by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
randolphp@umkc.edu

LANDLORD/TENANT; ASSIGNMENTS AND SUBLETS; LANDLORD'S APPROVAL RIGHT; "RECAPTURE CLAUSE:" Clause in commercial lease permitting landlord to obtain 75% of compensation received by tenant for transfer of tenant's business is unconscionable when value in transfer does not lie in "bonus value" in lease. Ilkhchooyi v. Best, 45 Cal. Rptr. 2d 766 (Cal. App. 1995)

The lease in question was for a dry cleaning establishment in a shopping center. The point of law is somewhat obscured because the court relies so heavily on the particular facts of the case. These facts are as follows:

Tenant took over the premises originally as a sublessee. The original lease was terminated, and tenant claimed that landlord promised tenant that tenant could have the same lease. The lease that landlord presented to tenant, however, was not the same, and one notable difference was the clause in question, giving the landlord the right to 75% of amounts received in excess of the original rent, which amounts constituted

"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 . . . "

Actually, the original lease also provided for recapture of 50% of amounts paid upon transfer of the tenant's rights. The important distinction to the court seems to be the additional language that attempts to recapture portions of other payments as well. The tenant argued about elements of the new lease, and in general complained that it didn't match up to the old lease, but never hired an attorney and eventually signed the proposed lease with a few modifications not material here.

Later, the tenant proposed to transfer the business and the lease to another. The tenant proposed to sell personal property, a covenant not to compete, and other business assets, along with transferring the lease rights, and refused to share its consideration for these items with the landlord. Landlord, as a consequence, didn't approve the assignment of the lease. While things were still in dispute, landlord refused to accept a check drawn on the business account but signed by the proposed transferee. Transferee, who claimed that he had executed the check simply as an employee of the original tenant, claimed that the landlord's attitude had led him to reduce the offer for the business by $40,000.

The tenant sued for declaratory relief, breach of lease, breach of duty of good faith and fair dealing, and interference with prospective contract opportunity. The trial court found for tenant and awarded $30,000 punitive damages.

Held: No tort, no punitive damages, but the landlord's position regarding the lease clause was wrongful as clause was unconscionable, and the $40,000 reduction in price was compensable as damages for breach of lease.

The court acknowledged that a California statute altered to a degree the outcome of the famous case Kendall v. Earnest Pestana, Inc., which had held that landlords could not unreasonably refuse to consent to assignments and subleases. The statute permitted landlords to include in the lease a provision by which the landlord could recapture the "bonus value" of the lease.

The court here held that the provision in question in this case is not sanctioned by the statute because it reaches specifically beyond consideration paid for the lease and addresses instead other consideration received by the tenant for transfers of personal property and business assets that are not part of the leasehold estate. In fact, the court concluded that the lease rental was over market, and consequently there was no value payable for its transfer.

As the statute did not cover the situation, the court turned to the mysterious footnote 17 of the Pestana case, which the editor has always regarded as undercutting (for better or worse) the rationale of the entire decision. In that footnote, the court stated:

"[W]e make it clear that . . . nothing bars the parties to commercial lease transactions from making their own arrangements respecting the allocation of appreciated rentals if there is a transfer of the leasehold." 220 Cal. Rptr. at 818.

Again, however, the court concluded that this provision did not fall within the footnote, because it provided for payments other than "appreciated rentals."

Notwithstanding all of this, the court acknowledged that the overall purpose of the California legislation was to overrule Kendall on the issue of the application of the implied duty of good faith and fair dealing to express "recapture" clauses in leases. Consequently, it concluded that the landlord had not, as the tenant alleged, breached the implied duty of good faith and fair dealing in demanding a 75% share of the payments received by the tenant.

This didn't stop the court, however. It went on to analyze the offending provision as an unconscionable contract agreement. The court indicated that established common law precedent establishes one view of unconscionability to exist that might be applicable here:

"[unconscionability] has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms that are unreasonably favorable to the other party."

In this context, unconscionability has both a procedural and substantive element. The procedural element includes "oppression and surprise" disabling the contracting party from bargaining away from the offending provision, while the substantive element includes "one sided," unjustified, or "objectively unreasonable or unexpected" shifts of risk.

The court looked at special facts in this case to conclude that the landlord had attempted to disguise the provision in question in the fine print of a form lease, all the while assuring the tenant that the lease was no different from the earlier version. Unfortunately for the court's view of the situation, the tenant had in fact identified that the leases were not the same and had not taken the logical step of consulting an attorney to get a true analysis. The court then pointed out that the landlord had projected a "take it or leave it" attitude. Unfortunately for the court's view here, the tenant had not succumbed to this attitude, and in fact had refused to sign the lease as drafted, and had marked it up before signing. Notwithstanding these weaknesses in the factual support for its conclusions, the court held that the procedural requirement for unconscionability existed.

Apparently aware of the weakness of its conclusions on the "procedural" question, the court indicates that a very strong "substantive case" can overbalance a weak "procedural" case. Here, the court concludes that the landlord's lease provision was "blatant overreaching," since it already had the right to either terminate the lease or increase the rental to market upon a lease transfer. Thus, the trial court had the power to delete the unconscionable clause from the contract, and without it landlord was in breach.

As there was no evidence that the landlord intentionally or recklessly interfered with the sale of the business, the court dismissed the tort claim and the punitive damages associated with it.

Comment: Because it can be limited to its facts, this case may do very little damage. But it nevertheless has the potential of permitting parties to avoid recapture clauses in leases by recharacterizing the consideration paid the tenant as relating to some other business asset.

The best approach for the landlord is the most traditional approach - if you don't like the terms of the transfer, terminate the lease. Make your deal with the new tenant. Let the parties to the lease transfer work out between themselves who will bear any additional costs you might want to impose as landlord upon the new tenant.

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