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UPDATE: Did a California Court Just Create the "Grand Prospect" of Trouble for Retail Tenants?

 

A California appellate court recently sent a shock wave into the retail industry by holding that parts of a cotenancy provision in a shopping center lease were unenforceable, even though the parties had agreed to the provision and the retail tenant had relied on it.  

In Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. (2015 DAR 409, Fifth App. Dist., January 12, 2015), the Fifth Appellate District held that a contency provision -- which allowed a tenant to withhold rent in the event the center's primary tenant ceased operations -- was an unenforceable penalty. As a result of the decision, cotenancy provisions in retail leases could be subject to greater scrutiny by the California courts.  

I.          Cotenancy Provisions in Retail Leases.

Before retailers lease space in shopping centers, they frequently want assurances that the center is vibrant and that its tenant mix is sufficient to "draw" customers. Sports Authority, for example, might not want to lease space in a center unless it knows that Bloomingdale's will be there too.  To address this issue, retailers frequently negotiate over the inclusion of cotenancy provisions in their leases. A cotenancy provision requires another tenant in the center, usually an anchor tenant, to maintain occupancy and operations at a minimum square footage threshhold in the center.  If the anchor tenant ceases operations or downsizes below the minimum threshhold, the retailer may avail itself of its right under the cotenancy provision to early terminate its lease, sometimes without further obligation to the landlord.

II.        The Retail Lease between Grand Prospect Partners and Ross Dress for Less.

Grand Prospect Partners, LP (“Grand Prospect”) owned and operated part of a shopping center in Porterville, California. The rest of the center was owned by Mervyn’s Department Store (“Mervyn’s”), which operated a store in its space.  On April 4, 2008, Grand Prospect entered into a commercial retail lease with Ross Dress for Less, Inc. (“Ross”).  The parties agreed to include a cotenancy provision in their lease.  Under the provision, if Mervyn’s did not occupy at least 76,000 square feet of leasable floor area in the center or operate its store on the commencement date of Ross's lease, Ross could elect to not open its store and withhold rent until Mervyn’s had restarted its operations in the space or was replaced by another similar anchor tenant.  Ross also had the option of terminating the lease in the event Mervyn’s vacancy or failure to be open for business continued for a period of 12 months. 

In early July of 2008, Grand Prospect notified Ross that its space was ready for occupancy.  Ross said that it intended to take the space in February 2009, as stated in the lease.  However, Mervyn’s subsequently filed for bankruptcy and closed its store prior to Ross’s lease commencement date.  Grand Prospect and Ross attempted to negotiate a lease amendment pursuant to which Ross would open its store and pay reduced rent until Grant Prospect found a replacement anchor tenant.  But the parties were unable to reach an agreement, and Ross elected to not to open its store or pay rent, as permitted by the cotenancy provision.  

III.       The Grand Prospect Litigation and Appeal.

Grand Prospect sued Ross, seeking (1) a judicial declaration that the cotenancy provision was unenforceable and (2) an award for money damages for unpaid rent, future rent and expenditures on tenant improvements.  The trial court ruled that the cotenancy provisions were unenforceable because they were both unconscionable and an unreasonable penalty.  It awarded Grant Prospect $4,701,990.83 in total damages and $916,275 in attorneys’ fees.  Ross appealed.

The appellate court affirmed the trial court’s ruling that the cotenancy provision was an unenforceable penalty, but reversed on the issue of unconscionability. The court concluded that Grand Prospect was only entitled to recover damages for unpaid rent and it reduced the award to $672,100, but kept in place the original award of attorneys’ fees.

The court held that the rent abatement remedy of the cotenancy provision constituted a penalty rather than an "imaginatively drafted" contractual condition.  It reached this conclusion because Grand Prospect had no alternative course of performance:  Mervyn’s owned its space in the shopping center and Grand Prospect could neither affect Mervyn’s decision to close its store nor lease Mervyn's space to another tenant. 

The court then turned to the issue of whether the penalty was reasonable. Under California law, a penalty is unreasonable, and therefore unenforceable, if “the value of the money or property forfeited or transferred to the party protected by the provision bears no reasonable relationship to the range of harm anticipated to be caused to that party by the failure of the provision’s requirements.”  In applying this rule, the court compared (1) the value of the property forfeited by Grand Prospect and (2) the anticipated harm or damages that Ross was likely to have experienced by the failure of the cotenancy requirement.  The court concluded that the penalty was, in fact, unreasonable.

Ross's position on this issue was likely doomed by the fact that, at trial, the evidence presented established that Ross did not anticipate any losses or adverse impact on its business as a result of Mervyn’s closure and never attempted to determine the impact  on its sales of Mervyn’s traffic or closure.  In fact, the trial court determined that Ross had availed itself of its remedies under the cotenancy provision as a negotiation tactic to pressure Grand Prospects to lower Ross’s rent through the remainder of the term. Ross never challenged this finding of fact on appeal.

The court held that there was no reasonable relationship between the total value of the forfeiture and Ross’s anticipated harm.  The value of the total property forfeited by Grand Prospect totaled approximately $39,500 per month, while the anticipated harm to Ross in the event of Mervyn’s closure totaled $0 per month.  Since the amount forfeited by Grand Prospect was in no way related to Ross’s anticipated harm, the rent abatement clause of the cotenancy provision was deemed to be unenforceable. 

The appellate court's opinion was not entirely bad news for Ross. The court did hold that Ross's right to terminate its lease (if Mervyn’s ceased to occupy or operate its store  for a period of 12 months) was not an unreasonable forfeiture.  It concluded that, because Grand Prospect and Ross were sophisticated parties and had agreed to the early termination right, and because termination was not based on a default by either of them, the provision was valid and enforceable.  The court also ruled that the cotenancy provision was not unconscionable because the lease had been freely negotiated without coercion or economic pressure. 

IV.     Conclusion.

Grand Prospect poses a challenge to retailers when drafting and negotiating cotenancy provisions. California courts may refuse to enforce such provisions in the future -- even if the parties are sophisticated and agree to them -- if they deem the remedies to be overly-harsh and insufficiently related to the tenant's anticipated harm. The courts may be more likely to enforce a tenant’s option to terminate the lease rather than allow the tenant to withhold paying rent.  If a retailer wishes to withhold rent or delay commencement of its lease as a remedy, instead of terminating its lease, it should reasonably estimate the costs and losses it would incur if a cotenant were to shut down or downsize, and only allow for the withholding of rent to the extent of such costs and losses.  On a broader level, Grand Prospect introduces uncertainty about rent abatement provisions generally and the extent to which they will be scrutinized as unenforceable penalties in other leasing contexts.

This posting is intended to summarize recent developments in the law for informational purposes only. It is not intended, and does not constitute, legal advice. We make no warranties of its completeness or accuracy. Because questions regarding the application and interpretation of these and other laws require qualified legal analysis, we ask that you direct any such questions to us following an appropriate, formal retention.

 

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