Commercial leases often contain provisions that provide the tenant with an option to purchase the leased property upon the satisfaction of certain conditions. The issue of what constitutes the forfeiture of a tenant’s right to exercise an option to purchase a leased property was recently decided by the Connecticut Supreme Court in a decision titled Pack 2000, Inc. v. Cushman, 2014 Conn. LEXIS 137 (May 20, 2014). In Pack 2000, Inc., portions of the relevant option-to-purchase provision in the lease agreement read as follows:

“So long as [the tenant] has been in compliance with the terms and conditions of this Lease, the Letter of Intent, and Management Agreement … and is in compliance with such instruments when the option is exercised, [the tenant] shall have the option to purchase the real estate subject to this lease … The option shall be exercised by [the tenant] giving [the landlord] three months advanced notice, in writing. The option may be exercised by giving the aforesaid notice between the date of this Lease [July 25, 2002] and the fifth anniversary of [the] same.”

The tenant timely notified the landlord in August 2003 that it wished to exercise its option to purchase the real estate by a proposed date. The landlord thereafter refused to convey the property because it contended that the tenant had failed to strictly comply with the terms of certain provisions in the lease and management agreements, such as failing to timely pay rental and other payments. However, no prior default notices had been issued by the landlord to the tenant for noncompliance with the lease or with any of the other applicable agreements. The tenant subsequently commenced an action for specific performance – to force the landlord to sell the property in accordance with the lease terms. At the conclusion of the trial, the trial court ruled that the tenant had “substantially” complied with the terms of the lease and management agreements, had effectively and timely exercised its option, and was therefore entitled to purchase the property from the landlord [being that under the substantial compliance doctrine, a technical breach of an agreement is excused because the breach is considered immaterial]. The landlord appealed to the Connecticut Appellate Court, claiming, among other things, that the trial court improperly applied the “substantial compliance” standard rather than the applicable “strict compliance” standard. The Appellate Court agreed with the landlord and reversed the trial court’s decision.

The Connecticut Supreme Court was then presented with having to decide the limited issue of whether the Appellate Court correctly ruled that the lease/option agreements at issue are subject to the strict compliance standard. The Connecticut Supreme Court sided with the tenant and reversed the Appellate Court. It ruled that in the absence of express contractual language to the contrary in the lease, the substantial compliance test was properly applied by the trial court. It reasoned that there is a discernible difference between the strict compliance standard that is generally applied to the tenant’s “actual exercise of an option” to purchase – which was not in dispute – and the less stringent substantial compliance standard that must be accorded the tenant when determining the sufficiency of the tenant’s performance under the lease at the time of the exercise. For example, had the tenant failed to meet the deadline required to exercise the option, the strict compliance standard would have applied.

In reaching its ruling, the Connecticut Supreme Court underscored a few scenarios that should be heeded by any landlord who might be contemplating the forfeiture of a tenant’s option to purchase: Even if there is overwhelming evidence showing that the tenant was often tardy in making rental payments, or real estate tax payments, or hazard and liability insurance payments, or utility payments – even to the point of receiving a shut off notice – absent any action by the landlord to formally default the tenant for noncompliance with the lease or other relevant agreements prior to the exercise of the option, or absent any express language in the lease agreement (or other agreements) stating that prompt payment is an absolute condition precedent to the tenant’s right to exercise the option, the tenant’s option will be enforceable under Connecticut law so long as (1) the tenant has substantially complied with, and has not been in breach of, the material terms of the lease; and (2) the tenant’s actual exercise of the option was timely made.

The import of this case is that a landlord must not wait until after the tenant’s timely exercise of its option before raising a noncompliance argument, because as cited by the Court, “Upon exercise of the option [to purchase], the lease is extinguished and the relationship of landlord and tenant becomes that of vendor and vendee.” In that instance, a landlord cannot attempt to revive alleged breaches that had not been formally brought to the tenant’s attention during the landlord/tenant relationship, as grounds upon which to declare a forfeiture of the tenant’s option to purchase the leased property.