper standards of health and safety. However, where the covenant is substantially performed by the tenant and there is no evidence of injury to the landlord, the tenant should not lose all rights of renewal because of the variance from total satisfaction of the covenant.

Lastly, here is how it reconciled the “law” of “strict enforcement of conditions, as we expressed above when we quoted: “Where the right to renew a lease depends on the performance of definite conditions or covenants, the right cannot be exercised unless there is full compliance” with the relaxed rule of “substantial performance.” It explained:

The exception to the strict compliance rule in landlord and tenant law recognizes the sound distinction between general covenants and the particular covenant here in issue. The covenant requiring the tenant to comply with governmental regulations or to keep the premises in good repair rests upon an intention ancillary to the major consideration inherent in the lease. These covenants suggest a continuing performance during the term of the lease and imply a quality of performance which is not immediately ascertainable as being full or partial within the framework of compliance under the circumstances present at the time of demand to perform.

What does all of this teach us? As Ruminations has pointed out, again and again, you can’t determine the outcome of a lease or other contractual dispute just by reading the words in the agreement, especially just by reading the words “you like.” The law is not stupid or unforgiving. It is intended to foster a civil society. Yes, courts are charged with preserving the rightful expectations of contracting parties, but those expectations cannot have been formed in a vacuum. Just as words have generally accepted meanings and there are dictionary publishers who collect, edit, and present those meanings for our use, there are courts that interpret the law and present the meaning of those laws in the form of written opinions. Those court opinions are a dictionary of sorts; they give all of us a common resource that allows us to frame our expectations. More importantly, those opinions give us guidelines for negotiating and crafting our agreements.

A reader or two (and maybe even thousands of you) may have reduced today’s blog posting to one that could have merely have said that courts (and not just this isolated New York one) read the words, “no default” as “no material default.” Roughly speaking, that’s right. So, why do we write agreements that mislead one party or the other into thinking that leaving out the word “material” somehow creates a bright line test? Folks, it is in there even if you don’t see it. And, since it is in there, why not write the word out so that one party or the other doesn’t have a false expectation? Doing so could engender discussion and avoid battle. When parties think something is “black and white,” compromise is harder to find that when they admit to themselves that the question of materiality doesn’t have a single answer, “yes or no.”

We’d be remiss if we didn’t acknowledge a common approach to get around the issue of materiality and substantial compliance – making the condition one that depends on the absence of a monetary default. If you still ask, “what about the missing penny,” then put in a reasonable threshold. Courts should respect such an agreement.

Another approach, one we don’t see very often, but one that makes good sense to us, is to allow a post-notice cure right. Basically, if a tenant (or some other party) sends a notice exercising an option or other right, and the recipient believes a disqualifying default exists, let the recipient send a notice of objection within a limited period of time and allow the exercising party time to cure the default. If the alleged default is a monetary one, there should be a right to pay under protest.

Those are simple, clean approaches, but if those suggestions don’t resonate because of fear of being taken advantage of, then negotiate a more particularized set of conditions. Keep in mind however, if the default “really doesn’t matter, really doesn’t put the landlord (or the granting party) in a ‘bad’ place,” then don’t expect the court to reject the option exercise. So, if you want a predictable outcome, be reasonable and write out reasonable rules. Agreements are not supposed to contain traps for the unwary, and courts will teach us that (almost) every time.