California’s Top Court Upholds Validity of Retail Cotenancy Clauses
The California Supreme Court has upheld the validity of cotenancy clauses in retail leases, provisions that allow tenants to pay lower “substitute” rental rates after an anchor tenant at a retail center stops operating there.
The ruling sets a precedent that could reverberate nationwide as an epidemic of store closings by retail chains is projected to shutter up to 15,000 outlets in the U.S. this year.
Cotenancy clauses typically stipulate that a retail tenant is not obligated to pay full base rent when specified anchor tenants are not open and operating or when a minimum gross leasable area in a shopping center is not occupied. These clauses usually give the tenant the option of paying a lower rent, called a “substitute” rent, or terminating the lease.
In the California case, the state’s top court ruled in favor of Joann Stores, the fabric and crafts chain, which invoked a cotenancy clause in its lease for a 35K square foot outlet at a shopping center in Elk Grove.
The store lease required landlord JJD-Hov Elk Grove (JJD) to maintain active leases with three anchor stores or 60% or more of the gross leasable area at the shopping center. The lease allowed Joann to pay lower rent or to terminate the lease if this condition was not met.
In July 2018, after anchor tenants Sports Chalet and Toys “R” Us closed, reducing the shopping center’s occupancy below 60%, Joann invoked the cotenancy clause and paid substitute rent until May 2020, when Scandinavian Designs opened in the former toy store space.
JJD filed a lawsuit against Joann for breach of contract, arguing that the cotenancy provision constituted an unenforceable penalty and demanding that Joann pay $638K plus interest, the difference between the fixed rental payments in the lease and the substitute payments.
Landlords often challenge the implementation of retail cotenancy clauses by arguing that they are tantamount to an unenforceable liquidated damages penalty and therefore a breach of contract.
Joann counter-sued, seeking a judicial ruling that the cotenancy provision in its lease was valid and enforceable. A lower court ruled in favor of the crafts chain, a ruling that was upheld on appeal by California’s Third Appellate District and now by the California Supreme Court.
In its ruling, California’s top court said that cotenancy clauses must be construed as an alternative form of compliance with the terms of the lease, rather than as a conventional breach of contract (liquidated damages) event.
The state Supreme Court rejected JJD’s argument that it was powerless to ensure compliance with the cotenancy clause because third party (the anchor stores cited in the lease) decided to close their operations at the Elk Grove shopping center.
The top court noted in its ruling that the cotenancy provision in Joann’s lease was included in the agreement by JJD “with the purpose of inducing Joann to sign the lease, which was actually made explicit in the language of the provision itself.”
The California Lawyers Association said in a blog post that the California Supreme Court weighed the substance of the cotenancy provision over its form, yet ultimately reached a “formalistic conclusion to uphold the enforceability of the cotenancy provision as written.”
The blog post indicated that the ruling may be “revisited” during ongoing Chapter 11 proceedings for bankruptcies filed in 2024 by large retail chains, including Party City, Big Lots and Joann, that involve hundreds of store leases in California.
Joann, which filed for bankruptcy for the second time in less than a year in January, announced in February that it would close 500 stores this year as part of a restructuring plan, including 61 in California.
The ongoing retail reckoning for large chain stores is expected to result in 15,000 total shutters in the U.S. in 2025, according to a projection from Coresight Research.
Source: GlobeSt/ALM