Covenant of Good Faith And Exclusive Use Rights

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Have you ever seen a lease that grants a tenant certain exclusive use rights and then offers, as the tenant’s sole remedy, that the tenant (eventually) can go to half rent (or something like that) and then if the violation persists, the tenant can terminate its lease? Of course you have.

Have you ever then seen the following scenario. A larger, more important, much higher rent paying tenant comes along, but its use just tramples that of the existing tenant with the exclusive use rights? Then, the landlord decides to sign up with the new, larger, more important, much higher rent paying tenant and justifies it by saying – “it’s OK with me if the old tenant goes to half rent (because, I’ll be much, much better off anyway). It’s even OK if the older, smaller, lower rent paying tenant terminates its lease because I’ll still be better off.”

So, the objective observer shouts out, “but that not right. It isn’t fair. You’ll kill the little guy. Etc., etc.” And, the landlord responds – “there is nothing unfair about it. That was the deal. The older, smaller, less valuable tenant made its deal – its remedy is what it is. That was the deal.”

The newer, larger, richer, more valuable tenant doesn’t care. After all, the landlord will take the lumps. It will lose the smaller tenant’s rent, and maybe it will lose the smaller tenant. But, “we’ll” be selling the prohibited items.

Are the landlord and the new tenant “off the hook”? What about the covenant of good faith and fair dealing implied in every contract, such as a lease? Maybe it didn’t mean much in the past, but that may not be true at the leading edge (which has cut fairly deeply into jurisprudence around the country). New Jersey, our home state, has a seminal decision from its Supreme Court – Sons of Thunder, Inc. v. Borden, Inc., 121 NJ 520 (1997). It said: “[a] party to a contract may breach the implied covenant of good faith and fair dealing in performing its obligations even when it exercises an express and unconditional right to … .” This decision is now 15 years old and its application has been expanded several times since then. (And for the grammarians, the court didn’t say it was OK to breach the contract; it said it was still possible to do so even if the contract expressly gave it the right to take the “breaching” action.)

So, what do you think? Even though the older, smaller tenant’s lease said that the stated remedies were its sole remedies, will the landlord be liable for damages? What about the newer, larger tenant – how about the tort of “intentional interference with [the smaller tenant’s] prospective economic advantage”?

I’m not aware of any cases, but I am aware of the scenario described above. Are you? What do you think the law WOULD “say”? What do you think the law SHOULD “say”? There are no right or wrong answers. Post your comments to www.retailrealestatelaw.com and help move the discussion forward. Ruminate with all of us, if you will.

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  1. In my opinion, a Court would imply that the Landlord has to act reasonably, & would uphold the smaller Tenant’s exclusive covenant.

    Harvey M. Haber, Q.C., J.D.

  2. I would think that the exclusive holder must be content with its remedy and I see no breach of an implied covenant of good faith and fair dealing. I see this as a rent adjustment, a monetary remedy that the exclusive holder took on and must live with it. There are additional ways that the exclusive holder could have better adjusted its economic remedies if the occasion arose but I see no “breach” here. I once represented a tenant who was subject to a radius restriction that read;” If Tenant opens another store within 3-miles, then its rent will increase to $…”. It said nothing more. When the tenant opened another store within 3-miles, it began paying the increased rent. The landlord nevertheless brought suit alleging a breach and sought an injunction. The court ruled for the tenant holding that the clause simply provided the landlord with a compensatory remedy if the tenant did something but there was no breach of any covenant, implied or otherwise.

    • Joel, You may want to look at: Seidenberg v. Summit Bank, 348 N.J.Super. 243, 791 A.2d 68 (N.J.Super.A.D.,2002) where it picked up the following from Sons of Thunder:

      We start with the premise that in New Jersey the covenant of good faith and fair dealing is contained in all contracts and mandates that “neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.” Sons of Thunder v. Borden, Inc., 148 N.J. 396, 420, 690 A.2d 575 (1997); Palisades Properties, Inc. v. Brunetti, 44 N.J. 117, 130, 207 A.2d 522 (1965). While this general statement represents the guiding principle in such matters,*254 determining whether the present action may be maintained requires closer examination.

      The implied covenant of good faith and fair dealing has evolved to the point where it permits the adjustment of the obligations of contracting parties in a number of different ways. Some cases have focused on a plaintiff’s inadequate bargaining power or financial vulnerability in order to avoid an inequitable result otherwise permitted by a contract’s express terms. See e.g., Sons of Thunder. Other decisions have revolved around the expectations of the parties, generating a need to contrast those expectations with the absence of any express terms. See e.g., Onderdonk v. Presbyterian Homes, 85 N.J. 171, 425 A.2d 1057 (1981). And still others have emphasized the defendant’s bad faith or outright dishonesty. See e.g., Pickett v. Lloyd’s, 131 N.J. 457, 621 A.2d 445 (1993). Yet, as the implied covenant of good faith and fair dealing continues to develop, and in light of the covenant’s essential factors as discerned from the existing case law, we cannot say, in examining the unadorned record in this case, that an actionable claim cannot be found in plaintiffs’ allegations.

      Sons of Thunder-often viewed as a watershed event in the course of the implied covenant of good faith and fair dealing-is, **1075 perhaps, the best example of how a plaintiff’s unequal bargaining power will bring the implied covenant to the forefront even if defendant acted in conformity with the express terms of the contract. In the wake of Sons of Thunder, it certainly would have *255 been fair to conclude that bargaining power is a critical aspect of any application of the implied covenant to a contractual dispute.

      Or, look at: Electronics Store, Inc. v. Cellco Partnership, 127 Md.App. 385, 732 A.2d 980 (Md.App.,1999).

  3. I’m putting on my policy maker hat for a minute. What happened to the principle from Contracts 101 that the law favors the breach of inefficient contracts? The weaker tenant gets what it bargained for, and the stronger tenant and the landlord make more money than they would have. That is a harsh result for the weaker tenant, but a contract is not necessarily voidable simply because one party is stronger than the other.

    If I offer to buy your real estate for a given price and we agree that keeping my deposit is your sole remedy for breach, does it violate the covenant of fair dealing and good faith if I refuse to close because I got the chance to buy comparable next door from the foreclosing lender for a fraction of the price, so that I saved 50% even taking into account my forfeited earnest money? Remember that we are talking about law, not morality. (As I recall, there are times that the Talmud considers certain failures to perform and says “The Sages consider the guy who backed out to be bum” but then conclude that there is no remedy at law absent certain prerequisites.) Does that supposed bad faith on my part entitle you to damages beyond keeping my earnest money?

    Good faith and fair dealing started out as a way to determine whether a party breached its duty. Here, even though we all seem to agree that one party did breach its duty, the lack of good faith and fair dealing is being asserted as an independent ground for additional damages.

    None of this is to downplay the very real hardship of the injured tenant. But that was the remedy the tenant bargained for and agreed to accept. Why isn’t it a violation of the duty of good faith and fair dealing for the injured tenant to disavow the agreed limitation of remedy?

  4. Ira, I will look up those cases and read them as your blog continues to stimulate my curiosity to enrich my knowledge of commercial leasing.

    I like Jack’s analysis, especially the concept expressed in the last paragraph.

    And I envy, truthfully, Harvey’s uncanny ability (unlike my posts) to reduce into a single sentence the concise legal conclusion being sought and the rationale behind it. A rare gift for a lawyer Harvey.

  5. Michael HassanPour says:

    How about “interference with contractual relationship” when it comes to the larger tenant. What if the larger tenant knew of the exclusive use clause in the smaller tenant’s lease?
    Jack makes a very good points. I don’t see how you could prove bad faith in this scenario. This was the result of a bargained for exchange unless there is more to it than the fact pattern here. I realize that the doctrine has bee expanded of late but I have not seen a case that applies it to a duty performed as bargained for.

    • I’m going to do some educated “speculating.” This isn’t based on legal research because this is a discussion, not a real life set of facts for which the answer means life and death. And, I’m pretty certain that the results will be jurisdiction-related and not readily predicted. The law in this area is a little like a swinging pendulum, but one that is moving in the general direction of protecting legitimate expectations.

      1. The reason I speculated “intentional interference with prospective economic advantage” rather than with “contractual rights” (and with apologies to the late Professor Prosser), is because it isn’t very clear (to me) that the kind of contractual right protected by the intentional infererence with contractual rights tort doctrine covers implied covenants. If you can reach “prospective economic advantage,” I think you get ther same result.

      2. It is hard to argue whether there is “bad faith” in a set of hypothetical facts. The key to the covenant of good faith and fair dealing is that it is an independent provision of every contract, even if it is only an implied provision. Clearly, there is a breach of the Lease by the landlord when it allows a larger tenant to breach the smaller tenant’s exclusive use right. The question is whther the limited, defined damage provision applies only to that breach or if it also applies to a breach of the implied covennat. What Sons of Thunder and its progeny say is that each party to a contract has a reasonable expectation that the other party won’t exercise its own rights in a way that “sneaks” around a fundimental bargained-for right. Perhaps, it might be said that “you can’t do indirectly what you weren’t supposed to do directly, especially if the result is to deprive a party of an important bargained-for expectation.” I’m not opining that a court would hold against the landlord or the larger tenant, but only that there is a non-frivolous argument to be made based on the implied covenant. As to proofs, you would pursue all of the comunications, etc. hoping that you could show that the parties, expecially said, “to heck with the poor little guy and his struggling family, he should have been smarter.”

      • Michael HassanPour says:

        Thank you Ira. I am sure you can tell I’m trying to remember my law school days. Long, long time ago (last year).
        I don’t see the breach by the landlord or the larger tenant. The clause in question could have been either for penalty purposes or to provide a fair remedy for tenant in case of this event. In either case landlords actions, I don’t believe, can be characterized as a breach since they were provided for in the lease as possible events with exact consequences.
        Recently I have come accross a few foreclosure related cases where the doctrine has been pleaded and argued as a cause of action. It seems to me the courts in California (and Nevada) are looking at whether there is a duty that has been breached or if not breach, the act was unfair or in bad faith. If I understand them correctly, they are looking at existance of a fiduciray relationship between the parties. In the case of a landlord tenant relationship, I do not see a fiduciary relationship. However, I do see duty existing in habitability (residential) and Quiet Enjoyment Doctrines which I don’t believe are applicable here in addition to those created by the lease itself.
        A cause of action for breach of the covenant of good faith and fair dealing can lie in contract or tort. “It is well established that all contracts impose upon the parties an implied covenant of good faith and fair dealing, which prohibits arbitrary or unfair acts by one party that work to the disadvantage of the other.” Nelson v Heer, Nevada. As between a lender and a borrower, it is established that there is no foduciary relationship. I am not sure if that extends to or can be argued to apply to landlords and tenants. In addition the words “arbitrary or unfair acts … to the disadvantage of the other” concern me. What if the “arbitrary or unfair acts” that are to the disadvantage of the lessee is provided for in the lease such as here.
        It seems I have come full circle.
        Thank you for taking the time to read these.

  6. Danny Bogart says:

    Application of the doctrine of good faith and fair dealing in commercial leases has a somewhat checkered history. A number of courts have applied the doctrine much as they would in the residential sphere (which to my mind, does not make good sense.) For those interested, or in need of a cure to insomnia, I have written an article on the doctrine of good faith and fair dealing in the commercial leasing context: Good Faith and Fair Dealing in Commercial Leasing: The Right Doctrine in the Wrong Transaction, 41 John Marshall L.Rev. 275 (2008). It was part of John Marshall’s Kratovil real estate series. In it I look at the origin of the doctrine, and how it has been misapplied in commercial leasing cases.

    The doctrine is often discussed in context of Section 205 of the Restatement of Contracts, which defines the doctrine for purposes of the Restatement. Two approaches to the doctrine vied for primacy: an approach that focuses on an open set of bad faith acts and an approach based in lost economic opportunities.

    The first approach, adopted in the Restatement, states rather simplistically that any act in performance of a contract that is not bad faith is good faith, and meets the requirement. This first approach lists an open ended catalogue of bad faith acts. Comment d gives as examples: “evasions of the spirit of the bargain, lack of diligence or slacking off, willful rendering of imperfect performance, abuse of a power to specify terms, and interference with or failure to cooperate in the other party’s performance.” If you think about it, that is a rather vague set of examples. The second approach, not adopted by the Restatement, is an examination of lost economic opportunities. Under this approach, a court would ask whether the party that allegedly acts in bad faith could have negotiated for the right to act as it did in the original contract. If so, to put it in lawyers terms, the party acts in bad faith for taking a second bite at the apple after the contract commences.

    Under the second approach, the tenant bargained for the provisions in the lease, and the landlord is not taking a second bite at the apple by enforcing a sole remedies provision. Tenant could have said no to the deal, or structured the lease differently to satisfy its needs. Under the second approach landlord should be held to have acted in good faith. Remember, the determination of whether a party acts in does not require some moral compass; a party can engage in hard nosed manner and still act in good faith.

    However, under the first — and Restatement approach — I would be worried. Although I think it would be the wrong result, a court could look to many aspects of the language in the comments, and more generally, in the accepted behavior of landlords and tenants — and decide to expand the catalogue of bad faith in such a way as to eviscerate the sole remedies provision.

  7. Danny – an excellent comment and made me think a lot about it. While I still come out on the landlord’s side on this (for now), I’m a little less secure in my position than I was before. There just may be a “good faith” issue lurking in the background where the landlord deliberately violates the grant of exclusivity and cavalierly points the tenant to its sole remedies.

  8. Moshe Friedman says:

    Is there any scenario under which the existing small tenant would have a direct cause of action against the new big tenant (e.g. if the existing tenant had recorded a memorandum of lease containing the exclusive provision, or if the new tenant had actual notice of the existing tenant’s exclusive before it signed its lease)? Or does the lack of privity between existing tenant and new tenant prohibit such an action?

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