A recent decision by the California Court of Appeal answers this question to a large extent, and the answer is… it depends!
In Grand Prospect Partners LP v. Ross Dress for Less, Inc. (2015) 182 Cal. Rptr. 3d 235, the Court looked at a co-tenancy clause agreed upon by two sophisticated parties to a commercial retail lease, and addressed the issues of whether the clause was unconscionable and/or an unenforceable penalty. It found that despite the relatively equal sophistication of the two parties, under some circumstances, the co-tenancy agreement can constitute an unreasonable penalty and be unenforceable, although it may not be unconscionable.
Ross Dress for Less (Ross) signed a commercial lease with a sophisticated landlord called Grand Prospect Partners LP (landlord) wherein Ross agreed to lease space at a commercial retail shopping center, contingent on the “anchor” tenant, Mervyn’s, being a co-tenant. Not long after the lease was signed, Mervyn’s filed for bankruptcy and later closed their store at that retail shopping center location. Ross exercised its rights under the lease and did not move into the retail space and did not pay rent. The landlord sued, alleging that Ross was obligated to pay rent for the full 10 year term of the lease because the lease terms authorizing rent abatement and termination were unconscionable or, in the alternative, an unreasonable penalty and thus unenforceable.
The landlord won at the trial level with a jury verdict of roughly $3.8 million, comprised of $672,100 for unpaid rent and approximately $3.1 million in other damages. Both parties appealed and the Court of Appeal affirmed in part and reversed in part, reducing the damages to $672,100. This represented the unpaid rent only.
The Court of Appeal noted that there was no unconscionability because such a finding requires both procedural and substantive unconscionability. Because both parties were sophisticated and experienced in the negotiation of commercial leases, and the terms were reached by way of a free and unpressured choice, there was no procedural unconscionability in the transaction. The agreement was not unenforceable on unconscionability grounds.
The Court also noted that as a general rule, a contractual provision is an unenforceable penalty if the value of the property forfeited under the provision bears no reasonable relationship to the range of harm anticipated to be caused if the provision is not satisfied. In this case, the Court held that there was no reasonable relationship between $0 of anticipated harm due to Mervyn’s not being open and the forfeiture of $39,500 per month rent. Ross failed to show what harm would arise in the event that Mervyn’s was not a co-tenant. Because Ross did not show what damages they anticipated, the Court concluded that the rent abatement provision was an unenforceable penalty. On that basis the Court awarded the landlord the amount of the unpaid rent.
The lesson to be learned from this particular case is that if you are the landlord, you should consider whether to allow such a co-tenancy agreement at all. If you are a tenant and want to enter into a lease conditioned on a co-tenancy, make sure that you can prove a reasonable relationship between the value of the property being forfeited and the range of harm to be caused if the provision is not satisfied.
Roland Amundsen is an Associate with Kring & Chung, LLP‘s Irvine, CA office. He can be reached at (949)-261-7700 or amundsenat-sign kringandchung DOT com.