Cross A State Line And Co-Tenancy Failure Remedies Can Become Valid/Invalid

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In early 2015, we characterized a California court’s decision in a co-tenancy clause case as: “[A] California appellate court has found a typical lease provision to be an unenforceable penalty.”  There, a tenant’s lease gave it the right to take a rent reduction and, after a period of time (if the landlord did not replace the lost co-tenant), it could terminate the lease. The California court allowed the tenant’s lease termination but made the tenant pay full rent during what was supposed to be the reduced rent period. Basically, it agreed with the landlord by holding that the substantial loss from the lower rent constituted an unenforceable penalty. For those interested in our description of that case and implied criticism as well, click HERE to step back to February 2015.

Move forward 4-1/2 years and one state over, to Nevada. There, we had a different landlord, but the same tenant was involved in the California dispute. The lease had a co-tenancy provision and a time came when it wasn’t satisfied, thus giving the tenant a “substitute rent” remedy followed by a termination right. Rent went to 2% of gross sales, eventually reaching an almost $600,000 in savings for the tenant. After six months of co-tenancy failure, the tenant had an on-going termination right. It never exercised it; it just continued to pay the reduced rent. [Well, that’s not exactly what happened. At some point, threatened with eviction, the tenant paid full rent under protest.]

Within a week after the tenant notified its landlord that it would start paying the substitute rent instead of the fixed rent set forth in the lease, the landlord raised its central objection. Probably relying on, and emboldened by, the 2015 California court decision, it asserted that going to the much lower substitute rent constituted an unenforceable penalty and, consequently, its tenant had to continue paying full rent.

Basically, to be valid, a pre-determined amount of damages to be paid (“liquidated damages”) must reflect a reasonable estimate of the damages that a party would incur in a situation where the actual damages will be certain but are not expected to be capable of accurate determination. A much more thorough and possibly thoughtful explanation can be seen in a blog posting from long ago, one that can be read by clicking: HERE.

So, the parties found themselves in the Nevada court system where the landlord explained its reasoning. The effective rent reduction was significant. It resulted in a shortfall far, far in excess of whatever harm the tenant could ever have experienced by the loss of a required supermarket co-tenant. It never represented a “reasonable” estimate of the tenant’s harm. As such, the reduced rent didn’t represent the tenant’s damages as much as it constituted a penalty imposed on the landlord for losing a tenant. If true, the landlord’s argument, in general, would be a good one, and consistent with that put forth in California by a successful landlord against the same chain store tenant.

But, it didn’t work this time. The Nevada court saw the lease provision in the same way as Ruminations saw it in 2012. The landlord’s failure to obtain a qualified replacement tenant for a supermarket that left following a bankruptcy was NOT a default. The landlord did nothing wrong. It didn’t breach the lease. Instead, it was a failure of a condition. The parties negotiated two sets of rents: one if certain other tenants were operating at the property, and another if not. The Nevada court convincingly described both parties as sophisticated. In fact, they were. It also spelled out how the parties had gone back and forth before reaching their agreement on what co-tenants would be required and what the substitute rent would be. Ruminations isn’t sure at all that, absent overreaching or fraud, either or both “sophistication” or “vigorous negotiation” is or should be a factor. Certainly, the presence of those factors made the court comfortable that the co-tenancy provision accurately reflected the parties’ agreement, but would (should) a court apply those tests to every lease provision? We don’t think it would or should.

So, where does this issue – reduced substitute rent – stand? Well, if it is in California, we think the unenforceable liquidated penalty argument is alive and well and leases should be drafted with that in mind. If we stand elsewhere, we’d be comfortable that the Nevada outcome is the one we’d see. BUT, an ounce of prevention is worth a pound of cure. That proverb is a good guide when drafting all agreements, not just for this issue. For this specific issue, however, the parties should spell out that the “remedy” is not intended to constitute damages, but establishes a freely negotiated rent for a property where the required co-tenants are not open and operating.

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Comments

  1. Tim Scott says:

    Ira – Kudos to the Nevada Court (but no link to the case?) I too am unsympathetic and disappointed with the Grand Prospect ruling. In rightly rejecting the unconscionability argument, the Court had to go to the penalty analysis but never commented about the fact that if the provision wasn’t unconscionable, that judgement should be considered in any penalty argument (a weaker and more subjective attack). After all the very economic basis for the deal, the required anchor, failed ab initio. Ross’ no anchor, no deal position and that is where it ended, gives substantial evidence that the issue was central to picking that location over any other. The Court cherry picked its penalty argument ignoring all evidence it was the “without which not” of the deal. Had the anchor disappeared later and then Ross wanted to stay at zero rent, the Court’s argument would have a greater rational basis. Here it does not. One has to look at the timing (the pit of the great recession) and the Ross admissions about the anchor’s impact (a poor record), and feel that the Court was splitting the baby and giving something to a likely struggling landlord. This outcome is one reason why many (me to) have long favored a more measured alternate rent – such as paying half rent if the co-tenancy fails, raising the bar on arguing forfeiture. It is interesting that the Court could not cite a single Cali case that mirrored these circumstances (on either side). I would be surprised if this or something quite similar was never litigated and appealed in Cali.

  2. Richard Belthoff says:

    Anybody have specific wording that addresses the last sentence of this article? I have searched but it doesn’t appear that any sample templates, on Westlaw or otherwise, have addressed this specific issue. Thanks.

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