A recent case provides a new approach to analysis of the enforceability of co-tenancy clauses in shopping center leases. In JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC (June 28, 2022, No. C094190) __ Cal.Rptr.3d __ [2022 WL 2313437] ("JJD"), the Third District Court of Appeal declined to apply penalty analysis under Civil Code §1671 to a co-tenancy clause, as the Fifth District had done in Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. (2015) 232 Cal.App.4th 1332 (“Grand Prospect”). In JJD, the Court held that a co-tenancy clause that provides for an alternative rent if a specified occupancy threshold is not met is not substantively equivalent to a liquidated damages provision, and therefore will be generally enforceable under longstanding principles that enforce negotiated contractual terms between sophisticated parties.

Co-tenancy provisions provide a commercial tenant with rent reduction and sometimes a right to terminate the lease if a shopping center's occupancy falls below certain minimums. Co-tenancy provisions often feature prominently in shopping center lease negotiations because retail tenants with bargaining power do not want to pay full rent if a center’s occupancy is too low.

In JJD, the lease required fixed minimum rent of $42,292 per month, but the co-tenancy provision allowed Jo-Ann to pay substitute rent of the greater of 3.5% of gross sales or $12,000 per month if the shopping center did not meet specified co-tenancy thresholds. Applying penalty analysis under Civil Code §1671, JJD argued that the alternative rent bore no reasonable relationship to the harm Jo-Ann would suffer upon the happening of the specified conditions, and thus was an unenforceable penalty under the holding of Grand Prospect. The trial court disagreed, finding that the occurrence of the specified conditions was not a “breach,” and therefore the penalty analysis under Civil Code §1671 did not apply.

The Court of Appeal affirmed, agreeing that the co-tenancy provision was not a liquidated damages clause, and therefore penalty analysis did not apply. Instead, the Court of Appeal held that the co-tenancy provision was governed by the established maxim that "[T]he parties' contractual intent when reduced to writing should be controlling and enforced, particularly as applied to the commercial leasing market in arms-length negotiations and transactions." (JJD, supra, 2022 WL 2313437 at *6.) The JJD Court noted that courts routinely enforce contractual terms providing for different rental rates, such as holdover rent provisions that increase rent if a tenant fails to vacate at the end of the lease term. (Id. at *7.) The Court also noted that it did not hold that a co-tenancy provision can never be an unenforceable penalty, only that the triggering provision in the clause before it was not a breach, therefore it should not be analyzed under Civil Code §1671.

While JJD declined to apply the penalty analysis that carried the day in Grand Prospect, the different outcomes are best explained by the key factual differences in the two cases. In Grand Prospect, the co-tenancy provision allowed Ross to pay no rent at all because of the anchor vacancy, regardless of whether it opened for business, and Ross admitted it was not damaged by the circumstance. Applying penalty analysis, the Grand Prospect Court affirmed a finding that the co-tenancy clause was substantively unconscionable under Civil Code §1670.5. In contrast, in JJD, the landlord did not raise an unconscionability argument, and conceded that Civil Code §1671 did not apply. (Id. at *4-6, fns. 4 and 6.) Thus, the two cases can be reconciled to stand for the proposition that co-tenancy provisions will be generally enforceable, unless they are substantively unconscionable. Whether penalty analysis under §1671 should apply to a contractual term that changes the amount to pay based on the happening of a condition, as held by Grand Prospect, or whether such analysis only applies if the triggering event is a breach, as held by JJD, remains debatable.