What is a Cotenancy Provision in Commercial Retail Leases in California?
In the unanimous decision in JJD-HOV Elk Grove, LLC v Jo-Ann Stores, the California Supreme Court reviewed the nature of a cotenancy provision in commercial retail leases.
A cotenancy provision is a feature found in some commercial retail leases.
These provisions typically allow retailers to pay reduced rent or terminate the lease when the number of anchor tenants (large retailers that are attractive to a broad range of shoppers) or the overall occupancy level of retailers in a shopping center falls below a specific threshold.
Generally, courts endeavor to enforce contracts as the parties have written them.
California Civil Code section 1671, however, prohibits the enforcement of liquidated damages provisions when they operate as unreasonable penalties for contractual breach.
The issue in this case was whether a cotenancy provision that allows the tenant to pay a reduced rent when a shopping center’s number of anchor tenants or occupancy level of retailers falls below a specific threshold is valid as an alternative performance of the contract or whether it is a penalty subject to section 1671’s reasonability limitation.
For the reasons discussed below, the Supreme Court affirmed the judgment of the Court of Appeal and upheld the cotenancy provision in this case as reflecting the parties’ agreement regarding acceptable alternative performance of agreed upon contract obligations.
Cotenancy clauses condition a retail tenant’s opening or operating of its business on whether other tenant businesses in a specific shopping center are also open for business.
These clauses, which are typically only found in retail leases, provide the tenant with the option to pay reduced rent, or occasionally to terminate the lease, should the provision’s specified tenancy levels for the shopping center not be met.
Even if landlords do not usually control the events that lead to vacancies within shopping centers and therefore resist being bound by cotenancy requirements, a knowledgeable tenant may request that a landlord incorporate the clause into the lease to protect a tenant’s financial viability should the shopping center not be utilized to its full capacity.
Anchor tenants greatly impact the economic viability of other retail tenants in a shopping center by attracting customers.
Cotenancy provisions assure a retail tenant that other tenants and, in particular, anchor tenants, will be open for businesses.
These provisions are typically a result of extended negotiations between a landlord and tenant, who tend to be sophisticated and well-represented.
Cotenancy provisions generally include the following provisions: (1) specific named cotenants and occupancy levels, (2) any right the landlord has to cure a failure to satisfy a cotenancy provision, and (3) any remedies the tenant has should a cotenancy provision not be satisfied.
Historically, when interpreting cotenancy agreements, courts have applied the general contract principle that, absent unconscionability or significant public policy concerns, contracts should be enforced as written and agreed upon by the parties.
The fundamental goal of contractual interpretation is to give effect to the mutual intention of the parties. (Civ. Code, § 1636.)
If contractual language is clear and explicit, it governs. (Id., § 1638.).
It is not the province of the Court to alter a contract by construction or to make a new contract for the parties; its duty is confined to the interpretation of the one which they have made for themselves, and, in the absence of any ground for denying enforcement, to enforcing or giving effect to the contract as made, that is, to enforce or give effect to the contract as made without regard to its wisdom or folly, or to the apparent unreasonableness of its terms.
Courts generally appear to enforce cotenancy provisions when called upon to do so.
Landlord JJD-HOV Elk Grove (JJD) owns a shopping center in Elk Grove, California. Jo-Ann Stores, LLC (Jo-Ann), a national fabric and craft chain store, leased approximately 35,000 square feet of retail space in JJD’s shopping center.
Jo- Ann’s lease was for 10 years, starting in September 2004 with four options to extend the lease for five years each.
The lease provided two different calculations of rent: “Fixed Minimum Rent,” which was initially $36,458 per month (with an increase every five years and totaling $42,292 at the commencement of the litigation), or “Substitute Rent” (totaling the greater of three and one-half percent of Jo-Ann’s gross sales of all goods and services minus pattern sales or $12,000 per month).
This case concerned the Substitute Rent clause of Jo-Ann’s lease, which is triggered when the lease’s cotenancy provision is not satisfied.
The cotenancy provision stated: “To induce Tenant to enter into this Lease . . . Landlord represents that it has entered into or shall enter into binding leases . . . for the use and occupancy of either: (x) [three so-called ‘anchor tenants’ or comparable substitutes] . . . or (y) sixty percent (60%) or more of the gross leasable area of the Shopping Center (excluding the Premises).”
The cotenancy provision can be satisfied only by anchor tenants that are open for business. If the cotenancy provision is not satisfied for a period of six months, Jo-Ann has the option either to “continue its tenancy . . . subject to the obligation to pay only Substitute Rent until the satisfaction of the co-tenancy requirement” or to terminate the lease.
The cotenancy agreement was the result of extended negotiations by the parties, both of whom were represented by counsel. Little evidence, however, was produced about the specific details of those negotiations.
Jo-Ann invoked the cotenancy provision twice prior to the dispute that commenced this litigation.
Jo-Ann first paid Substitute Rent for several months in late 2004 and early 2005, before the anchor tenants opened for business.
In 2007, Jo-Ann again paid Substitute Rent after Sacramento Food Cooperative, an anchor tenant, was replaced by Grocery Outlet.
Jo-Ann’s 2007 invocation of Substitute Rent resulted in litigation over whether Grocery Outlet was a comparable substitute tenant within the meaning of the cotenancy provision.
That litigation did not involve a dispute over whether the Substitute Rent provision was enforceable. In the course of that litigation, JJD acknowledged that Jo-Ann may pay Substitute Rent when the cotenancy provision is not satisfied. The dispute over comparable substitute tenants was ultimately settled and neither party waived its respective contentions regarding how the cotenancy provision was defined or satisfied.
This case came to to the Supreme Court after Jo-Ann invoked the Substitute Rent Clause for a third time. In July 2018, Jo-Ann informed JJD it intended to pay Substitute Rent because two anchor tenants, Sports Chalet and Toys “R” Us, closed.
These closures reduced the shopping center’s retail occupancy below 60 percent, meaning that the cotenancy provision was no longer satisfied.
Jo-Ann continued to pay Substitute Rent for approximately 20 months until May 2020, when Scandinavian Designs opened in the former Toys “R” Us space, satisfying the cotenancy provision.
Following Jo-Ann’s 2018 decision to pay JJD Substitute Rent, JJD filed a complaint against Jo-Ann for declaratory relief and breach of contract, arguing that the parties’ cotenancy provision is an unenforceable penalty.
JJD requested a judicial declaration that the cotenancy provision is an unenforceable penalty and thus Jo- Ann has always been obligated to pay Fixed Minimum Rent. JJD contended that Jo-Ann owed it $638,293 — the difference between Substitute Rent and Fixed Minimum Rent for all three periods where Jo-Ann paid Substitute Rent — plus interest.
Jo- Ann filed a cross-complaint against JJD seeking a judicial declaration that the parties’ cotenancy provision is valid and enforceable.
The trial court ruled for Jo-Ann, finding that the cotenancy provision with JJD was an alternative rent structure, rather than a penalty.
The Court of Appeal for the Third Appellate District affirmed. (JJD-HOV Elk Grove,
The Supreme Court held that the JJD court properly analyzed the cotenancy provision as a form of alternative performance. The cotenancy provision allocates risks and benefits between the two parties and provides JJD a realistic choice between accepting lower rent or taking additional efforts to increase occupancy rates or secure replacement anchor tenants.
According to JJD, the cotenancy provision is not a method of alternative performance but rather a penalty.
In Jo-Ann’s view, and that of the Court of Appeal, the cotenancy provision is enforceable as written.
The Court of Appeal reasoned that the lease and cotenancy provision simply created a rent scheme in which there are two applicable rents
The court determined that the triggering of the cotenancy provision and Jo-Ann’s subsequent payment of Substitute Rent was an alternative form of compliance with the lease as explicitly spelled out in the lease terms, rather than a contractual breach (or its functional equivalent).
A contractual provision that merely provides an option of alternative performance of an obligation does not impose damages and is not subject to section 1671 limitations.
In contrast, if the provision provides for liquidated damages, courts apply section 1671. In this case, the Supreme Court reached only the first step of this inquiry. Since the cotenancy provision provides for alternative performance, section 1671 does not apply.
If JJD wishes to avoid receiving a lower level of rent, it can choose to make inducements to attract additional anchor tenants or raise the overall occupancy rate. These efforts may include offering favorable lease terms, providing additional amenities to tenants, or renegotiating important leases.
The totality of the relevant economic circumstances here belies JJD’s characterization of the clause as a penalty.
The cotenancy provision does not realistically contemplate no element of free rational choice on the part of the obligor insofar as his performance is concerned.
Rather, JJD has a credible choice between two alternative methods of contractual performance, which are clearly designated in the duly negotiated contract.
Moreover, cotenancy provisions are not negotiated in a vacuum. The parties — who are often sophisticated and well- represented — consider such provisions alongside other lease terms during an arms-length negotiation process.
The bargaining power of the parties, their ability to rigorously negotiate contract terms with the assistance of counsel, their understanding of the real estate market, familiarity with how cotenancy lease provisions work, and ability to walk away from the bargaining table should the contract negotiations not meet with their approval, all inform what it means for the parties to have made a “realistic and rational choice” in entering a lease agreement in light of economic realities.
While a cotenancy provision standing alone may seem disadvantageous to one party or the other, its inclusion in the lease may be the result of one party acquiescing to less-desirable terms elsewhere in the lease.
JJD ignored the possibility that cotenancy provisions may exist to entice retailers into rental agreements, giving them a level of ameliorative protection should the shopping center’s other retailers close, reducing foot traffic and sales.
Anchor tenants attract customers to the shopping center. No retail tenant wants to be stuck in a shopping center filled with vacant stores.
These considerations likewise bear on whether contractual parties had a “realistic and rational choice” in entering the lease agreement.
Contracts exist to allocate risk between parties.
Allowing parties to allocate risk for mutual benefit has advantages. Cotenancy provisions benefit both parties; they allow the landlord to court tenants, and they protect tenants should the landlord provide a reduced level of service.
The commercially sophisticated parties here mutually negotiated a cotenancy provision that accounted for the risk of reduced occupancy levels, outlined specific measures for what would happen if that were to occur, and provided the landlord the choice of accepting lower rent in lieu of taking the steps necessary to retain or attract tenants.
In light of the parties’ compliance with the lease through alternative performance, the Court of Appeal below properly applied general contract interpretation norms to assess the validity of the cotenancy provision.
These norms favor leaving contracts intact and unamended by the courts.
As noted extensively throughout this litigation, JJD and Jo-Ann were sophisticated, represented parties who duly negotiated a lease, including a detailed cotenancy provision.
JJD knowingly agreed to these terms when it signed the lease with Jo-Ann. The parties should continue to be bound by those lease terms.
LESSONS:
1. Generally, courts endeavor to enforce contracts as the parties have written them.
2. California Civil Code section 1671, however, prohibits the enforcement of liquidated damages provisions when they operate as unreasonable penalties for contractual breach.
3. Cotenancy clauses condition a retail tenant’s opening or operating of its business on whether other tenant businesses in a specific shopping center are also open for business.
4. Cotenancy provisions generally include the following provisions: (1) specific named cotenants and occupancy levels, (2) any right the landlord has to cure a failure to satisfy a cotenancy provision, and (3) any remedies the tenant has should a cotenancy provision not be satisfied.