JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC

The following is a case summary written by Chase A. Stone regarding the recent California Supreme Court’s recent decision in JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC,  17 Cal.5th 256, 560 P.3d 297 (2024). 

Summary

The California Supreme Court recently affirmed the Court of Appeal’s (Third Appellate District) judgment in favor of tenant Jo-Ann Stores, LLC (“Jo-Ann”), in holding that the Jo-Ann’s enforcement of a negotiated ‘cotenancy’ provision under its commercial lease agreement with landlord JJD-Hov Elk Grove, LLC (“JJD”) was not an unenforceable penalty under California law. 

Factual Summary

JJD and Jo-Ann executed a lease to a commercial retail store in Elk Grove, California in September 2004.  The lease provided for a fixed rent, which totaled $42,292 at the commencement of the litigation between the parties.  Under the lease agreement, the parties negotiated a ‘cotenancy provision’ which required, in pertinent part:

“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 or more of the gross leasable area of the Shopping Center (excluding the Premises.”

560 P.3d 297, 300 [full Cal. Citations not yet published].

If the requirements under the tenancy provision fell below those stated threshold amounts, after six months, Jo-Ann would be entitled  either to pay only Substitute Rent until the satisfaction of the tenancy requirement (e.g., the anchor tenants are restored) or to terminate the lease. 

During the lifetime of the lease, Jo-Ann had twice already paid “Substitute Rent” which was 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.

In July 2018, however, the two anchor tenants (Sports Chalet and Toys “R” Us), closed, and the reduced shopping center’s occupancy fell below 60 percent.  Consequently Jo-Ann elected to pay Substitute Rent for roughly 20 months (through May 2020), at which time, Scandinavian Designs opened in the former Toys “R” Us retail space. 

JJD filed a complaint against Jo-Ann for declaratory relief and breach of contract, arguing that the cotenancy provision constitutes an unenforceable penalty, and demanded Jo-Ann pay $638,293, plus interest, which represented the difference between the Substitute Rent and the fixed rental payments owed for each of the three periods that the cotenancy provision was enforced by Jo-Ann.

In response, Jo-Ann filed a cross-complaint against JJD, seeking a judicial declaration that the cotenancy provision was valid and enforceable.  The parties each filed cross-motions for summary judgment, and the trial court ruled in favor of Jo-Ann, which was affirmed on appeal to the Third Appellate District.  The Third Appellate District’s ruling was appealed by JJD, on the grounds that the tenancy provision was an unenforceable penalty.

Result and Reasoning

The California Supreme Court affirmed the Court of Appeal in holding that such cotenancy provisions must be construed as an alternative form of compliance, rather than as a conventional ‘breach of contract’ (liquidated damages) event.  In this instance, the cotenancy provision was properly construed as affording JJD, the landlord, the option of ‘alternative performance’ in the event that its shopping center’s occupancy rates (based upon square footage) or number of anchor tenants fell below the thresholds specified under the lease with Jo-Ann.  As a result of this decision, Jo-Ann was entitled to pay Substitute Rent and enforce the co-tenancy provision under the lease, as written.  560 P.3d at 305; see also footnote 7. 

Commercial lease agreements freely negotiated between two sophisticated parties often contain a cotenancy provision, under which the tenant is entitled to pay reduced rent, or eventually terminate its lease altogether, if the landlord fails to satisfy the cotenancy requirements set forth under the lease.  Under the so-called “realistic and rational choice” test set forth in Blank v. Borden (1974) 11 Cal. 3d 963, 971 (“Blank”), the California Supreme Court considers ‘the substance’ of the cotenancy provision over its ‘form’: if a reasonable person understands this provision’s ‘alternative’ as merely a threat to induce performance, and not an actual “eligible alternative,” it is an unenforceable penalty.  560 P.3d at 302  (quoting Blank, supra, 11 Cal.3d at p. 971, fn. 7.)  On the other hand, if the provision contemplates a realistic element of choice, on the part of the obligor, it is not an unenforceable penalty, but rather, an alternative form of compliance. See id. (citing McGuire v. More-Gas Investments, LLC (2013), 220 Cal.App.4th 512, 523).  560 P.3d at 302.

With respect to the cotenancy provision at issue, JJD “can choose to provide a higher level of service (i.e., a mall with anchor tenants or specified occupancy levels) and receive a higher rental amount, or alternatively, to provide a reduced level of service (i.e., a mall with reduced anchor tenants or occupancy levels) and receive reduced rental amounts.”  Opinion, pp. 10-11.  In addition to the element of choice afforded to JJD, the California Supreme Court noted the evidence on the record of the parties’ pre-execution lease discussions, which were at an arms-length, rigorously negotiated with the assistance of counsel, and gave each party the ability to walk away from the bargaining table.  560 P.3d at 303. 

The California Supreme Court distinguished, and ultimately rejected, arguments by JJD that it was powerless to ensure compliance with the cotenancy provision because a third-party to its lease, e.g., another anchor tenant in the shopping center, may cease operations or close its store, by no fault of JJD.  In response to this argument, the California Supreme Court noted that the cotenancy provision negotiated with Jo-Ann was created with the purpose of inducing Jo-Ann to signing the lease, which was actually made explicit in the language of the provision itself.  See 560 P.3d at 303; see also the discussion at 305-306.

Finally, the California Supreme Court specifically analyzed the applicability of the Court of Appeal in Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. (2015) 232, Cal. App. 4th 1332, 1336 (“Grand Prospect”).  In Grand Prospect, Mervyn’s was the anchor tenant in the shopping center at the time that Ross Dress for Less, Inc. (“Ross”) executed its lease agreement with landlord, Grand Prospect Partners, L.P. (“Grand Prospect”).  However, prior to commencement of the lease agreement, Mervyn’s filed a Chapter 11 petition for reorganization and closed its stores.  Under the lease agreement between Ross and Grand Prospect, Mervyn’s was required to be open and operating on the date that Ross’s lease commenced, and if not, Ross could withhold rent, and eventually, terminate the lease entirely.  560 P.3d at 302-303. 

The California Supreme Court distinguished Grand Prospect on several grounds, including, among other  things, the critical fact that the Mervyn’s actions could not be controlled—not necessarily in light of the bankruptcy petition—but due to the fact that Mervyn’s owned its own building, and Grand Prospect was therefore powerless to act, such as by executing a lease with a new anchor tenant for the space previously occupied by Mervyn’s.  560 P.3d at 305. 

With respect to Jo-Ann and JJD, the California Supreme Court concluded that, unlike Grand Prospect, JJD was in exclusive control over the entirety of the shopping center’s leasable square footage, and therefore, could choose to offer higher or lower level of services to its tenants. In that respect, JJD was free to choose an another form of compliance, which is a cotenancy provision that offers an alternative to breaching the lease.  560 P.3d at 305.  As a result, the parties negotiated a cotenancy provision which specified different rental amounts for different levels of service, and the payment of Substitute Rent was reflective of the fact that JJD was providing Jo-Ann with reduced level of services.  Therefore, Jo-Ann was entitled to enforcement of the cotenancy provision as a valid alternative form of compliance, not a penalty.  560 P.3d at 306-7. 

AUTHOR’S COMMENTS

Overall, the California Supreme Court describes its analysis as weighing the ‘substance’ of the cotenancy provision over its form, yet ultimately, the Court reaches a formalistic conclusion to uphold the enforceability of the cotenancy provision as  written.  The ‘substance-over-form’ analysis that the California Supreme Court engages in was intent on resolving whether the cotenancy provision offers the landlord an ‘alternative’ choice or is merely a threat to induce compliance.  The Court raises a few possibilities as to why the outcome of this functional analysis may or may not depend on other factors, some of which are not presented in this case.  The possibility of other factors is especially apparent in the Court’s extended discussion of JJD’s arguments regarding the landlord’s ability to control third-party tenants (or lack thereof).  In those passages, the Court showcases how certain facts may require a court to place even greater weight on analyzing function, in light of the Grand Prospect case, though such issues are only touched on briefly.

Ultimately, the California Supreme Court may soon revisit aspects of this opinion, as roughly a dozen large chain retail stores filed Chapter 11 petitions in 2024, including Party City, Big Lots, and recently, ironically, Jo-Ann.  These bankruptcy cases involve thousands of leased locations, many in California, and have resulted in Bankruptcy Court approved assumptions, assignments, or rejections of lease locations where landlords and the non-debtor tenants freely negotiated cotenancy provisions prepetition.  While it is generally foreseeable that any retailer might file for bankruptcy, from a functional perspective, there are further issues that a state court may need to consider as part of a ‘substance’ over form analysis (in the context of a bankruptcy), such as whether the tenants (interested parties in a bankruptcy) have sufficient notice of the Bankruptcy Court’s proceedings to object to an assumption or assignment, or whether the replacement tenant has a positive, negative, or neutral economic impact on the co-tenant, regardless of whether the original purpose of the cotenancy provision was premised on the fact that certain competitors are bad for business.

Finally, for the bankruptcy practitioner, the application of this case in a bankruptcy context could be potentially significant, depending on whether the debtor is the landlord or the tenant, and especially on the issues of both breach and assessment of the amount of rent due based upon the terms of the commercial lease.  It will be interesting to see if or when this case is cited in an insolvency context.   These materials were authored by Chase Stone, an Associate at the Beverly Hill firm of ERVIN COHEN & JESSUP LLP, with editorial contributions from ILC member Kathleen A. Cashman-Kramer, a director at Fennemore LLP’s San Diego office and by the Hon. Merideth Jury (ret.).