Key Takeaways
- In JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC, the Supreme Court of California upheld the validity of a cotenancy provision in a retail lease, affirming that in certain instances where clauses are drafted specifically, such provisions can establish valid, negotiated alternative rent structures rather than being deemed unenforceable penalties.
- This decision reinforces the importance of carefully structuring and drafting cotenancy provisions to ensure that reduced rent triggers are clearly tied to specific circumstances (such as diminished customer traffic or a decline in fair market rent following the loss of major tenants) where reduced rent is a reasonable and appropriate remedy.
- The ruling also provides valuable guidance and further clarity regarding the enforceability of remedies for cotenancy violations under California law.
Background
Cotenancy requirements are commonly negotiated in commercial leases by national retailers and typically allow tenants to pay reduced rent or terminate the lease if the number of anchor tenants or the overall occupancy level of a shopping center falls below a specific threshold. These provisions are designed to protect tenants' financial viability by ensuring that the shopping center maintains a certain level of attractiveness to shoppers.
In this case, Jo-Ann Stores, LLC (Jo-Ann) leased approximately 35,000 square feet of retail space from JJD-HOV Elk Grove, LLC (JJD) in a shopping center. The lease included a cotenancy provision that allowed Jo-Ann to pay reduced rent if the occupancy level fell below 60% or if fewer than three anchor tenants were open for business. The lease provided two different calculations of rent: "Fixed Minimum Rent" or, in the event of a cotenancy violation, "Substitute Rent" totaling the greater of (1) 3.5% of Jo-Ann's gross sales of all goods and services minus pattern sales or (2) $12,000 per month.
When two anchor tenants, Sports Chalet and Toys "R" Us, closed, Jo-Ann invoked the cotenancy provision and paid reduced rent for approximately 20 months until May 2020, when Scandinavian Designs opened in the former Toys "R" Us space, satisfying the cotenancy provision. JJD filed a complaint against Jo-Ann, arguing that the cotenancy provision was an unenforceable penalty and seeking the difference between the Substitute Rent and the Fixed Minimum Rent. The trial court ruled in favor of Jo-Ann, and the court of appeal affirmed. The Supreme Court of California granted review to determine the validity of the cotenancy provision.
Holding
The Supreme Court of California upheld the cotenancy provision, ruling it as a valid alternative performance rather than an unenforceable penalty. The court emphasized several key points:
- Alternative Performance vs. Penalty
- The court distinguished between a penalty and an alternative performance. It found the cotenancy provision offered JJD a realistic choice between accepting reduced rent or taking measures to increase occupancy to the specified threshold.
- The provision was not a penalty because it did not compel a forfeiture disproportionate to the harm caused by the reduced occupancy.
- Sophisticated Parties and Negotiation
- The court noted that both parties were sophisticated and well-represented, having engaged in extended negotiations to reach the lease terms, including the cotenancy provision.
- The provision was part of a mutually agreed-upon allocation of risk, reflecting the parties' understanding of the economic realities of retail leasing.
- Economic Rationale
- The court recognized the legitimate business purpose behind the cotenancy provision. Reduced occupancy could significantly affect foot traffic and sales, justifying a rent adjustment to reflect the decreased value provided to the tenant.
Other Caselaw
California
In Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc., the California Court of Appeal held that a cotenancy provision was unenforceable as a penalty because the landlord had no control over the continued operation of the anchor tenant, Mervyn's, which owned its own building and was not subject to the landlord's lease or management. The court reasoned that since the landlord could not influence or cure the loss of the anchor tenant, the provision did not offer a true alternative performance but instead imposed a penalty for circumstances outside the landlord's control.
Oklahoma
Rockwell Acquisitions, Inc. v. Ross Dress for Less, Inc. involved a dispute between a shopping center owner, Rockwell, and one of its tenants, Ross, regarding the interpretation of a lease provision defining "anchor tenants." "Anchor tenant" was defined in the lease as a national retailer with at least 100 stores or a regional retailer with at least 75 stores occupying no less than 90% of the vacated tenant's space. The central issue was whether Rockwell violated the lease agreement when it replaced an anchor tenant, Big Lots, with smaller retailers and whether Ross was consequently entitled to pay reduced rent. The U.S. Court of Appeals for the Tenth Circuit found the lease language was precise, mandating that only a single anchor tenant could serve as a replacement, not multiple smaller tenants, even if together they met the square footage or anchor tenant criteria. Accordingly, the court of appeals affirmed the district court's summary judgment in favor of Ross, finding that Rockwell had indeed violated the required cotenancy provision of the lease.
While both cases illustrate how courts may scrutinize the precise language of cotenancy provisions, they also highlight the importance of a landlord's ability to control the cotenancy requirements.
Drafting Considerations for Retail Leases
The JJD ruling has several important implications for retail landlords and tenants. The following should be considered when drafting cotenancy provisions:
- Clearly define triggering conditions. Specify the exact circumstances that activate the cotenancy clause, such as the required number of anchor tenants and their locations, the definition of an anchor tenant (i.e., national or regional sales), occupancy thresholds, what it means to "go dark," and the duration of any deficiency before remedies are triggered.
- Tie remedies to business impact. Structure remedies (like reduced rent) to reflect the actual business impact on the tenant (e.g., tied to decreased foot traffic or sales).
- Avoid liquidated damages and penalty structures. Draft the provision as a true alternative performance (e.g., reduced rent as a response to reduced occupancy), rather than as a penalty or liquidated damages for breach. Ensure that remedies are not disproportionate to the harm suffered and are not triggered by events entirely outside the landlord's control to reduce the risk of the clause being struck down as an unenforceable penalty.
- Include cure periods and good faith negotiation. Provide landlords with a reasonable opportunity to cure deficiencies before tenant remedies take effect, and ensure both parties engage in good faith negotiations, documenting the process to demonstrate a mutually agreed-upon allocation of risk and to show that the parties negotiated alternative performance.
Conclusion
The Supreme Court of California's decision highlights the importance of carefully structuring and drafting cotenancy provisions. By following the best practices outlined above, landlords and tenants can create enforceable cotenancy provisions that reflect the economic realities of retail leasing and withstand judicial scrutiny.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
