What Makes An Agreement’s Provision Illusory Or An Unenforceable Penalty?

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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. That’s how we began our February 1, 2015 blog posting, where we introduced readers to a California court decision lots of us now refer to as the “Grand Prospect Partners” case. [See that posting by clicking: HERE.] Two months ago, Grand Prospect Partners came up in a Nevada court decision and, there, the court had no trouble with the validity of the agreed-upon rent reduction. [See that one by clicking: HERE.]

Well, “it’s déjà vu all over again,” a Yogiism, except that it’s Oklahoma’s turn to deal with the appropriateness of a termination remedy for a co-tenancy failure. The case also gives us a chance to look at some conventional lease language through the eyes of a court. To begin with, (with some editing) this is how the court summarized a lease’s co-tenancy clauses:

The “Initial Co-Tenancy Requirement” meant that: (1) certain identified key stores are open at the Shopping Center; and (2) a specified portion of the remaining space in the Shopping Center is operated by certain types of national or regional retailers (“Required Tenants”) that are actively open and operating as a retail use in substantially all of their premises.

“Required Tenant” meant either a “national” retailer operating at least 50 high quality retail stores nationally, or a “regional” occupant satisfactory to [the tenant] in its sole discretion.

It was agreed that part (1) of the Initial Co-Tenancy Requirement had been satisfied. The parties, however, did not agree whether a particular bank, occupying two spaces at the shopping center (one for a loan office and one for an insurance office), qualified under part (2) of the definition. At the heart of the problem was that certain terms, “regional,” “national,” “bank,” and “retail” were not defined in the lease. The landlord complained (belatedly, Ruminations thinks), that because these terms were undefined, their meaning were left to its tenant’s sole discretion. The tenant responded that it was not asserting “such a unilateral right, but rather ‘the terms should be given their plain meaning and the meaning they are given in the retail leasing industry.’” So, today’s first lesson is that our readers and we need to define these (and other such) terms in our leases. Do you always do that? [Why did we write “belatedly”? That’s because the landlord should have raised this issue before signing the lease.]

The landlord’s first try at “qualifying” the bank was to claim it was a national tenant (for which the tenant’s approval would not be needed). It argued that the bank qualified because it was “‘deemed retail’ and ha[d] More than 50 locations.’” To the court, this interpretation would have rendered the word “national” meaningless. Every word, phrase, clause, and sentence of the lease had to be given effect, and merely having 50 or more locations did not, by itself, make the bank “national.”

So, the landlord’s “fallback” was to assert that if the bank wasn’t “national,” at least it was “regional.” Though this term was undefined, the tenant accepted that the bank was “regional,” and then rejected it as not being satisfactory (in the tenant’s sole discretion).

That’s the background. Were the bank’s uses retail or “retail enough” to qualify? Was the tenant bound to any standard if it rejected a particular tenant as qualifying? Did its “sole discretion” right make the provision illusory? If the Initial Co-tenancy Requirement failed, was the tenant’s right to terminate the lease a lawful remedy?

To begin with, as readers would expect, the landlord claimed the bank’s uses were “retail,” but its tenant did not. It appears that the court, faced with a lease that didn’t define “retail,” deferred to the tenant’s right to exercise its “discretion” to decide if the bank’s uses qualified. Interestingly, the court conflated the condition that a Required Tenant was “actively open and operating as a retail use in substantially all of their premises” with a provision in the bank’s leases requiring the bank’s businesses to be: “‘open . . . fully staffed, stocked and operated by an Occupant in substantially all’ of their premises (as the Lease required).” Though not clear, it appears that the bank’s facilities had no “stock” and, at the time in question, were not fully staffed. More broadly, the court rejected (i.e., found unpersuasive) the landlord’s argument that a bank’s activities, per se, are “retail” or “incidental to retail.” Implicitly, the landlord argued that any sales to an ultimate consumer were “retail” sales. Opining that such a definition was “untenable,” the court ruled that “[u]nder [the landlord’s proposed construction, [the bank] could have opened a hotel, and it would have been deemed retail.”

Oh, how a definition of “retail” would have made this journey to court unnecessary or, if taken, much shorter and cheaper.

A more thorny issue was whether there are limits to the exercise of “sole discretion.”

At the core of this lease dispute was the landlord’s argument that “[t]he effect of [its tenant] reserving to itself in the Lease both the right to terminate and the right to define after the Lease was signed the basis for termination, in its sole discretion, renders the right to terminate provision illusory.” Setting aside that “reserving to itself” denies that the landlord participated in this “reservation,” there are some circumstances where agreed-upon contract terms make that contract illusory and, by extension, the illusory terms can be excised, i.e., will be unenforceable.

But, courts work to enforce agreements by giving force to the provisions chosen by the parties. Oklahoma case law is substantially the same as everywhere else when it holds: that “[a]n offer pursuant to which the promisor retains an option exercisable in his sole discretion will be held illusory unless the court can determine that his discretion is bridled by a good faith or other standard” and that “we hold that the objective ‘reasonableness’ standard is appropriate for contract provisions that are conditioned on the sole satisfaction of one party.” The court also adopted authority cited by the tenant from other states, including:

While “the reservation of a unilateral right to cancel [an] entire agreement is so broad as to negate the existence of any consideration in that the promise is essentially empty or illusory,” if “notice of cancellation is required the promisor is bound sufficiently so that his promise to buy or give notice of cancellation meets the requirement of consideration.”

Here, “the tenant’s right to terminate was not unrestricted; it was subject to a notice requirement.” The tenant “gave such notice, which moreover could only be given after the expiration of two years from the Rental Commencement Date.” Around the country, this requirement that a party give notice of its decision is often used to dismiss an argument that the use of “sole discretion,” however expressed, makes a contract provision illusory.

The court wasn’t finished. It needed to address the “argument that, despite the bare language quoted above, a cancellation even given with required notice might be found arbitrary.” After all, Oklahoma and all other states imply a duty of good faith and fair dealing in every agreement. This court, citing a well-regarded legal treatise, stated the following:

If one party to an agreement reserves an unqualified right to cancel the bargain, no legal rights can arise from it while it remains executory. However, if the party may only cancel upon dissatisfaction, for good cause shown, in the exercise of the judgment of the promisor as a fiduciary for others, upon the giving of reasonable notice, or upon any other condition not within the promisor’s control, the promise is nevertheless enforceable.

Can we sum up the issue as to whether a provision giving a party “sole discretion” is enforceable? Yes, we can. Yes, it will be provided the condition being evaluated is outside of the decider’s control and, at a minimum, the deciding party must give reasonable notice of its decision. Of course, if the decision is “objectively reasonable,” courts will be far less prone to look for some other reason to support a complaining party if the only support for a “sole discretion” decision is a thin, legal thread.

Oops, we’ve just remembered that our opening paragraph promised we’d be addressing our remaining question: “If the Initial Co-tenancy Requirement failed, was the tenant’s right to terminate the lease a lawful remedy?” That’s because we only intended to use the court’s words for an answer. So, here they are:

Both parties discuss Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc., 232 Cal.App.4th 1332 (2015) [Click HERE to read it] and reach different conclusions. In that case, the Lease contained a clause granting a tenant an option to terminate upon 30 days’ notice if the anchor tenant ceased operations. The court (applying California law) held that “when a commercial lease contains a clause allowing termination upon the occurrence of contingencies that (1) are agreed upon by sophisticated parties and (2) have no relation to any act or default of the parties,” the clause did not constitute a penalty.” After finding the first prong satisfied, the court also found the second prong satisfied because “neither [the cancelling tenant] not [the landlord] could control whether [the anchor tenant] continued to operate a store in the shopping center or whether that space would be occupied by the type of anchor tenant specified in the Lease.”.

This ruling appears to precisely fit the present facts and support a conclusion that the clause does not constitute a penalty. This court, however, finds itself in disagreement with the application of the second prong by the California court. Rather, this court agrees with the [landlord] that the cancellation in Grand Prospect did have relation to acts or default of the parties. While the landlord [in Grand Prospect] could not control whether [the anchor tenant’s] continued operations, it did have the responsibility to bring in a satisfactory replacement anchor tenant. In the case at bar, the Lease imposed the obligation on [the landlord] to achieve co-tenancy.

If this court were to employ the Grand Prospect test (as stated, not as applied, by the California court) the court would find [the landlord here] — while not meriting summary judgment in its favor—has raised a genuine dispute of material fact as to whether the cancellation clause herein constituted a penalty. This court, however, declines to adopt that test. No Oklahoma case has adopted the test used in Grand Prospect. A federal court is generally reticent to expand state law without clear guidance from the highest court. A party encouraging a federal court to apply a new legal principle under state law must make a “strong showing” that the highest court of that state would adopt that principle if presented with the question. [The landlord] has failed to make such a showing.

A party invoking the cancellation option (standing alone) is not imposing a penalty; such action merely restores the parties to the status quo ante. If (by contrast) terminating the lease were accompanied by seeking to enforce a liquidated damages provision of some sort, such might constitute a penalty, but no such conduct appears here. [The landlord] argues that the provision is “penal in effect,” based upon inequitable cost to [itself] and lack of cost to [its tenant], but the court is not persuaded. The Oklahoma cases cited by [the landlord] appear to deal with monetary penalties, and this court finds them distinguishable.

That’s a long way for the court to say that it endorses the California court’s holding in Grand Prospect Partners to the effect that a termination right is not, per se, an unenforceable penalty. “A party invoking the cancellation option (standing alone) is not imposing a penalty; such action merely restores the parties to the status quo ante. If (by contrast) terminating [a] lease were accompanied by seeking to enforce a liquidated damages provision of some sort, such might constitute a penalty.”

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Comments

  1. Ruminations was asked to post the following comment anonymously:

    The definitional issues are interesting. You can always go further to define anything in greater detail. And even then your definition might turn out to be leave some wiggle room or uncertainty. There’s an argument you ought to be able to paint with a broad brush in ordinary English, without excruciating detail in definitions… which of course creates the risk of uncertainty. 99% of the time you work it out. 1% of the time it ends up in litigation, perhaps with expert witnesses to define the meaning of ordinary words as applied. I wonder if the benefit of avoiding that possible risk (by making every definition as detailed and complete as possible) outweighs the genuine cost of negotiating ad nauseum to drill down to every possible level of detail just to squeeze out any possible uncertainty should it ever arise and become relevant. When you read cases, you see the examples where broad brush drafting didn’t work out. You don’t see the 99% of examples where it does work out.

  2. Grand Prospect remains one of the great examples of the incompetence of too much of the CA bench in even understanding business transactions and why a tenant would demand and why landlord would ever give on such points. I wonder if including a “this is not a penalty” clause (we do this for liquidated damages) explaining how a retail space’s value is directly affected by the use of nearby space, and how each location chosen precludes other worthy locations – might have helped tenant convince the court it wasn’t a penalty and wasn’t arbitrary. That approach is inefficient and dumb, but its often necessary to dumb down significant business issues in order for fact finders to get it. Grand Prospect seems an example of the Court through ignorance bailing out poor negotiations by sophisticated landlord – exactly what shouldn’t happen. GP is wrongly decided on the law and on the facts (and even on its own test). And yet it is the law, at least for now. Since tenants won’t abandon such clauses they should treat them like liquidated damages provisions and put some justification in the lease – at least when operating in CA.

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