New On Lease Clauses

Lease Provisions v. Judicial Re-Writes:
When Does The Contract Prevail?

Brown v. Green and Hadian v. Schwartz:
The California Supreme Court Speaks.

On November 23, 1994, the California Supreme Court released two, consecutive, unanimous decisions of great importance to all of us who deal with non-residential leases, and the news is not good. The Court refused to be constrained by a literal reading of the text of the lease, and instead looked to six factors to be examined from the facts of each case on a case-by-case basis.

In both cases the lease in question was on the American Industrial Real Estate Association (AIREA) Standard Industrial Lease-Net. The Court quoted Paragraph 6.2(b) which provides:

Compliance with Laws. Lessee shall, at Lessee's expense, comply promptly with all applicable statutes, ordinances, rules, regulations, orders, covenants and restrictions of record, and requirements in effect during the term or any part of the term hereof, regulating the use by the Lessee of the Premises.... [Emphasis added by the Supreme Court.]

and Paragraph 7.1:

Maintenance, Repairs and Alterations. Lessee shall keep in good order, condition and repair the Premises and every part thereof, structural and non-structural, (whether or not the need for such repairs occurs as a result of Lessee's use, any prior use, the elements or the age of such portion of the Premises) including, without limiting the generality of the foregoing, all plumbing, heating, air conditioning...."

and Paragraph 7.4:

Except for the obligations of Lessor under Paragraph 9, it is intended by the parties hereto that Lessor have no obligation in any manner whatsoever, to repair and maintain the Premises nor the building located thereon nor the equipment therein, whether structural or non-structural, all of which obligations are intended to be that of Lessee under Section 7.1 hereof....

6 Factor Test Replaces The Contract Language. Notwithstanding this language, the California Supreme Court held that in determining who was responsible for asbestos abatement or seismic retrofitting, where those issues were not specifically addressed in the lease terms, general lease terms would not be strictly construed, and instead the determining factors would be (1) the cost of the repairs relative to the total rent payable over the term of the lease, and (2) whether the term of the lease was long term or short term and the ability of the tenant to receive the benefit of the repairs over the remaining term of the lease.

In Brown v. Green 94 CDOS 8930, the Supreme Court held that since the cost of asbestos abatement represented only five percent of the total rent to be paid during the lease term, and there were 12 years remaining in the 15 year term of the lease during which the tenant would have the benefit of an asbestos free building, that the tenant should pay the cost of asbestos abatement.

In Hadian v. Schwartz 94 CDOS 8936, the same author Justice Arabian, again writing for a unanimous Supreme Court, held that the landlord should bear the cost of seismic retrofitting because the cost of the work would be 145% of the total rent payable over the lease term, and the lease was for only three years.

The other four factors examined by the Court in both cases were: (3) the relationship of the benefit to the tenant relative to that of the landlord; (4) whether the curative action is structural or non-structural in nature; (5) the degree to which the tenant's enjoyment of the premises will be interfered with while the curative action is being undertaken; and (6) the likelihood that the parties contemplated the application of the particular law or order involved.

The Court's sense of logic and the community's need for consistent interpretation of laws was clearly challenged by the unfairness of the factual situations with which it was presented. In the Brown case the cost of the asbestos abatement was $251,856.00 compared with a monthly rent of $28,500.00 or over $5,000,000.00 for the lease term, and an abatement plan which would not require that the tenant close its business while the work was done. In the Hadian case the rent for the initial lease term of three years was $650.00 per month for a total rent of only $23,400.00, but the total costs of the seismic retrofitting project was $34,450.26, 145% of the total rent for the initial term. The Court ignored the rent for the option term of $800.00 per month for five years, a total rent of $48,000.00, even though the City of Los Angeles had not required the seismic retrofitting until after the tenant had elected to exercise its option to extend.

The Supreme Court did not establish a test or provide any guidance regarding where between costs relative to total rent of 5% as in Brown and of 145% as in Hadian, the responsibility for repairs required to comply with governmental laws switched from tenant to landlord. The Court even pointed out that it was not deciding what constituted a long term lease versus a short term lease, specifically stating that a 15 year lease could qualify as a long term lease but that the Court was not deciding that 15 years constituted a long term lease in every case.

CONCLUSION: In negotiating and drafting commercial leases, do not rely on broad, all-encompassing language regarding compliance with laws, and specifically address compliance of the building as distinguished from compliance of the tenant's business operations. In addition to asbestos abatement and seismic retrofitting which were the subjects of these cases, consider HVAC refrigerants, hydraulic elevator fluid, Americans with Disabilities Act (ADA) compliance, lead paint and lead plumbing solder, and electromagnetic fields (EMF).

In interpreting existing leases for any such issues that may arise, a case-by- case examination will be required, and a huge unknown area remains for future interpretation and guidance by the courts. There are six factors to be examined and even as to the two most important, cost relative to total rent and lease term, there are no absolute rules.

Unconscionable Assignment Provisions

How many of your leases include a provision like this:

"If in connection with a transaction involving the proposed assignment or sublease, tenant receives rent or other consideration including without limitation any consideration for tenant's business, business opportunity, good will, a covenant not to compete and/or the like, either initially or over the term of the assignment or sublease, in excess of all sums then payable hereunder, whether as minimum rent, percentage rent or otherwise, tenant shall pay to Landlord as additional rent hereunder three-quarters of the excess of each such payment of rent or other consideration received by tenant promptly after its receipt."

In Ilkhchooyi v. Best (Orange County, July 31, 1995) 95 CDOS 6094 a California Court of Appeal held that such a provision is substantively unconscionable.

Ilkhchooyi sublet a dry cleaning establishment located in a southern California shopping center. After the original tenant went bankrupt the landlord continued to accept the subtenant's rent, demanded an increase in the security deposit, and demanded signatures on a new lease. Ilkhchooyi noticed that the security deposit had been increased and that his partner's wife was required to sign the lease. Mr. Ilkhchooyi could not afford an attorney tot review or negotiate the new lease, so he demanded that the new lease be on all the same terms as the old lease.

The landlord threatened to evict Ilkhchooyi if he and his partner did not sign the new lease. The landlord did not disclose what other changes had been made in the new lease. One of the undisclosed changes was the new assignment and subletting clause quoted above. The replaced provision had not mentioned good will or compensation for a covenant not to compete, and took only one-half (+) of any additional rent.

Ilkhchooyi found a buyer for the business. The buyer agreed to pay $80,000.00 for fixtures and equipment, $40,000.00 for good will and a covenant not to compete, and nothing for the leasehold since the rent was higher than current market value. Pursuant to the lease language quoted above, the landlord insisted that $30,000.00 of the good will/covenant not to compete compensation be paid to it. Ilkhchooyi tried to sell the business without the landlord's consent, and the buyer required that the price be reduced $40,000.

Statute Repealing Reasonableness Case

California Civil Code section 1995.240 specifically provides:

"A restriction on transfer of a tenant's interest in a lease may provide that the transfer is subject to any express standard or condition, including, but not limited to, a provision that the landlord is entitled to some or all of any consideration the tenant receives from a transferee in excess of the rent under the lease."

This statute was enacted specifically to overrule or limit the California Supreme Court decision of Kendall v. Ernest Pastana, Inc. (1985) 40 Cal.3d 488, which adopted the minority view that where a commercial lease provides for assignment only with the prior consent of the lessor, such consent may be withheld only where the lessor has a commercially reasonable objection. 40 Cal.3d 506-07.

The Appellate Court noted that the legislative history to section 1995.240 indicated that the statute was enacted to eliminate attacks based on unreasonable restraint on alienation and violation of the implied covenant of good faith and fair dealing, and that it did not affect general principals limiting freedom of contract such as unconscionability.

Commercial Unconscionability

The court described commercial unconscionability as being a two part test, procedural and substantive. Procedural unconscionability arises from oppression, arising from inequality of bargaining power which results in no real negotiation and surprise where provisions are hidden in extensive boiler plate. Substantive unconscionability goes to basic fairness, just like it sounds.

The facts as described in the court's opinion suggest a strong case for procedural unconscionability. However, that is not how the court saw it.

"We concede, however, that the procedural infirmities of this case alone would not sustain a finding of unconscionability in the context of commercial lease but there is a 'sliding scale relationship between the two concepts of procedural and substantive unconscionability: the greater the degree of substantive unconscionability, the less the degree of procedural unconscionability that is required to annul the contract or clause.' And it is the substantive unconscionability of the clause in question that concerns us the most."

Owners, managers and brokers can reasonably protect against procedural unconscionability. They can allow the tenant a reasonable opportunity to consult with an independent broker or attorney. They can point out in a cover letter any areas that should be of particular concern such as a provision requiring ADA or seismic upgrade compliance, an arbitration provision, the assignment and subletting provision, or any other provision that is felt to be especially controversial. However, none of this is as good as having the tenant represented by an independent broker or attorney.

The substantive challenge to the clause cannot be cured. The assignment and subletting provision from the original lease called for the landlord to receive 50% of any bonus value or other compensation. It made no mention of good will, business opportunity or a covenant not to compete.

There is nothing in the decision to indicate that this difference in the two clauses would necessarily make the difference, and clearly lease drafters should not be encouraged to open up a loophole where a tenant can avoid sharing bonus value with the landlord by the simple expedient of characterizing it as compensation for good will or a covenant not to compete.

What seemed to set off the court was the finding that there was no bonus value in this lease and that what the landlord was seeking to obtain was a share of the sale value of the tenant's business that was not attributable to the leasehold. There are plenty of leases outstanding at rents which are higher than current market rent. In such a situation, there is no bonus value in which this court would allow the landlord to share. Until there is further clarification from either a supreme court appeal or a subsequent appellate decision, an owner, manager or attorney should make a good record to support the claim that there is bonus value for the landlord to share before asserting the owner's rights under an assignment clause like the one in Ilkhchooyi.

Supreme Court review has not been granted yet; however, in light of its decisions in Brown v. Green and Hadian v. Schwartz regarding asbestos abatement and seismic retrofitting which virtually ignored the provisions of the lease agreement, the outcome of a Supreme Court decision cannot be predicted.

CONCLUSION: California courts no longer can be counted on to adopt a literal interpretation of lease provisions where the court concludes that such an interpretation was unexpected by either party and produces a burdensome and unfair result. If you want to shift a burden to the landlord or tenant, the burden must be identified specifically. One cannot count on enforcement of a dragnet clause that attempts to cover a broad collection of burdens rather than specifically listing the burdens to be shifted. Likewise, in vigorously protecting the interests of one's client in negotiating leases, one must be careful not to impose overreaching or unconscionable provisions not reasonably related to burdens or benefits to which the parties are entitled.

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