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Calif. App. Courts Disagree Whether Liquidated Damages Limitations Apply Without a Breach of Contract

On Behalf of | Jul 1, 2022 | Litigation |

The California Court of Appeal, Third District, recently affirmed a trial court’s judgment enforcing a co-tenancy provision that allowed a tenant to pay less rent if the shopping center suffered from high vacancy.  The Court of Appeal held that California’s limitations on liquidated damages apply only to penalties for breaches of contract.  In so ruling, the Third District declined to follow the rule announced by the Fifth District in Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. that a co-tenancy provision reducing rent if a specified condition occurs (e.g., if an anchor tenant is not open or if occupancy drops below a certain level) is an unenforceable penalty unless the reduction has a reasonable relationship to the harm the parties anticipated would be caused thereby.

A copy of the Court of Appeal’s opinion in JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC may be found here.

The Grand Prospect Decision

In 2015, the California Court of Appeal, Fifth District, decided Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. (2015) 232 Cal.App.4th 1332 (Grand Prospect).  There, the co-tenancy provision allowed the tenant to withhold rent for up to one year and then terminate the lease after one year, if a specified anchor tenant failed to open for business.  Co-tenancy provisions are often requested by tenants, since fully leased shopping centers and shopping centers with anchor tenants generally attract more potential customers.  The anchor tenant failed to open for business in the first year of the tenant’s lease.  The tenant withheld rent and then cancelled the lease.  The trial court found that both the co-tenancy provision’s rent abatement remedy and its lease termination remedy constituted unenforceable penalties.

On appeal, the Fifth District ruled that the co-tenancy provision’s lease termination remedy was valid and enforceable.  The Fifth District explained that prior appellate decisions had set out a specific rule concerning termination provisions.  Namely, no forfeiture results from the exercise of the termination clause 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.

However, the Fifth District did determine that the co-tenancy provision’s rent abatement remedy constituted an unenforceable penalty and that the tenant owed monthly rent for the lease’s first year.  In reaching its decision, the Fifth District first considered whether a rent abatement provision could operate as an unenforceable penalty.  The Fifth District surveyed decisions from other jurisdictions (some finding the co-tenancy provision enforceable and some finding the co-tenancy provision unenforceable).  The Fifth District found that whether a particular rent abatement provision operates as an unreasonable penalty depends upon the specific facts and circumstances of the case.  The Fifth District held that a co-tenancy provision reducing rent if a specified condition occurs (e.g., if an anchor tenant is not open or if occupancy drops below a certain level) is an unenforceable penalty unless the reduction has a reasonable relationship to the harm the parties anticipated would be caused thereby.

The Fifth District then noted that because the tenant was not required to pay any rent, the value of the property forfeited by the landlord was the full monthly rent specified in the lease.  The Fifth District affirmed the trial court’s judgment as to the rent abatement remedy, since the landlord’s forfeiture of 100% of monthly rent bore no relationship to the harm suffered by the tenant due to high vacancy.

The JJD-HOV Elk Grove, LLC Decision

More recently, the Third District considered a similar co-tenancy provision’s enforceability.  There, JJD-HOV Elk Grove, LLC (“JJD”) leased 35,000 square feet of space in a shopping center to Jo-Ann Stores, LLC (“JoAnn”).  The lease included a co-tenancy provision, whereby JoAnn could pay Substitute Rent (defined as the greater of 3.5% of gross sales or $12,000 per month) in lieu of the lease’s Fixed Minimum Rent, if JJD 1) failed to lease to three anchor tenants and 2) failed to lease 60% of the shopping center’s gross leasable area.

In July 2018, JoAnn began paying Substitute Rent, after two anchor tenants closed.  At the time, the lease’s Fixed Minimum Rent amounted to $42,292.  In May 2020, JoAnn resumed paying Fixed Minimum Rent, after JJD found a new tenant for one of the anchor tenant spaces.

JoAnn and JJD filed competing complaints for declaratory relief as to the co-tenancy provision’s enforceability.  JJD argued that the co-tenancy provision constituted an unenforceable penalty under Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. (2015) 232 Cal.App.4th 1332 (Grand Prospect).  JJD sought $638,293 – i.e., the difference between the Substitute Rent (which JoAnn paid) and the lease’s Fixed Minimum Rent.

The trial court found in favor of JoAnn and enforced the co-tenancy provision.  The trial court distinguished Grand Prospect, holding that the co-tenancy provision did not impose liquidated damages, but instead simply provided for a different rent structure or alternative rent payments in the event of certain contingencies (e.g., reduced occupancy of the shopping center).

On appeal, the Third District analyzed Grand Prospect.  The Third District first noted that in reaching its holding, the Fifth District relied heavily on cases interpreting Civil Code § 1671, i.e., “a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”

As you may recall, California courts have long applied Section 1671 to bar enforcement of disproportionate liquidated damages as unenforceable penalties, if the liquidated damages bear no reasonable relationship to the range of anticipated harm flowing from the contractual breach.  (See, e.g., Beasley v. Wells Fargo Bank (1991) 235 Cal.App.3d 1383 [bank’s late fees and overlimit fees]; Harbor Island Holdings v. Kim (2003) 107 Cal.App.4th 790 [deferred rent provision providing for double rent in the event of any breach of the agreement]; Garrett v. Coast & Southern Fed. Sav. & Loan Assn. (1973) 9 Cal.3d 731 [charges based on percentage of loan’s unpaid principal balance when any installment payment in default]; Ridgley v. Topa Thrift & Loan Assn. (1998) 17 Cal.4th 970 [prepayment fee equal to six months’ interest, if borrower had been more than 15 days late with any scheduled interest payment or had defaulted on any other contractual obligation]; Greentree Financial Group, Inc. v. Execute Sports, Inc. (2008) 163 Cal.App.4th 495 [settlement for 50% of amount demanded included liquidated damages provision for 100% of amount sought in the complaint, as well as prejudgment interest, attorney fees, and costs].)

The Third District then observed that Grand Prospect did not find that the landlord breached the lease when its anchor tenant failed to timely open for business.  Instead, the Grand Prospect found that the co-tenancy provision was substantively equivalent to a liquidated damages provision.  Grand Prospect reasoned that “a contract provision triggered by one or more conditions precedent can be deemed a penalty under California law,” and that “it is possible for a condition precedent to operate as a penalty.”  Grand Prospect then applied Section 1671’s limitation on liquidated damages to contractual conditions:  “The general rule for whether a contractual condition is an unenforceable penalty requires the comparison of (1) the value of the money or property forfeited or transferred to the party protected by the condition to (2) the range of harm or damages anticipated to be caused that party by the failure of the condition.”

The Third District declined to follow Grand Prospect and found that Section 1671’s limits on liquidated damages did not apply to JoAnn’s co-tenancy provision.  The Third District held that Section 1671 applies only to liquidated damages for contractual breaches.  The Third District reasoned that Section 1671’s plain language only applied to “a provision in a contract liquidating damages for the breach of contract.”  Thus, California’s liquidated damages limitations did not apply to the co-tenancy provision, since JJD did not breach its lease agreement with JoAnn when vacancy rose at the shopping center.

In reaching its decision, the Third District also surveyed decisions from other jurisdictions enforcing co-tenancy provisions that provided for alternative rent in response to high vacancy.  The Fifth District pointed to Boca Park Marketplace Syndications Grp., LLC v. Ross Dress for Less, Inc. (D.Nev. June 20, 2019, 2:16-cv-01197-RFB-PAL) 2019 U.S. Dist. Lexis 103985, which reasoned that a co-tenancy provision’s replacement of “base rent” with “substitute rent is not a penalty, but alternative rent schemes.  The Boca Park court observed that parties negotiate co-tenancy provisions based on “the relative value of the property to [the tenant] dependent on various states of tenancy and occupancy in the Shopping Center.”

The Third District also pointed out that courts routinely enforce contracts that provide for different payment terms where future conditions arise.  Specifically, courts enforce holdover rent provisions that increase rent by 150%, if a tenant fails to vacate at the end of a lease term.  (Constellation-F, LLC v. World Trading 23, Inc. (2020) 45 Cal.App.5th 22.)

Moving Forward

California courts may continue to grapple with this issue.  Contracts often provide for varied payment schemes based on potential future events.  Can conditions that impose alternative payment schemes constitute unenforceable penalties?  What if the provision reduced monthly rent from $10,000 to $100?  Do Civil Code section 1671’s limitations on enforcing liquidated damages apply only where a breach of contract has occurred?  The California Supreme Court may ultimately weigh in on these questions.

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