Careful What You Contract For … You Just Might Get It.

Careful What You Contract For … You Just Might Get It.

“Contracts are, by their very nature, allocations of risk and responsibility as between the parties.” However, when the allocations of risk and responsibility become unbalanced, parties may ask the courts step in. One way in which trial courts balance the allocations of risk and responsibility is by not enforcing contractual liquidated damages provisions that essentially serve as unenforceable penalties. Liquidated damages are damages paid in the event of a breach of contract or the failure of a condition. The amount of damages is fixed by the contract, and may not ordinarily be modified in the event of breach, regardless of the actual damage suffered. Because damages are set ahead of breach, though, there is potential for the liquidated damages to overcompensate for the breach.

In JJD-HOV Elk Grove, LLC v. Jo-Ann Stores, LLC, Judge Shama Mesiwala of the Sacramento Superior Court considered the enforceability of a co-tenancy provision in a retail lease for space in a shopping center. Commercial tenants typically insist on co-tenancy provisions, which require landlords of malls or shopping centers to maintain a certain level of occupancy on the premises. In this case, the landlord, JJD-HOV, was required to either have three anchor tenants, specifically Sports Chalet, the Sacramento Food Co-Op, and Toys-R-Us, or lease at least 60 percent of its space. If not, the tenant, Jo-Ann Stores, was permitted to pay “Substitute Rent,” which was approximately $30,000 less than regular rent.

In 2018, after Sports Chalet and Toys R Us closed, which also caused the occupancy of the shopping center dropped below 60%, Jo-Ann Stores started paying Substitute Rent. In response, JDD-HOV filed a complaint for breach of contract and declaratory relief.

In arguing its case, JJD-HOV relied heavily on a case known as Grand Prospect Partners, L.P. v. Ross Dress for Less, Inc. for its argument that the co-tenancy provision was an unenforceable penalty. The court in Grand Prospect analyzed a similar co-tenancy provision under statutes pertaining to liquidated damages. Liquidated damages are, typically, acceptable ways for parties to contract in advance for the damages they foresee if a party either breaches a covenant or fails to ensure a condition attains. However, in California, liquidated damages provisions become penalties (which are unenforceable) when there is little or no proportionality between the forfeiture compelled and the damages that might be suffered.

The appellate court here, however, declined to follow the holding of Grand Prospect. Because the rule announced in Grand Prospect was based on Civil Code section 1671, which governs the enforceability of contract provisions liquidating damages for breach of contract, its holding was not applicable in this case. No party in this litigation contended that JJD-Hov’s failure to ensure a 60% occupancy of the shopping center constituted a breach of the parties’ contract.

The appellate court ultimately affirmed Judge Mesiwala and found the co-tenancy provision at issue to be enforceable. Returning to a basic principle of contract law, the appellate court found that the parties’ contractual intent controls and should be enforced. It thus left the Substitute Rent provision undisturbed. The appellate court noted that both parties were represented by counsel in negotiating the lease, and that all the terms of the contested provision were actually negotiated. The parties considered the risk of reduced occupancy in the shopping center, and their solution was to permit Jo-Ann to pay Substitute Rent if that condition occurred.

While trial courts are still empowered to decline enforcement of liquidated damage provisions that slide into the realm of penalties, contracting parties should be exceptionally careful when drafting those provisions. Consider carefully the risk of harm in the event of a breach, and, if damages are set at the time of contracting, set proportionally to the actual risk to ensure the provision will be upheld.

If you have any questions about liquidated damages provisions or contractual penalties, please contact the authors or any of our other experienced attorneys at Boutin Jones.