DIRT DEVELOPMENT for March 25, 2009
Daniel B. Bogart
Donley and Marjorie Bollinger Chair in Real Estate Law
Chapman University School of Law, Orange, California
LANDLORD/TENANT; MISREPRESENTATION; “AS IS” CLAUSE: Landlord’s deliberate misrepresentation of size of premises not shielded by exculpatory provision in lease. Landlord did not violate obligation to deal in good faith with tenant in negotiation of lease.
McClain v. Octagon Plaza, LLC, 71 Cal. Rptr. 3d 885 (2008)
McClain operated “A+ Teaching Supplies” and leased spaced for a five year and two month term in a shopping center located in Valencia, California, from Octagon. The two principals of Octagon were Ted and Wanda Charanian. The lease provided McClain with an option to extend the term by two successive five year periods. According to the case opinion, the lease agreement was styled as a “Standard Industrial/Commercial Multi- Tenant Lease-Net” and was a form created by the American Industrial Real Estate Association. The parties entered into the lease on February 28, 2003.
The primary dispute concerned the size of the space and the share of operating expenses that should have been allocated to it. Paragraph 1.2(a) of the lease described the space as containing “approximately 2,624 square feet.” This number was used to determine both the tenant’s base rent as well as its share of the operating expenses for the shopping center.
Paragraphs 2.1 and 2.4 seemingly tied the McClain’s hands to object to this calculation. Paragraph 2.1 stated that “unless otherwise provided herein, any statement of size set forth in this Lease, or that may have been used in calculating Rent, is an approximation which the Parties agree is reasonable and any payments based thereof are not subject to revision whether or not the actual sizes is more or less.” Paragraph 2.4 is the Octagon’s exculpatory provision. It provides that “Lessee acknowledges that (a) it has been advised by Lessor … to satisfy itself with respect to the condition of the Premises …, and their suitability for Lessee’s intended use, [and] (b) Lessee has made such investigation as it deems necessary with reference to such matters and assumes responsibility therefore as the same relate to its occupancy of the Premises ….”
The lease contained standard language permitting Octagon to pass through operating expenses and to estimate operating expenses prior to each calendar year. As is common, the lease required Octagon to provide a statement to McClain of actual operating expenses within 60 days following the end of each calendar year. McClain was required to pay Octagon the amount of any under payment and Octagon would credit McClain with the amount of any overpayment. In any event, McClain’s payments depended on the correct statement of the size of its space, and the portion of the shopping center that McClain occupied relative to the total rentable square footage of the shopping center.
Facts reflected in the opinion suggest that Octagon may have misrepresented the size of the space (and perhaps quite knowingly.) In June of 2005, McClain obtained a copy of the landlord’s earthquake insurance policy. It reflected different numbers for the size of the shopping center and for the premises than those given to the McClain by Octagon. According to the policy, the shopping center contained 12, 800 square feet, and not 11,835 square feet used by Octagon in calculating operating expenses requirements for McClain. In addition, the policy reflected the premises at 2,438 square feet rather than the 2,624 square feet shown in the lease. As a result, the base rent was overstated by nearly $270 per month and McClain’s share of operating expenses for the shopping center was set at 23% instead of 19%. The total loss to the tenant was nearly $90,000 over the term of the lease.
What made this so upsetting to tenant – apart from the fact that she was simply paying too much money – was the behavior of Octagon leading up to execution of the lease. According to the opinion, McClain attempted to independently confirm the size of the premises prior to execution of the lease, and asked the landlord for an opportunity to check the numbers. The Charanians, according to the court, “purported to be offended by her inquiries,” and “responded that measuring the area would be unreasonably costly due to the unit’s unusual angles.” The Charanians further “insisted that they [the landlord] had intimate knowledge of every detail of the shopping center, and that McClain could rely on their representations regarding the sizes of the unit and the shopping center.” Rather than simply walk away from the lease, McClain signed.
Having discovered the discrepancy, McClain brought suit against Octagon. For our purposes, two claims are especially pertinent. McClain claimed that that Octagon misrepresented the size of the space and its portion of the shopping center, and that Octagon breached its implied obligation to deal with the McClain in good faith and honestly. The trial court sustained Octagon’s demurrer on all grounds and entered a judgment for the Octagon. The California Court of Appeals agreed with the trial court on a number of issues. It affirmed the trial court’s holding that the landlord did not violate its obligation to act in good faith.
However, the Court of Appeals reversed the trial court on a key claim of McClain. The court held that the Octagon may have acted fraudulently and the exculpatory language in the lease did not shield the Octagon from its misrepresentations.
The court remanded for determinations on the issue of fraud and misrepresentation.
(McClain’s other claims included a demand of a right to an accounting of documents other than the detailed statement of tenant’s share of operating expenses. McClain argued on appeal that the Octagon violated the Consumer Credit Reporting Agencies Act. The tenant failed on both counts on appeal, but the author will leave it to the reader to examine these issues more fully.)
The court draws upon a reservoir of California law and secondary sources to determine both that the behavior of Octagon and its principals could constitute fraud, and that the exculpatory provision in the lease is no shield to this behavior.
Witkin, a primary treatise of California law, explains that one party will have an action even when she knows what she is signing “but consent is induced by fraud.” The primary elements of the cause of action are misrepresentation, knowledge of falsity, intent, justifiable reliance and resulting damages. Negligent misrepresentation is similar, except that the action does not require knowledge of falsity or intent to deceive and induce reliance.
Thus, in this case, (according to the facts presented in the opinion) the Charanians knew or had reason to know of the falsity of their statements. It is reasonable to suppose that the principals of Octagon were totally familiar with their own insurance policy reflecting the different space calculations. Yet they rebuffed attempts of McClain to investigate the size of the space, were (or feigned) offense at the request, and insisted that they could be relied upon.
There is a two step process to examining the fraud and misrepresentation claims. First, the court determined whether the exculpatory language controlled. Second, even if the language was unavailing to landlord, the court determined whether the elements of the underlying action were met.
If the lease contract’s exculpatory language controlled, there would be really no reason to argue about fraud or misrepresentation. It is very broad language. In it, McClain acknowledged his right to verify the size of the space and gave up pretty much any claim he might have against the landlord. The court summarily rejected the notion that an exculpatory provision of this kind can shield either affirmative or negligent misrepresentation. Section 1668 of the California Civil Code states “contracts which have for their object, directly or indirectly, to exempt anyone from responsibility for his own fraud, … whether willful or negligent, are against the policy of the law.” This section has been previously interpreted as applying to negligent misrepresentation in addition to active fraud.
Indeed, some of the cases cited by the court, while not directly on point, come from the realm of shopping center litigation. For example, the court cited Hinesley v. Oakshade Town Center, 135 Cal. App. 4th 289 (2005), in which the landlord’s agent made representations to the tenant that the other stores in the center would be occupied and attract “heavy foot traffic.” The lease in that case contained a representation that the tenant had not relied on such representations. Nevertheless, the court held that the provision did not shield the landlord from liability.
The second issue relating to the fraud and misrepresentation is that of the tenant’s justifiable reliance. Reasonable reliance is necessary to McClain’s fraud and misrepresentation claim. Octagon argued that McClain’s reliance on the statements of the landlord were not reasonably justified on two grounds. The lease stated that the square footage of the premises were an “approximation.” The court was unimpressed, citing an earlier case Furla v. Jon Douglas Co., 65 Cal App. 4th 1069 (1998) (residential seller and brokers not shielded by language in contract to seller regarding square footage of lot; contract provisions repeated that buyer had opportunity to independently obtain survey and that calculation in contract was approximation). Relying on Furla, the court equated “approximate” as “near to,” “about,” or “a little more or less.” In the case at issue, Octagon’s exaggeration of the size of the premises and McClain’s share of operating expenses, while not huge, was neverthel
ess significant. These calculations were not “near to” the actual numbers.
Also, according to Octagon, the discrepancy between what Octagon told McClain and what the lease actually said should have clued McClain in to the possibility that the numbers were off. As the court explained, “Octagon’s counsel also suggested that because the [First Amended Complaint] alleged that McClain had been assured the square footage figures used in the lease were “exact,” the contract’s “approximation” language necessarily put her on notice of a discrepancy she should have pursued.” The court admitted that this might affect the ultimate determination of whether McClain’s reliance was reasonable, but alone “it does not bar her claim as a matter of law.”
It is the overall weight of all the facts – the “approximation” language of the lease differing from exact square footage language used to induce McClain, the actual misstatements of the landlord, the degree to which the landlord worked to induce McClain’s reliance – that allowed the court to determine that the reliance might be justified.
Octagon’s attorneys carefully parseD the language of the contract in an attempt to preclude the court from finding that McClain reasonably relied on the statements of landlord – to no avail. Octagon’s lawyers noted that Section 2.1 of the lease “not only uses the term “approximation,” but states (1) that the parties agreed the approximations were “reasonable” and (2) that McClain’s rent was not subject to revision regardless of the actual sizes.” As to the first assertion, the court simply stated that any attempt to lock parties into language permitting one party to act fraudulently is inoperative. The court reads the second assertion essentially like an “as-is” clause – that McClain would take the property no matter how great the disparity between the actual square footage and that reflected in the lease. But the court stated “California courts have routinely rejected such clauses as ineffective in insulating a contracting party from fraud claims regarding non obvious defects
in goods.” As to this latter assertion, the court cited a case in which a home purchaser was not barred from bringing an action against his seller for concealing termite damage, when the contract contained an ”as is” clause.
McClain did not fare so well on her argument that Octagon breached its implied obligation to deal fairly and in good faith. The problem is not that Octagon behaved well. Rather, the court held that the implied covenant of good faith and fair dealing applies to performance of a contract and not its negotiation. In this case, Octagon’s misstatements regarding the shopping center and the premises, and the unwillingness of the Charanians to allow a separate determination by McClain, occurred prior to execution of the agreement.
Reporter’s Comment 1: The court’s treatment of the implied obligation of good faith and fair dealing is not surprising. Section 205 of the Restatement of Contracts (2d) details the implied covenant, and it only addresses “performance” of an agreement, and not pre contract negotiations. The comments leave open the possibility that a court might imply the covenant into contract negotiations, but this is not a position expressly taken by the language of the section. Some courts do imply a covenant of good faith into contract negotiations where there is finding of express fraud, or where the parties reach a precise understanding and one party relies to its detriment on the agreement. However, most courts shy away from finding an implied good faith obligation at the stage of contract negotiation.
Reporter’s Comment 2: California statutory law governs (perhaps intrudes on) many aspects of the common law, and lease law is no exception. The state adopted statutory language invalidating broad exculpatory provisions in contracts and the court applied that law. However, even in jurisdictions that do not have such statutory language on the books, many courts have taken the position that parties cannot exculpate themselves from their own fraudulent behavior. Whether negligent behavior (negligent misrepresentation) would be similarly prohibited in such jurisdictions is an area of conflict.
Reporter’s Comment 3: “As-is” clauses typically can protect sellers and landlords from negligent misrepresentation, but not from affirmative fraud. This may not be the case in California, according to the court in McClain. That said, McClain was not really a negligent misrepresentation case – at least as described in the appellate opinion.
Reporter’s Comment 4: The real question here is the justifiable reliance of McClain. In order to demonstrate fraud, the tenant must show that she reasonably relied on the statements of Charanians. At what point is a prospective tenant negotiating a lease for commercial space supposed to see red flags that the landlord is not telling the truth, or at least, to become suspicious of the landlord’s statements? Here the principals of the landlord refused a reasonable demand of McClain to measure the space to determine the actual size of the premises. The landlord’s principals acted offended that such a request might even be made (presumably because this would be an assault on their honesty.) Should the law protect the tenant here, even in face of an affirmative misrepresentation? This is an issue of reasonable reliance, and the court does not answer it, leaving this determination instead to the lower court on remand. The author sympathizes with the tenant and does not wish to see
bad behavior rewarded. In this case, though, the red flags were pronounced. A reasonable business person might not have simply signed the lease agreement.
Editor’s Comment: Compare: the recent Texas decision in Prudential Ins. Co. of America v. Italian Cowboy Partners, Ltd., 2008 WL 2841848 (Tex.App.7/24/08), the DIRT DD for 10/24/08 (similar exculpatory clause upheld against Landlord’s alleged fraud when tenant sophisticated, negotiations extended, and tenant given broad latitude to inspect. Case involved undisclosed intermittent sewer gas - not size.)
The Reporter for this case was Professor Daniel Bogart of the Chapman Law School.
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