Gietzen v Covenant Re Management, Inc. (Cal.App.) – California Court of Appeal holds provision limiting liability in lease is no longer enforceable after the lease is subsequently assigned to foreclosing lender.

The following is a case update written by Monique D. Jewett-Brewster, a member of the ad hoc group of the California Lawyers Association’s (CLA) Business Law Section, analyzing a recent decision of interest:

SUMMARY:

The California Court of Appeal for the Second District has held that a third party beneficiary of a contract has no more rights than the promisee. Specifically, the court held that a lease provision limiting liability in the event of the lessor’s breach is unenforceable as to original parties or third party beneficiaries of the lease after the lease was assigned to the foreclosing lender. [Gietzen v Covenant Re Management, Inc., 40 Cal.App.5th 331 (Sept. 24, 2019)] To view the entire opinion, click here.

FACTS: Lessee entered into a lease with lessors, a limited liability company (LLC) and a limited partnership (LP), to operate a restaurant at a shopping center. Unbeknownst to the lessee, lessors were also in negotiations to lease another space in the shopping center to a gym. The gym’s customers monopolized the parking spaces in the center’s common parking lot, resulting in a loss of business for lessee.

Lessee successfully sued lessors, alleging, among others, claims of fraud and breach of lease and obtained a judgment of almost $2 million plus attorneys’ fees and costs. While that judgment was on appeal, lessors lost their interest in the shopping center through foreclosure. Lessee thereafter brought a motion to amend the judgment to add additional judgment debtors on the grounds that, among others, Covenant Real Estate Management, Inc. (CREM) was the general partner of the judgment debtor LP and therefore liable for the LP’s obligations pursuant to Corporations Code section 15904.04, subd. (a), which provides, in part, “[A]ll general partners are liable jointly and severally for all obligations of the limited partnership unless otherwise agreed by the claimant or provided by law.”

CREM asserted it had no liability for the judgment due to a provision in the lease (“article 39”) which expressly limited lessee’s recourse under the lease to the lessors’ interest in the shopping center and waived any recourse against lessors’ partners. The trial court denied lessee’s motion, holding that CREM is a third party beneficiary protected by article 39’s limitation of liability provision in the lease.

REASONING: Reversing the trial court with instructions to amend the judgment to include CREM as a judgment debtor, the court of appeal first acknowledged that all of the lessors’ interest in the shopping center had been acquired by the foreclosing lender:

Upon assignment, all rights in the lease belong to the assignee and the assignor’s rights are extinguished. [Citations omitted].

The court then examined Principal Mutual Life Ins. Co. v. Vars, Pave, McCord & Freedman (1998) 65 Cal.App.4th 1469, upon which CREM relies, and Syufy Enterprises v. City of Oakland (2002) 104 Cal.App.4th 869, which reached a different conclusion on different facts. As the court explained, in Principal, a law firm’s lease contained an attornment clause requiring the lessee upon foreclosure to enter into a new lease with landlord’s successor on the same terms. When the lender foreclosed during the lease term, the firm abandoned the premises, claiming that the foreclosure of a senior lien terminated the lease. The court agreed with the Principal court’s conclusion that the lender’s foreclosure did not extinguish the firm’s duty of attornment under the lease.

However, the court noted that Syufy Enterprises presented an entirely different set of facts than Principal. In Syufy Enterprises, the city leased a large parcel of land to a master lease for a commercial development. The lessee under the master lease subleased a portion of the premises to Syufy for the construction and operation of a movie theater. During the term of the sublease, the master lessee filed for bankruptcy. After the debtor rejected Syufy’s lease in bankruptcy, the city brought an unlawful detainer action against Syufy on the ground that the termination of the master lease terminated the sublease on which it depended. Syufy countered that it was a third party beneficiary of the master lease and, because the master lease had not terminated by rescission, Syufy was entitled to enforce the sublease. The trial court rejected Syufy’s argument, and the court of appeal affirmed, noting that Syufy identified no clause, attornment or otherwise, designed to take effect on termination of the master lease. The Syufy Enterprises court of appeal further noted that a third party beneficiary cannot assert greater rights than those of the promissee under the contract.

Evaluating the facts before it, the Gietzen court reasoned:

Syufy Enterprises guides us here. Unlike the attornment clause in Principal, [citations omitted], article 39 here is not rendered meaningless by the foreclosure. Instead, the benefit of article 39 is now with the foreclosing lender, [lessors’] successor in interest. Nor do we read Civil Code section 1559 as abrogating the rule that a third party beneficiary cannot assert greater rights than those of the promissee. [Lessors] lost [their] right to assert article 39 when the lease was assigned in foreclosure. Because CREM cannot have more rights than [lessors], CREM also loses its rights. CREM may not have anticipated the foreclosure, but foreclosures do occur.

The court concluded that policy justifications also supported its decision:

The general rule is that an assignment extinguishes the rights of the assignor and its third party beneficiaries. CREM presents no reason why that rule should not apply here. Article 39 and similar lease provisions are in the nature of an exculpatory clause. Such a clause allows a landlord to establish an under-capitalized entity as a nominal landlord. This insulates an actual landlord from liability for harms to its tenants. CREM cites no policy affording such clauses preferential treatment after assignment. Nor can we think of any.

AUTHORS’ COMMENT: This decision is likely to withstand further appeal, as a third party beneficiary cannot hold greater rights in a contract than the promisee. Lessors’ rights under the lease – including the right to invoke article 39’s exculpatory clause – terminated upon assignment of the lease to the lender in foreclosure.

This decision was not as straightforward as it might appear, however, as lessee also argued that article 39 was merged into the judgment in its favor, and that a different court’s earlier determination on the applicability of article 39 in the context of denying lessors’ motion for summary judgment was issue preclusive. (The lessee in this case, Yolanda’s Inc., has embarked on a veritable “odyssey to collect its judgment,” involving multiple courts.) In an earlier action, the Orange County trial court ruled that the article 39 defense was not available because it had been merged into the original judgment. Lessee argued that this earlier decision precluded any different ruling on the issue in its present action filed in the Ventura County trial court.

As the court of appeal acknowledged here, “a valid final judgment in favor of the plaintiff merges the claim in the judgment.” [Citations omitted.] However, as the court also explained, “[t]he rule would be better stated that the particular causes of action on the contract are merged into the judgment, not the contract itself. [Emphasis added.] Thus, a judgment favorable to plaintiff does not bar a different cause of action brought by plaintiff on the same contract.” [Citations omitted.]

As the court noted, any questions concerning whether article 39 limited the enforceability of the judgment were not before the trial court in this case or the court of appeal. Further, as the court pointed out, for the purposes of res judicata, an order denying summary judgment is not a final judgment that is sufficiently firm to be afforded preclusive effect.

Of interest to litigation strategy was the lessee’s decision to use alter ego as the ground to bring in CREM as an additional judgment debtor, then tossing in as a secondary argument that, as the general partner of the limited partnership judgment debtor, it was also liable under the California Corporations Code. The appellate court wisely added CREM as a judgment debtor only on the general partner status, refusing to use the alter ego ground. It seems odd, and neither economically nor judicially efficient, for the lessee to have pursued alter ego when the statutory liability of a general partner for limited partnership debt is straightforward, a question of law with few exceptions. To the contrary, alter ego requires a factual finding, often after extensive costly discovery and the trial presentation of complex forensic evidence. A reversal on that ground would have resulted in a protracted and expensive proceeding, certainly not sound litigation strategy.

For discussions of cases dealing with related issues, see:

• 2012 Comm. Fin. News. 64, Even Though Vendor and Purchase Enter into Subsequent Settlement Agreement, Commercial Purchase Is Still Protected from Deficiency Liability Because Agreement Modified Purchase Money Note but Did Not Supersede It.
• 2016-05 Comm. Fin. News. NL 10, Foreclosure Purchaser’s Eviction of Holdover Homeowner Does Not Violate Automatic Stay in Bankruptcy Because Unlawful Detainer Judgment Terminated Former Homeowner’s Possessory Rights.
• 2019-3 Comm. Fin. News. NL 6, Unauthorized Modification of Commercial Lease is Extinguished When Holder of Senior Mortgage Forecloses on Landlord’s Interest in Property.

These materials were written by members of the California Lawyers Association Business Law Section for the Commercial Finance Newsletter, published weekly on Westlaw. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them.  This material may not be further distributed without the consent of Thomson Reuters.