by Tracy E. Reichmuth, Counsel; Crowell & Moring LLP
When it comes to bringing customers into a retail store, there are certain factors that are simply outside a shopping center tenant’s control. Occupancy and tenant mix are crucial in driving the kind of foot traffic that keeps sales robust. Unfortunately, vacancies remain high in 2016. As landlords scramble to fill empty storefronts, they are often signing up tenants that do not fit the character of the shopping center, including non-retailers like medical offices and military recruiters. Tenants often rely on lease provisions such as co-tenancy and use clauses to protect themselves from the impact of vacant storefronts and substantially changed tenant mixes. Tenants may also negotiate exclusivity provisions that reduce the chance of a direct competitor moving in next door.
Of course, these types of provisions must be carefully drafted. Tenants and landlords will negotiate at length regarding the terms of a co-tenancy clause: What will trigger a co-tenancy failure? How is floor space calculated in the shopping center? What is a suitable replacement for an anchor tenant?
However, tenants should remember that the remedies available under such provisions are just as important, and should receive just as much attention in the negotiation and drafting process. Most often, these remedies fall into one of three categories: (1) a reduction or abatement of rent; (2) a right to terminate if the landlord’s obligations are not met for a certain period of time; and (3) a right not to open the store (or not to operate a store that has already opened).
In order to adequately protect a tenant, the remedy or remedies ultimately selected must (1) be enforceable and (2) have teeth. In other words, the remedies must stand up to any legal challenge a landlord might make. Those remedies should also adequately compensate and protect the tenant in the event the landlord fails to meet its obligations.
A recent California case demonstrates that these two concerns are closely tied together. If the remedy for the breach of a co-tenancy, exclusivity, or similar provision is not tied to the harm the parties anticipate a tenant will experience if the provision is breached, a court might hold that it is an unenforceable “penalty.” This article will examine some concerns regarding the enforceability of tenant remedies and discuss some strategies to craft a strong but enforceable remedy.
Is Your Remedy an Unenforceable Penalty?
Courts often treat remedies under co-tenancy, exclusivity, and similar clauses as “liquidated damages.” Liquidated damages provisions are intended to compensate a party to a contract in situations where it will be hard to calculate the exact damages the party will suffer if a contract is breached. In the case of retail leases, when a landlord fails to meet minimum occupancy thresholds or enters into a lease with a tenant’s direct competitor, the tenant’s sales will most likely suffer. However, it may be difficult to establish exactly how much sales are affected, excluding other factors that may impact sales. Remedies like reduced rent provide protection to the tenant in a form that is easily calculated.
However, courts may refuse to enforce a liquidated damages provision if it is not tied to the parties’ reasonable estimation of the damages a party will actually suffer if contract obligations are not met. Courts treat such provisions as impermissible “penalties.” One California court recently invalidated certain remedies under a retail co-tenancy clause on such grounds.
In Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc.1, a California appellate court considered an opening co-tenancy clause providing that if a particular anchor store did not open at the shopping center, (1) the tenant could decide not to open the store until the anchor opened; (2) the tenant was excused from paying any rent; and (3) if the anchor did not open for 12 months, the tenant could terminate the lease. When the anchor failed to open in the shopping center, the tenant declined to open its own store, and did not pay rent. After twelve months, it terminated the lease.
The court held that the tenant’s right not to open or pay rent for an indefinite period operated as an unreasonable “penalty” that was unenforceable under California law. According to the Court, the record did not establish that the tenant would suffer any harm from the anchor’s failure to open, let alone $39,500 a month (the amount of full rent) in damages. Thus, the remedies “bear[ed] no reasonable relationship to the range of harm anticipated to be caused to that party by the failure of the provision’s requirements.”2 In other words, instead of serving as the parties’ reasonable estimate of the actual harm that would be experienced by the tenant, the co-tenancy provision simply called for a forfeiture by the landlord.
The court did uphold the tenant’s right to terminate the lease after 12 months. Under California law, a contract that establishes a right to terminate a contract if a contingency is not met is not generally considered a penalty.
Although the Grand Prospect case applies California law only, and has not yet been cited in published decisions outside of California, it may be wise to consider it in negotiating remedies in retail leases. In particular, tenants may want to think carefully about crafting remedies that are reasonably related to the harm they anticipate from a landlord’s failure to meet its obligations. Not only will this help ensure that the tenant is adequately compensated, it may help prevent any attacks on remedies as unenforceable penalties.
Crafting a Strong but Enforceable Remedy.
A few lessons can be drawn from Grand Prospect to help craft remedies that have teeth, but are unlikely to be challenged as unenforceable penalties.
- Consider what remedies you need to adequately protect yourself. You may already have internal records that analyze how your stores are affected by closures in a shopping center, or by the opening of a competing store in the same center. These can help you think about what kind of remedy you need to protect your business, as well as establish the reasonableness of that remedy if it is later challenged by the landlord.
- Create a record that the parties intend and agree that the remedies bear a reasonable relationship to the potential harm. You may consider making this part of the written negotiations with landlord. For example, you could establish that a reduced rent remedy is designed to account for potential lost sales (or the reduced value of the lease to the tenant if the landlord does not meet its obligations).
- Avoid all or nothing provisions. Unless a landlord’s failure to meet its obligations may literally make the lease worthless to you, it could be difficult to justify complete abatement of rent. For example, in an exclusivity clause, it would be easier to justify a reduced substitute rent tied to sales than a complete abatement of rent while a competitor operates a store at the shopping center.
- Include a clear termination right. Even the Grand Prospect court did not consider a termination right an improper penalty.
Capturing the Full Value of Your Remedy.
In negotiating your lease, you should also ensure that you get the full value of your remedies. The strongest possible rent reduction provisions would include:
- A requirement that the landlord affirmatively notify you when your right to pay substitute rent is triggered (for example, that there is a co-tenancy failure or that the landlord has violated an exclusivity clause).
- A right to reimbursement of the difference between full rent and substitute rent paid before you discover that your right to pay substitute rent was triggered.
- The right to offset such amounts from future rent.
In short, your remedies for a landlord’s failure to meet its obligations under the lease should be strong enough to offset any harm to you as the tenant. However, they should also be carefully negotiated and drafted to avoid any legal challenges down the road.
1 232 Cal. App. 4th 1332 (2015).
2 Id. at 1338.